THE BLOG
10/13/2015 01:49 pm ET Updated Dec 06, 2017

How Thin Political Markets Undermine Democracy: An Interview With Harvard B-School's Karthik Ramanna

By Christian Sarkar

With his forthcoming book - Political Standards - Harvard Business School's Karthik Ramanna develops the notion of "thin political markets" to describe a key problem facing technical rule-making in corporate accounting and beyond. When standard-setting boards attempt to regulate the accounting practices of corporations, they must draw on a small pool of qualified experts--but those experts almost always have strong commercial interests in the outcome. Meanwhile, standard setting rarely enjoys much attention from the general public. The reliance on nonindependent experts and the absence of accountability, Ramanna argues, allows corporate managers to game the system. What can be done to alleviate the situation?

Let's start at the beginning. What caused you to get interested in this topic?

For the last ten years, I've been engaged in evaluating our system of accounting rules. I studied numerous accounting issues largely outside the public's attention, such as accounting related to mergers and acquisitions, related-party transactions, and foreign currency translations.

I also studied the rule-making process in various jurisdictions - the United States, China, India, and the European Union. Three basic findings emerged.

First, on any given specific accounting issue, there are a usually just a handful of individuals - somewhere between five and 50 people in the world - that are truly experts on the subject. These individuals are also usually the people with the strongest concentrated commercial interest in the outcome.

Second, the "rules of the game" that emerge from the political process are subtly but in significant ways tailored to favor these experienced few that really understand the issue.

And third, there is no villain in this story. There is no one person or group or organization that one can point to and say, "There's the problem; that's the institution 'capturing' the system." Because nobody is really an expert on and deeply interested in everything. The outcome of the political process looks like a quilt of special interests.

Experts show up when they really understand the issue at hand. And when they show up, there is often nobody sitting across the table from them supporting an alternative. So, not surprisingly, they get their way - the rules subtly favor their interests.

These three findings provide an insight into the nature of the accounting system underlying our modern market economy - an insight into the nature of capitalism's plumbing. And it appears that accounting rule-making is a patchwork of various informed interests seeking their own ends. But there is another conclusion from this investigation - the problem in accounting foreshadows a broader problem with how some of the most critical institutions of capitalism are determined. I call this the problem of "thin political markets."

What is a thin political market?

A thin political market, at its essence, has two basic features. The first is that a concentrated commercial interest, also known as a "special-interest group," has deeply relevant expertise on the issue at hand. Put differently, there is a co-location of interest and expertise in the political process.

This is the case with the investment banks in an area like Merger & Acquisitions accounting for example.

The second is that the public interest - also known as the "general interest" - is diffuse. It is diffuse because the specific issue at hand has a small individual impact on each member of the public. It is also diffuse because the issue at hand is not salient in the public's mind. It is not a hot, current-affairs topic like Medicare or Social Security.

Instead, it is a "boring" topic like accounting rules - one doesn't often encounter dinner party conversations lamenting the state of accounting rule-making.

How does a thin political market undermine capitalism?

In a thin political market the source of big players' expertise - the source of their knowledge advantage - is experience based. This means that the knowledge they bring is tacit or implicit rather than codified or explicit.

If you look at a classic collective-action situation, we've learned to reduce the threat of big players capturing regulations by bringing in outside experts who don't have strong commercial interests in the outcome. In a thin political market, however, such experts don't exist.

In thin political markets it is impossible to separate commercial interest in the outcome from relevant expertise to determine the outcome.

Another distinction is that thin political markets occur in areas of low salience with the general public.

The capture of regulations by big players (or special-interest groups) is a threat in many areas of public governance, but a relatively higher awareness among the public of this possibility induces intermediaries such as politicians or the media to act as safeguards for the public interest.

The collective result of these conditions is that the informed few in a thin political market get to shape the rules of the game. If our market system is operating such that our accounting and auditing rules are being gamed by a few key players, then collusive and manipulative outcomes are likely. Under such circumstances, rather than creating total wealth, markets simply serve to reapportion wealth from uninformed to informed players.

How is this problem going to be fixed? What can or must be done?

The oddity about thin political markets is that the various individuals, firms, and organizations that dominate thin political markets - the informed special-interest groups - are acting in a way very much consistent with what one would expect of good capitalists. They are acting in ways to increase their own profits.

