Preventing economists' capture

By Luigi Zingales     
June 17, 2014

From: Magazine

Late Chicago Booth Professor (and Nobel Laureate) George Stigler pioneered the concept of regulatory capture. In simple words, regulatory capture exists when a regulatory agency, created to act in the public interest, ends up advancing interests of the industry it is charged with regulating. Since Stigler, when economists talk about regulatory capture, they do not imply that regulators are corrupt or lack integrity. In fact, if regulatory capture were just due to illegal behavior, it would be easier to fight. Regulatory capture is so pervasive precisely because it is driven by standard economic incentives, which push even the most well-intentioned regulators to cater to the interest of the regulated. 

These incentives are built into their positions. Regulators depend on the regulated for much of the information they need to do their job properly, and this dependency encourages regulators to cater to the regulated. The regulated are also perhaps the primary audience of the regulators, as taxpayers and other citizens have much less incentive to monitor regulation, and generally remain ignorant. Hence the regulators will tend to perform their job with the regulated, rather than the public, in mind, further encouraging the regulators to cater to the interests of the regulated. Finally, career incentives play a big role. The regulators’ human capital is highly industry specific, and many of the best jobs available to them exist within the industries they regulate. Thus, the desire to preserve future career options makes it difficult for the regulator not to cater to the regulated.

If these are significant reasons regulators are captured, it is not clear why we economists should not be similarly susceptible to capture.  

For example, while not all data used by economists are proprietary, access to proprietary data provides a unique advantage in a highly competitive academic market. To obtain those data, academic economists have to develop a reputation that they treat their sources nicely. Hence, their incentives to cater to industry or to the political authority that controls the data are similar to those of the regulators. 

Second, outside of academia, the natural audience of academic economists’ work is either business people or the government officials applying some of that knowledge. Support among these two audiences and the popularity of a piece of research gives credibility to it and the person who did it. Even if no researcher purposefully caters to business or the government, this selection will ensure that the most popular and successful researchers will be those who cater to business or the government. 

Finally, academic human capital is highly specific. Opportunities in consulting and careers outside of academia are not equally distributed. Economists who cater to business interests clearly have a larger set of opportunities.

Another, more subtle source of bias arises from the publication process. In economics, authors cannot submit their work contemporaneously to several journals, and manuscripts are subjected to many lengthy revisions. This extenuating process maximizes the power of the editor vis-à-vis the author. Thus, if a few editors are captured, this effect spreads out through the entire profession. 

Most academic economists are honest people, who chose their career because they are motivated by noble goals, like questing for the truth, or making the world a better place. Yet, the same can be said for the regulators. 

To help prevent capture, I propose several remedies. 

Building a wall of shame

A very useful self-defense against lobbying pressure is adherence to principles. Principles force economists to be coherent through time and through situations. While not all economists adhere to the same principles and we cannot certainly expect that they will, the coherence with some principles, whatever they might be, is useful. Judges, for example, motivate their decisions on the basis of legal principles and precedents. While they have the flexibility to adapt the principals and the precedents to a particular contingency, nevertheless legal principles and precedents tie their hands.

In the same way, if economists had to justify on the basis of principles and data all their major public-policy statements as well as their expert testimony, they would be less malleable to industry pressure. This defense would be enhanced if they could be shamed by colleagues on the adherence to these principles. An economist who always opposes government intervention, but then makes an exception when the government bails out a certain industry where he has a direct interest, could be easily exposed to public ridicule.

Shaming is a public good, at least as far as good shaming (i.e., the shaming aimed at keeping people honest) is concerned. When it involves politicians and celebrity, it can pay off commercially (think about the program “Keeping them Honest” run by CNN). 

But when it comes to economists, this hardly seems a viable commercial enterprise. For this reason, this wall of shame should be organized by a professional association or some public-interest nongovernmental organization.

Ideally, this wall of shame would penalize economists who compromise their principles for money or make major mistakes. For example, in years past many famous economists wrote papers commissioned by Fannie Mae and Freddie Mac. In some of these papers, they went as far as to say, “This analysis shows that, based on historical data, the probability of a shock as severe as embodied in the risk-based capital standard is substantially less than one in 500,000—and may be smaller than one in three million.” Still, the authors do not seem to have suffered any consequence for these wrong statements. In fact, one of these authors was promoted to director of the office of management and budget and later hired as vice-chairman of global banking at Citigroup.

To facilitate public shaming and make it more difficult for economists to be captured, it will be useful to mandate the disclosure (possibly with a delay) of expert-witness testimonies, even when a case settles. Knowing that testimony will be read by colleagues and checked by students will increase the reputational cost of lying. The possible delay will protect the expertise of the academic from being immediately diffused,
but it will not prevent the reputational cost of defending positions most academic economists would consider untenable.

Forcing more disclosure

The beauty about empirical research is that you never know what you’ll find. In fact, the surprising results are the most interesting ones. This is precisely the risk companies do not want to face. Thus, when they disclose data, they generally disclose it with some strings attached. One common string is that they can prevent the publication of the data if the results are damaging to the company. Even if there is not an explicit agreement of this type, there is often an implicit agreement in this sense. Knowing the cost of getting the work buried, researchers do not even look where potential problems can arise. Hence, they only look for certain results.

If everybody knows that is the case and is able to properly discount this important selection, it is not a problem. If I can only report when a coin flip yields a tail, others can easily infer when it yields a head, as long as they know how many times I flipped the coin. If only tails are reported and published, but I do not know how many coin flips have taken place, then it is much more difficult to infer the proper picture of the underlying phenomenon, especially when some economists will dare to say that “tail” is an established fact, since all the published papers agree that coin flips yield tails.

