There was a very interesting article in Saturday's WSJ on a problem that we've noted before; namely, that the policy prescriptions of behavioral economists tend towards regulatory rather than market solutions. Hence, the oxymoron, "libertarian paternalism" advocated by BE types like Cass Sunstein and Richard Thaler.
The Journal reports that:
...while there is a lot of interest in the psychology and neuroscience of markets, there is much less in the psychology and neuroscience of government. Slavisa Tasic, of the University of Kiev, wrote a paper recently for the Istituto Bruno Leoni in Italy about this omission. He argues that market participants are not the only ones who make mistakes, yet he notes drily that "in the mainstream economic literature there is a near complete absence of concern that regulatory design might suffer from lack of competence." Public servants are human, too.
Mr. Tasic identifies five mistakes that government regulators often make: action bias, motivated reasoning, the focusing illusion, the affect heuristic and illusions of competence.
... The issue of action bias is better known in England as the "dangerous dogs act," after a previous government, confronted with a couple of cases in which dogs injured or killed people, felt the need to bring in a major piece of clumsy and bureaucratic legislation that worked poorly. Undoubtedly the rash of legislation following the current financial crisis will include some equivalents of dangerous dogs acts. It takes unusual courage for a regulator to stand up and say "something must not be done," lest "something" makes the problem worse.
As we all know, of course, I am reticent when it comes to blowing my own horn. But even so, I think it's worth noting that I was complaining about the lack of attention to the behavioral biases of regulators years ago in Mandatory Disclosure: A Behavioral Analysis, 68 University of Cincinnati Law Review 1023 (2000)
Assume arguendo that capital markets fail to produce optimal disclosure through voluntary corporate action. The mere existence of such a market failure does not—standing alone—justify legal intervention. In addition to the standard prudential arguments in favor of limited government, which counsel caution in concluding that a purported market failure requires government correction, behavioral economics itself argues against presuming the desirability of intervention:
Proposals designed to address biases generally entail the intervention of judges, legislators, or bureaucrats who are [themselves] subject to various biases. The very power of the behavioralist critique—that even educated people exhibit certain biases—thus undercuts efforts to redress such biases. In addition, the decisions of government actors also may be adversely influenced by political concerns—specifically interest group politics. Thus interventions to “cure” bias-induced inefficiency may ultimately produce outcomes that are worse than the problem itself.[1]
In other words, the claim that law can correct market failures caused by decisionmaking biases or cognitive errors treats regulators as exogenous to the system. Once the state is endogenized, however, regulators must be treated as actors with their own systematic decisionmaking biases. It thus becomes evident that behavioral economics loops back on itself as a justification for legal intervention.
A particularly trenchant objection to mandatory disclosure, for example, is that it functions in ways not unlike price controls. A regulatory regime is unlikely to peg prices at the equilibrium point at which marginal cost and marginal benefit are equal. As with any legal rule, the mandatory disclosure regime thus is likely to be under- and/or over-inclusive. Under-inclusive disclosure rules harm investors by denying them information they need. Over-inclusive rules harm investors by requiring the firm to spend money on unnecessary disclosures, which essentially comes out of the investors’ pockets. Investors presumably do not want management to engage in disclosure that produces diminishing returns; i.e., investors will not want management to spend a dollar on disclosure unless that expenditure produces at least a dollar’s worth of benefit to the shareholders. Under a regime of voluntary disclosure, management has an incentive to provide disclosure until it achieves that equilibrium. Because management’s wealth is closely tied to the firm’s financial well-being, it has an incentive to achieve an efficient trade-off between lowering the cost of capital and spending money on disclosure.[2] The government has no comparable incentive. Moreover, different firms are likely to achieve equilibrium at different levels of disclosure.[3] Hence, government regulation by definition will both over- and under-inclusive. To be sure, government could address the problem of under-inclusiveness by requiring issuers to disclose any additional information necessary to make the mandated disclosures intelligible and understandable. In determining the cost of disclosure, however, management would have to factor in the possibility of liability for fraud if they failed to disclose information a court, acting with the benefit of hindsight, thought should have been disclosed.[4] Hence management might tend to over-invest in disclosure. In any case, there is no way for the government to avoid the problem of over-inclusiveness.[5]
As a practical matter, legislators and regulators necessarily have less information about the needs of a particular firm than do that firm’s managers and directors. A fortiori, legislatures will make poorer decisions than the firm’s directors. Put another way, legislators and regulators are no less subject to bounded rationality and other cognitive biases than any other decisionmakers.[6] In the present thought experiment, regulators in our emerging capital market will observe that most developed economics have some form of mandatory disclosure.[7] Hence, the availability heuristic may skew their analysis of the necessity for mandatory disclosure, while herding could lead them to follow the example of more developed economies.