The players embody what modern economic theory considers the role of the firm in capitalism. They embody the spirit of Milton Friedman's famously influential call-to-arms - "the social responsibility of business is to increase its profits."

The problem, of course, is that for profit-increasing behavior to be legitimate and desirable - for profit-increasing behavior to generate aggregate prosperity and wealth - we must have a competitive process.

No one individual, group, or organization can dominate the outcome. But thin political markets, by definition, are one-sided. In such situations, expert special-interests can shape the rules of the game unopposed.

Can this sort of behavior possibly be legitimate? Can this behavior possibly represent what Milton Friedman and others behind the development of modern economic theory had in mind? No!

So, how do we solve the problem? The first step is reexamining the curriculum in our nation's business schools and economics departments.

Although some academics recognize that profit-seeking alone cannot be the purpose of the corporation, the teaching of economics, finance, and corporate strategy remains largely uninfluenced by this view. In fact, in our classrooms, by largely focusing on the mechanics of profit seeking and by ignoring the conditions under which profit seeking makes sense, we give legitimacy to the idea that profit seeking is all that matters.

Deepening the curriculum in our colleges and universities is one way to engage the next generation of business leaders in conversations about around the ethics of capitalism and profit-seeking. We must move away from the unidimensional view that the only thing a capitalist must do is pursue profit. As we see in thin political markets, such an objective can erode the structure of capitalism itself.

Beyond curricular reform, in the book, I discuss several practicable mechanisms that can be introduced in thin political markets:

First, managers lobbying in these political markets should be encouraged to publicly recognize their agency responsibility to the system. They should be encouraged to assert under penalty of liability that they are representing the public interest in their lobbying. This is akin to a professional oath a doctor is expected to take before being credentialed. This might seem like a superficial or an ineffective step, but research has shown that getting individuals to explicitly recognize their responsibilities can have a significant impact on their behavior.

Second, a group of subject-matter experts - e.g., academics, retired corporate executives, and retired regulators - should be invited to evaluate outcomes in various thin political markets. In accounting rule-making, Such a review will no doubt be imperfect, not least because the experts will be at a knowledge disadvantage relative to the insiders who shape outcomes in accounting rule-making. But the review will nevertheless shed some light on the political process and can serve as a follow-up accountability mechanism for managerial lobbying. If the results of such a review are publicized in civil society, managers and rule makers engaged in narrow capture will be at least subject to some reputational costs.

Third, managers identified as exhibiting public leadership in thin political markets should be publicly felicitated. Doing the right thing in thin political markets will seldom yield direct monetary rewards, so it is incumbent on us to find other ways to reward such leaders. Social recognition can play an important role in stimulating competitive individuals to achieve their best. On this front, business schools agian have an important role to play. Just as industry titans are heralded in business school classrooms for their commercial acumen, so too must they be celebrated for their public leadership when setting the rules of the game.

Let's go back to Milton Friedman.

Friedman himself was very careful to acknowledge that his clarion call to profit-seeking in business had its limits. In his iconic and immensely influential book, Capitalism and Freedom, he argued that every business should pursue profits "so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud."

But, from time-to-time, certain corporate managers have seen it within their purview - their "social responsibility" even - to manipulate the very definition of profits in the spirit of increasing profits (e.g., by changing accounting rules). This is a serious misunderstanding of capitalism, and we've got to get this to change.

Thank you. We look forward to your forthcoming book - "Political Standards."

Karthik Ramanna is an associate professor of business administration at Harvard Business School, where he has also held the Henry B. Arthur Fellowship, an appointment supporting the research and teaching of business ethics, and a Marvin Bower Fellowship, an appointment to help faculty launch innovative new research agendas.

Related Posts:

- Move to Amend: We the People, Not We the Corporations

- The Decline of the Middle Class: Stealth Governance and Income Inequality

- Can We Fix Income Inequality?

- Fix Capitalism - Join Us!

Christian Sarkar is an artist, activist, and entrepreneur. He is the founder of the $300 House Project and manages a marketing consultancy in his spare time. He is the co-author of Inclusivity: Will America Find Its Soul Again?

FIXCapitalism.com is dedicated to saving Capitalism from itself. Visit us at www.fixcapitalism.com to join the debate. Follow us on Twitter and Facebook.

Sign up for our newsletter to get more insights.