How to avoid this severe distortion? By imposing two disclosure requirements at the submission stage. The first is a disclosure of the type of agreement with the company that provided the data at the time the data were granted (or the permission to conduct the filed study was granted). While the disclosure of explicit agreements cannot prevent implicit agreements to the contrary, a proper formulation of the contract can make them more difficult.

The second disclosure is the number of related studies that were conducted but have not been published. This is tantamount to disclosing the total number of coin flips, so that other researchers can correctly infer how many times the results turned out in an “undesired” way. 

Another way to reduce this potential distortion is to increase the disclosure requirements and to create more public datasets. It is not a coincidence that the emergence of the efficient-markets hypothesis in finance, which was strongly at odds with the interest of the financial industry, coincided with the creation of the Center for Research in Security Prices at Chicago Booth, which gave access to data to all researchers.

A new governance for the publishing market

In economic and financial journals, editors hold a lot of power vis-à-vis academic authors, especially untenured authors. A rejection of a paper after three rounds of revisions can easily make a difference between promotion and not. Most editors do not abuse this power. Nevertheless, their power creates a dangerous scope of abuses, since editors are likely to have interests outside of academia. Suppose I am advising Microsoft in its antitrust litigation, how likely am I to publish a paper showing that Microsoft abuses its dominant position in the operating-system market? One could argue that a smart researcher will know of this potential bias and submit the paper to another journal. Yet, this information is not publicly disclosed and only people “in the know” might find out.

Even if the editor is an honest person and will give the paper a fair chance, he or she is likely to shape it in a way that downplays disturbing results. Editors’ advice during the last round are rarely ignored by authors, especially young untenured ones. For most it is just too costly and risky to start from scratch.

To eliminate this potential distorting power, I suggest a few reforms in the governance of the publication process. First, economic journals should open up to competition, as law journals do. It is ironic that a profession that touts the benefits of competition limits it when it comes to the submission process. Contemporaneous submissions will reduce the power of the editors, to the advantage of the authors. For this reason, it is unlikely that this reform will start from the journals themselves.

The second element of the reform consists in allowing the authors to post online signed rejection letters. Journals insist that rejection letters are their sole property and they are sent to authors for their eyes only. Authors, thus, do not own the copyright. If rejection letters are kept confidential, editors’ reputation is unaffected, even when they make egregious rejection mistakes. If authors can post rejection letters, they can embarrass the editors when they make mistakes, especially when the mistakes seem to be driven by outside interests.

The last element of my reform will impose more rigid restrictions for editors. They should receive higher compensation from the journal, but commit not to do any other job outside of teaching. This restriction should hold not just for the period of their editorship, but also for two years after. While imperfect, this revolving-door policy can limit the most egregious cases of conflict of interest.

More diversity challenges conventional wisdom

In the 1950s and 1960s, Harvard Business School recruited its faculty from among the most talented analytical MBA students in the United States. Starting in the 1970s, the rise of big consulting companies and their competition for talent started to deprive HBS from its natural pool: those analytical MBAs with high social skills. As a result, the school started to recruit among PhDs from other academic institutions. There are generally two characteristics of PhDs: they are smart and they tend to lack social skills. They are smart, because otherwise they never would have entered a PhD program. They lack social skills, because otherwise they never would have chosen to enter a PhD program: smart and socially skillful people make much more money in the industry. 

When they ran out of talented American PhDs (because many moved to the industry), HBS and many other schools started recruiting foreigners. There are several ways in which diversity in backgrounds and the presence of faculty with social handicaps help reduce the degree of capture. A lack of social skills makes a person less suitable to an industry job, reducing the value of what business has to offer down the line and thus reducing a possible channel of capture.

Similarly, diversity of backgrounds can be beneficial in several ways. First, diversity forces people to challenge the conventional wisdom and gives them a broader perspective, making social pressure and environmental capture less likely. Second, foreign-born faculty may not be easily employable due to US employment laws, reducing this channel of capture. Third, people with dual citizenship have two communities in which they can be captured. If the interests of these two communities are not perfectly aligned, this multiple potential capture can generate competition, reducing the power of each individual captor.

In this respect, the internationalization of the academic market is positive because it facilitates the debate among academic groups influenced by different interests. Once again, competition among these different groups leads to a more efficient outcome.

Acknowledging the dangers is the first step

Shortly after the Greek debt crisis in May 2010, I spoke with a high-level official of the European Central Bank who was in charge of monitoring the market. We discussed the potential cost of having let Greece fail. The crucial question was how the debt holders of other sovereign debt would have reacted to a default of Greece. I agreed that that was the crucial question, but I raised concern that some market-makers had a vested interest in spreading the perception that the consequences would be disastrous, so that the ECB would intervene, reducing their losses. 

“I am aware of this bias,” said the ECB official, “And every day when I talk to market participants I try to undo it. Whether I am successful in fully undoing this bias remains an open question.”

Academic economists’ awareness of the risk of capture is the first line of defense. It might not be sufficient protection, but it is certainly a necessary one. Without this awareness, any other initiative is hopeless. Unfortunately, my experience talking with colleagues is that this sense of awareness is missing. There is a diffuse perception that we are different. While a simple application of economic principles, like I have done in this article, shows that we should be no different than regulators, we are unwilling to admit it. Until we are ready to do so, any other mechanism to prevent capture will be useless.

Adapted from Preventing Regulatory Capture: Special Interest Influence and How to Limit It, edited by Daniel Carpenter and David A. Moss. Copyright 2014 The Tobin Project. Reprinted with permission of Cambridge University Press. All rights reserved.