Public choice theory provides still another reason market failure is not a sufficient justification for government intervention. Again, the problem is one of treating an endogenous factor as exogenous. A welfare economics model that posits legal intervention as a solution to market failure ignores the fact that regulators are themselves actors with their own self-interested motivations. The capital, product, and labor markets give corporate directors incentives to attract capital at the lowest possible cost. Voluntary disclosure thus should be designed to meet specific firm needs relating to monitoring and information transmission. In contrast, the incentives of legislators and regulators are driven by rent-seeking and interest group politics, which have no necessary correlation to corporate profit-maximization.[8] Accordingly, mandatory disclosure is likely to be driven by the political concerns of the governmental actors drafting the mandates.[9]
[1] Arlen, supra note TBA., at 1769.
[2] See supra note TBA.. Of course, behavioral economics tells us that management disclosure decisions may depart from rationality. While this objection potentially complicates the analysis posited in the text, it is not fatal. Managerial decisionmaking biases will not disappear simply because the state adopts a mandatory disclosure regime. “If corporations habitually tend toward cognitive conservatism, overcommitment, overoptimism, and selfish inference, there is a considerable likelihood that the subjective forward-looking elements of their disclosure and publicity will have the potential to mislead.” Donald C. Langevoort, Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (and Cause Other Social Harms), 146 U. Penn. L. Rev. 101, 157 (1997). Again, behavioral economics-based arguments in favor of mandatory disclosure thus appear to loop back on themselves.
[3] Manne, supra note TBA., at 28 (“It is only logical to conclude . . . that there were competitive reasons why some firms did and others did not engage voluntarily in this disclosure” pre-1933).
[4] The hindsight bias is a well-established component of behavioral economics, positing that decisionmakers tend to assign an erroneously high probability of occurrence to a probabilistic event simply because it ended up occurring. Jolls et al., supra note TBA., at 1523. On the potential for juries affected by the hindsight bias to be too willing to impose negligence liability, see id. at 1523-27.
The hindsight bias itself may make out a case for mandatory disclosure in the following way: Suppose that an investor lost his shirt and brought an action against the firm in whose shares he made the disastrous investment. The issue is bound to arise as to whether the firm duped or inadequately informed this and other investors. In light of the fact that the losses occurred, it is not implausible assume that the hindsight bias might lead the trier of fact to find fraud by the firm, simply because the loss occurred. Ex post the loss, the disclosure is bound seem inadequate and the loss inevitable. To the extent that mandatory disclosure functions as a safe harbor against these sorts of lawsuits, the firm would prefer a regime of mandatory disclosure to taking their chances on the outcome of subsequent fraud litigation. See supra note TBA.. I'm grateful to Tom Ulen for this point.
[5] Cf. Dooley, supra note TBA., at 392 (mandatory disclosure may “inhibit the development of more efficient forms of disclosure that firms and investors would evolve if left to their own devices.”).
[6] Cf. Jolls et al., supra note TBA., at 1518 (“When beliefs and preferences are produced by a set of probability judgments, made inaccurate by the availability heuristic, legislation will predictably become anecdote-driven.”). Hence, for example, a few well-publicized securities fraud cases could result in the adoption of onerous securities regulation even if the vast majority of corporate managers are honest and trustworthy. Indeed, just such an over-reaction to the 1929 market crash probably drove the adoption of the U.S. securities regime. Cf. id. (noting “the well-known ‘pollutant of the month’ syndrome, where regulation is driven by recent and memorable instances of harm”).
[7] See OECD Principles, supra note TBA., at 19 (noting that most OECD countries have broad disclosure regimes).
[8] See Jonathan R. Macey, Corporate Law and Corporate Governance: A Contractual Perspective, 18 J. Corp. L. 185, 205 (1993) (“there is no reason to believe that politicians and bureaucrats are any more benign, selfless, and impartial than the corporate managers, directors, and controlling shareholders whose authority would be displaced in a legal regime governed by mandatory rules”).
[9] Cf. Manne, supra note TBA., at 33-36 (setting out circumstantial evidence that the mandatory disclosure regime was designed in ways that gave leading investment banking houses a competitive advantage).
