6 December 2019
By Anat Admati
Author’s note: This essay is based on a speech I gave at the Stigler Center 2019 Conference on Political Economy of Finance. Whereas the content refers to my experiences as an academic with expertise in finance and economics, the key ideas apply to other areas in business schools and beyond. I hope colleagues will reflect on the harm from silos and on our opportunities as academics to benefit society.
There is absolutely no way to understand events before, during, and since the financial crisis of 2007-2009 while ignoring the powerful political forces that have shaped them. Yet, remarkably, much of the economics and finance literature about financial crises focuses on studying unspecified “shocks” to a system that it largely accepts as inevitable while ignoring critical governance frictions and failures. Removing blind spots would offer economists and other academics rich opportunities to leverage their expertise to benefit society.
Commenting after the American Economic Association’s annual meeting in January 2017, The Economist urged economists to engage in deeper self-reflection and stated that economists must take politics into account to be relevant and useful. At the end of his recent book Crashed: How a Decade of Financial Crises Changed the World, which emphasizes the geopolitical context of events in recent decades, historian Adam Tooze laments the narrowness of economics. He quotes economist Abba Lerner, who famously said in 1972: “Economics has gained the title Queen of the Social Sciences by choosing solved political problems as its domain.”
The history of financial economics is revealing in this regard. By the second half of the 20th century, when modern finance emerged as part of economics, the holistic approach of early thinkers such as Adam Smith—which combined economics, moral philosophy, and politics—was long gone. Narrow social-science disciplines replaced the holistic approach by the end of the 19th century. In the 20th century, economists sought to make economics formal, precise, and elegant, similar to Newton’s 17th-century physics.
The focus in much of economics, particularly in finance, is on markets. Even when economists postulate a “social planner” and discuss policy, they rarely consider how this social planner gets to know what is needed or the process by which policy decisions are made and implemented. Collective action and politics are messy. Neat and elegant models are more fun and easier to market to editors and colleagues. In my first 25 years as a finance and economics academic, I had virtually no engagement with political economy.
Everything changed for me, professionally, after the financial crisis of 2007-2009. The crisis led me to wonder how financial markets could cause such havoc and why they needed such extraordinary government interventions. Staying initially within the academic debate, my frequent co-author Paul Pfleiderer and I proposed a way to address claims in the literature about the potential usefulness of debt for corporate governance while making banks safer. The idea was clever and based on economic concepts and insights, but our paper had no fancy mathematics or data. (A modified version was later published in a law review.) In the economics and finance academia, we realized, one cannot get any engagement on important corporate governance and policy issues without appearing “scientific” through symbols, tables or graphs.
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In the real world, it turned out, important economic outcomes are often the consequences of political forces. During 2010, people within regulatory bodies told me privately that false and misleading claims were affecting key policy decisions. They urged me to help clarify the issues and I felt compelled to become involved. Despite years of research and advocacy, however, flawed claims persist and still have an impact. (A recently updated document lists and debunks 34 such claims.)
Many of my experiences in the last decade, which involved extensive interactions outside as well as within academia, were sobering. I saw confusion, willful blindness, political forces, various and sometimes subtle forms of corruption, and moral disengagement, first hand. The harm from economists ignoring political economy became increasingly evident. There was no way for me to return to ignoring the issues.
It was also impossible to explain my experiences using economics alone. In writing an essay in 2016 for a book on Finance in a Just Society edited by a philosopher, I went beyond economics and finance and drew from scholarship in political science, law, sociology, and social psychology. My essay was entitled “It Takes a Village to Maintain a Dangerous Financial System.”
Sadly, among the enablers of our inefficient and distorted financial system are economists and academics. Perhaps most shocking, a fallacious claim about the impact and “cost” of more equity funding, which contradicts basic teachings in corporate finance, has been included in many versions and editions of banking textbooks authored by prominent academic and former Federal Reserve governor Frederic Mishkin. (See Section 3.3 here or Chapter 8 of The Bankers’ New Clothes.)A risk manager in one of the largest banks, whom I met in 2016 at a conference attended almost exclusively by practitioners and regulators and who had dropped out of a top doctoral program in finance, quipped in an email after quoting from an academic paper: “with such friends [as academics], who needs lobbyists?”
Lobbyists, who engage in “marketing” ideas to policymakers and to the public, are actually influential. They know how to work the system and can dismiss, take out of context, misquote, misuse, or promote research as needed. If policymakers or the public are unable or unwilling to evaluate the claims people make, lobbyists and others can create confusion and promote misleading narratives if it benefits them. In the real political economy, good ideas and worthy research can fail to gain traction while bad ideas and flawed research can succeed and have an impact.
Luigi Zingales highlighted political economy issues within our profession in a 2013 essay entitled “Preventing Economists’ Capture” and in his 2015 AFA presidential address entitled “Does Finance Benefit Society?” Zingales notes and laments a pro-business and pro-finance bias within economics and finance and the pervasive blindness to issues such as corporate fraud and political forces. “Awareness of the risk of [economists’] capture is the first line of defense,” he writes in his 2013 essay. I agree that the issues are real yet often denied or ignored, and that recognizing problems is essential for addressing them.
Governance and political economy challenges are pervasive beyond banking, where I encountered them so clearly. For example, corporate governance research, including my own coauthored papers (in 1994 and 2009) on shareholder activism, has focused almost exclusively on conflicts between shareholders and managers, effectively assuming that competitive markets, contracts, and laws protect everyone except for the narrowly-defined “shareholder”—who is implicitly assumed to own only one corporation’s shares and to care only about the price of those shares.
