If Bankers and Politicians Were Angels

The financial crisis in the United States and the domestic corruption in Spain have in common a certain prejudice against the interests of stockholders and citizens, due to CEOs who don’t have to contend with a system of checks and balances in their organizations.

What do the financial scandals of the U.S., which have unleashed the global economic crisis, have in common with the political corruption scandals that have caused the majority of the societies of Eastern and Southern Europe to fall below countries such as Chile, Botswana or Qatar, in terms of their international ranking as examples of good government?

The most common factor on either side of the Atlantic is “the greed of a few.” This is a very useful argument for the politicians. It gives a good impression in political meetings when one can pontificate about how greed is a result of the idolization of the forces of the unregulated market or the culture of “making the big sale.” What’s more, by appealing to natural human greed, politicians can propose the easiest possible solution to the electorate: greater public regulation (more administrative procedures and more detailed records of the activities of all types of institutions, both public and private) and more public committees to exert external control over institutions that are seen as potentially dangerous. Let’s send more public resources to the regulatory agencies of the financial institutions and to the offices of the prosecutor or to anti-corruption agencies.

However, there is reason to doubt that this growing industry, based on public control, actually functions well — if we refuse to consider, of course, that those who support such a system stand a better chance of winning elections. On the one hand, studies on political corruption show that neither increasing the number of administrative procedures (to carry out any economic activity, public or private) nor creating specific agencies to fight against corruption have any significant positive effects. For example, the majority of countries with low levels of corruption have no agencies dedicated to fighting corruption, nor did they have them when they were actively combating corruption.

On the other hand, if we analyze the banking scandals that have affected so many American banks, we see that the origin of those scandals isn’t so much due to the absence of regulatory agencies — we all know that it’s always possible to find creative ways to bypass almost any type of regulations — as it is to the excessive tolerance to risk shared by the boards of directors of some financial institutions. Executives have made (or have tolerated their subordinates making) high-risk decisions that they would not dare make with their own money. But these were the savings of the stockholders. In other words, an alternative reading of this whole financial crisis reveals a systematic abuse of stockholders’ interests in the institutions affected by the executives in charge of those very same institutions. These people knew that they wouldn’t pay the full consequences of their actions, and they played with fire or, in this case, with junk mortgages.

Therefore, there is something that the private-sector American institutions — those responsible for the financial crisis — have in common with public-sector institutions — those responsible for political corruption in Southern and Eastern Europe: That is an abuse of the interests of the stockholders (considered investors, first, and citizens, second) on the part of some boards of directors (executives and elected politicians, respectively) which are not limited by checks and balances within their own organizations. Both types of institutions suffer the so-called “Madisonian Dilemma.” It was James Madison, one of the Founding Fathers of the American Constitution, who established this classic formulation of the problem: “If angels were to govern over humans, neither external nor internal controls on the government would be necessary. In designing a government of man over man, the great difficulty rests in this: First you have to train the government to control the governed, and second, you have to obligate it to control itself.” The work of contemporary social scientists, such as Gary Miller, show that all governments — in the public sector, as well as the private — have to deal with this dilemma. The governors of any organization, independent of the regulations we impose on them from the outside, will always have the opportunity to trade on their own autonomy. For example, taking advantage of the fact that they know more than the stockholders, private executives can acquire an extra car (or jet) and charge it to the company, or they can expose the stockholders’ money to a high-risk proposition in exchange for a bond. And public governors can always construct a highway or a sports center over and above what’s really needed, or offer a favored contract to a friend, while disguising the transaction as something perfectly legal. Miller and others have come up with a solution to minimize the opportunism inherent in such executive positions: Create a relative level of conflict at the top of these organizations. Make it so that people with differing interests have to come to an agreement in order to make the most important decisions, those that could lead to a greater abuse of the interests of the stockholders.

In the private sector, this is what happens in those businesses where there is a chairman of the board who is independent of the chief executive. This separation of interests (or, at least, the existence of these two positions, independent of one another) is customary in European businesses and financial institutions. In the U.S., on the contrary, the norm is to have the same person occupy both positions, and this could explain why the great majority of financial scandals have occurred in that country. Many chief executives control, at their pleasure, the very regulatory bodies that ought to be controlling them. As stated in The Economist, one of the first reforms adopted by the American banks most affected by the crisis (such as Citigroup, Washington Mutual or Wells Fargo) has been to separate the position of chairman of the board from the chief executive. That is the same demand being made by one of the most prestigious groups in the world, the Norwegian Norges Bank Investment Management (NBIM): If you want us to invest in you, you need to separate those positions in order to avoid the accumulation of all the power in the same hands.

In the public sector, the example, par excellence, of a separation of powers is the federal government of the U.S. Designed by thinkers, such as Madison, conscious of the fact that governors are not angels, a sophisticated system of checks and balances assures us that the most powerful politician in the world (the president of the U.S.) will have less opportunity to benefit himself from corrupt activities than any regional or local politician in a country, such as Spain, a truth we see borne out on a daily basis.

Different versions of the Madisonian system of the separation of powers in the top echelons of public organizations has been implanted in Western administrations, which are now less corrupt. In many local and regional American governments (or in Northern Europe), elected politicians monopolize positions in what is the equivalent of the administrative council in a business (as in a plenary or area committees) and some professional managers who, at times, come from the private sector, take over positions on the board.

As in the “good businesses” of Europe, the chairman of the board (mayor, perhaps, or the highest political representative) is not, at the same time, the chief executive officer (the highest public manager). Just as politicians who are bound to their party have to be in agreement with managers who have different interests (some worried about their reelection and others about their professional reputation), the possibilities of carrying out corrupt activities through collusion are reduced to a minimum. To the contrary, in local and regional governments (and, in some cases, even in the central government) in Eastern and Southern Europe, something is happening similar to what happened in the “bad businesses” of America: The chairman of the board (mayor or regional conciliar) is, at the same time, the only and all-powerful chief executive officer. The interests of the stockholders (that is to say, the citizens) are left, then, unprotected, because the same hands (or those of the same party) make decisions that leave the greatest margin for abuse, such as the construction of a cycle track or the organization of the visit of the Pope.

In summary, what we need to bring up for serious debate on both sides of the Atlantic is the matter of internal organizational change and not only the issue of external controls. Europeans, as well as Americans, can learn a lot from one another. Europeans can learn how to better create an effective separation of powers in the higher echelons of public organizations, and Americans can learn how to do the same in the private sector. Since neither bankers nor politicians are angels, let’s not give them the freedom to act as though they were divine beings.