Study Helps Explain the Current Economic Crisis

Newswise — Politicians have an incentive to act in ways that benefit their re-election possibilities, and this means they may support policies and regulatory practices that are ultimately harmful to the economy.

This observation helps to explain the current economic crisis, according to Jack H. Knott, University of Southern California's Dean of the School of Policy, Planning, and Development, and Gary J. Miller, Professor of Political Science at Washington University in St. Louis, who have outlined a new theory " "trustee theory" - to explain the relationship between elected officials and government bureaucracies.

Their article "When Ambition Checks Ambition: Bureaucratic Trustees and the Separation of Powers," appears in the December, 2008, issue of The American Review of Public Administration and it provides a framework for analyzing the role of politics and professional expertise in the regulation of the economy.

"This current economic situation was precipitated by a combination of many complex factors, one of which was the way that governmental regulatory agencies came to reflect the priorities and mandates of elected officials," said Knott. "The result is that these agencies went along with policies that were ultimately harmful to the economy and the public good, departing from their role as 'trustees' of the common good."

The article argues that politicians are susceptible to what the authors call political moral hazard: the temptation for politicians to collude with private firms, groups, and individuals to benefit each other to the detriment of the broader public good. Political moral hazard can also impact economic regulatory agencies, so Congress addressed this possibility by creating safeguards such as fixed terms for agency commissioners - in addition to ensuring the traditional legislative separation of powers.

In their article, Knott and Miller develop a theory " "trustee theory" - that defines the independent role of federal economic regulatory agencies in American Government.

Under this theory, professional public agencies can act as agents of the politicians. But they also act as trustees, charged with making the tough, expert decisions that benefit the economy, even when these decisions might run counter to the wishes of politicians and interest groups.

"This isn't advocating that bureaucrats should themselves be unchecked, but they can provide a role in providing a system of checks and balances that is more relevant to the modern financial world than the one offered by our Founding Fathers 200 years ago," Miller said.

The theory applies to situations when the credibility of the decision maker " such as the elected official - is weak and subject to political moral hazard, giving opponents the opportunity to exploit this weakness to their advantage. To ensure a successful outcome, authority is delegated to a "trustee" who is able to make the tough decisions, which sometimes may run counter to the principal's wishes. An example is the decision by parents to entrust the inheritance for their children to a trustee until the children are of a more responsible age.

"Unfortunately, for several reasons, this trustee approach to economic regulation has weakened considerably over the past two decades, and especially since 2000," said Knott. "A broad political ideology in both parties and between the Congress and the president has held that all deregulation is economically beneficial. This weakened the usual check and balance of the separation of powers system. Over time politicians deregulated several industries, including deregulation of banks, investment firms, and accounting firms."

There was also a growing belief that federal government officials— bureaucrats—are the main cause of big and inefficient government, according to Knott. Both of the political parties, but especially the Republicans, sought to achieve greater accountability of bureaucrats to politicians as the path to more efficient government, he said.

"Trustee" theory provides an alternative approach to explaining the dynamics between elected officials and regulatory agencies. It stands in contrast to the "principal agent" theory, which assumes that the principals (politicians) act in support of the broad public interest. The "principal agent" theory breaks down, however, if politicians succumb to political moral hazard. When this happens, greater political control of agents (bureaucrats) can harm society, including threats to the safeguards for federal economic regulatory agencies.

An example of the "principal agent" theory's limitations is when the U.S. Securities and Exchange Commission (SEC) attempted to impose stricter disclosure requirements on accounting and investment firms in the 1990s and early 2000s. Rather than act in support of the public interest, Congressional committees opposed this action, which contributed to the abuses that led to the collapse of the Enron Corporation and WorldCom and the subsequent passage of the Sarbanes-Oxley Act.

"With deregulation of many aspects of the financial industry, the country needed strong, authoritative federal oversight and the ability to impose new regulations as abuses or threats emerged," said Knott. "Instead, the country got weak, ineffectual oversight and no ability to adapt regulation to the changing risks in the economy."

This occurred in part because of strong political ties between federal and state politicians and the deregulated firms - a situation that "trustee" theory considers as being potentially harmful to the public good. An example of the damaging consequences of collaboration between elected officials and firms is the very lax regulation of Freddie Mac and Fannie Mae, the two giant mortgage lenders. Both institutions developed close political relations with congressional committees, which prevented oversight agencies from exercising any serious regulatory authority. The president also failed to counter this political moral hazard but rather reinforced it by seeking to politically control the economic regulatory agencies. This weakened professional regulators' influence on and ability to adapt to the risks of the financial and banking industry, with disastrous consequences.

For additional information:

"When Ambition Checks Ambition: Bureaucratic Trustees and the Separation of Powers" is available at http://arp.sagepub.com/cgi/reprint/38/4/387