Having observed governance and policy failures in banking, I realized that the focus on shareholder-manager conflicts is far too narrow and often misses the most important problems. We must also worry about the governance of the institutions that create and enforce the rules for all. How power structures and information asymmetries play out within and between institutions in the private and public sectors is critical.
A 2017 Journal of Economic Perspectives Symposium on the modern corporation includes an essay I wrote on the distortions that arise as a result of the focus in corporate governance on financialized targets that purport to capture “shareholder value” when combined with political economy forces that can lead to governments failing to set and enforce proper rules. The symposium also includes an essay by Luigi Zingales on how political and market power feed off each other. We both noted that more public awareness and understanding of these problems is essential for addressing them.
Economists and academics have numerous opportunities to be helpful by looking more frequently out of their windows, expanding their domain beyond “solved political problems,” collaborating across disciplines, and bringing back a more holistic approach to their work. Small changes in this direction are starting to happen, as the Stigler Center’s conferences on the political economy of finance show, but we can and should do much more.
Numerous research topics are ripe for more study by theorists and empiricists. Within the following long list of topics (still a partial one) there are low-hanging fruits and more challenging problems that may require interdisciplinary reach and which tenured academics are in a particularly privileged position to take on: whistleblower policies, the impact of consumers, employees, and politicians on corporate actions, accounting rules for derivatives, the effectiveness of boards, audits and auditors regulation, the design of bankruptcy laws, money laundering, corporate fraud, the organization and pricing of deposit insurance, debt subsidies, the role of financial literacy and ideology in policy discussions, the structure and governance of regulatory agencies and central banks, lobbying of multinational corporations, the governance of international bodies such as Financial Stability Board, Basel Committee, and IMF, and the political economy of corporate enforcement.
Engaging with policy issues in our research and teaching, and even engaging in advocacy when appropriate and effectively lobbying on behalf of the public (for example by writing comment letters or opinion pieces) can be valuable and important. Policy involvement, however, requires not only disclosing potential conflicts of interest but, most importantly, scrutinizing research carefully to ensure it is adequate for guiding policy. A problem I have become acutely aware of is that economists and others can be cavalier in claiming that research is relevant for real-world application without such scrutiny.
As a theorist, I know models have unrealistic and sometimes stylized assumptions, yet models can bring important insights, and theoretical and empirical papers that capture key features of the real world can be useful for policy. It takes a big leap of faith, however, and can actually do more harm than good, to claim that models whose assumptions greatly distort the real world are adequate for real-world applications. Specific examples are discussed in the first paper I wrote with Peter DeMarzo, Martin Hellwig, and Paul Pfleiderer (Sections 5-7), the omitted chapter from the book I wrote with Martin Hellwig, Paul Pfleiderer’s paper on the misuse of models in finance and economics (which starts with the old joke about the economist assuming a can opener on a deserted island and, among other things, compares economics and physics) and a recent presentation by Paul Pfleiderer that discusses the role of assumptions in theoretical and empirical research and which includes great visuals.
The key takeaways if research is claimed to be relevant for the real world are:
- Just because a model claims to “explain” something in the real world does not give it logical or actual validity. Even if we may never have the data to be able to reject a model, there are ways to apply casual empiricism (“if this model was true, we would observe x and we don’t”), and we must be especially careful if a model contradicts other plausible explanations for what we see. (Consider: “cigarette smoking improves people’s health” as an “explanation” of why people smoke.)
- Just because a model can be “calibrated” does not give it logical or actual validity.
Applying inadequate economic models to policy in the real world is akin to building bridges using flawed engineering models. Serious harm may follow.
We can also enrich our teaching and connect more dots for our students by developing interdisciplinary courses and by bringing out the bigger picture, at least occasionally, in teaching standard courses. For example, basic corporate finance courses show how to calculate the debt tax shield, and we should point out that there is no good reason for the tax code to subsidize debt relative to equity and that this tax code can create distortions. We can also ask whether shareholders as individuals actually want a company in which they hold shares to pursue “positive Net Present Value” projects that involve pollution or deceptive marketing of harmful products.
Many students are anxious to have such discussions. There is a broad sense today that standard business practices and dysfunctional governments have exacerbated economic, social, and political problems. We must find ways to broaden the discussion beyond our narrow lanes. Academic silos are part of the problem, and we should break them to be part of the solution.
Finally, we can and should engage in trying to ensure that governments and other institutions serve society. If only conflicted experts engage in the process of creating rules, especially on important issues that appear technical and confusing such as accounting standards or financial regulation, we get what Karthik Ramanna calls “thin political markets” and our assumptions about markets are more likely to be false. Academics may be in the best position to inform policy, expose flawed or poorly enforced rules, and help hold power to account. We cannot assume others will be able or willing to do it without our help.
Governance and politics are key to outcomes everywhere. Related issues about power and control and about the respective roles of governments and private sector institutions are playing out prominently today in the technology sector. A course I taught recently about the internet allowed me to compare and contrast the finance and internet sectors. The Stigler Center has laudably been informing policy related to digital platforms.
In a recent Harvard Business Review piece, I argue that business schools should practice and promote “civic-minded leadership” much more than they currently do. (The text is also available here.) I hope more academics and academic institutions recognize and embrace the great opportunities we have to try to make the world a better place.
Republished from ProMarket.