Political Power: Who Makes the Call?

Last week saw the FASB proposals for some modest adjustments in the mark-to-market rules.  We were on the road for a campus guest lecture, trying to do a little giving back.

The coverage of this was amazing.  Seeking Alpha had a block of stories, all Editors' Choices. They all were very opinionated and critical about the decision.  Apparently Seeking Alpha could not find anyone who thought it was a good decision, since there were no Editors' Choices in support.  Bloomberg and other MSM sources bemoaned the "political pressure" on FASB.

These commentators all need to go back to school.  We have so many blogging economists now.  Why can't we get some help from some blogging political scientists or public policy types?

There is no subject where the gap between the self-perception of knowledge and the actual understanding is so great.

Let us try some examples.

How Experience and Education Colors Advice

Let us take a problem like environmental policy.  Let us further suppose that you had our job, teaching young people about these issues.  Your team included an economist, a scientist, and you.

Would it surprise you to learn that the economist favored a free-market solution with minimal regulation?

Would it surprise you to learn that the scientist thought that all pollution was bad?

The public policy problem is one of reconciling competing viewpoints and finding outcomes that generate something good for society.  (Defining this is difficult, so books are written about it.  Defining the public interest is beyond our scope.  For the moment, let us just accept that there is a  broad public interest, and it would be good to find it.)

On the environment, the solution might be a recognition that driving pollution to zero is too costly.  We might recognize that some firms can improve more readily than others.  The trading of "pollution rights" was an idea from the 70's and we are still debating it now.

Please note well that there is no criticism of either the economist or the scientist.  They are very intelligent and have great knowledge.  They are smarter and know more than most of those pundits evaluating their comments.  They are good!  The problem is that they see the world through their own experience.

We need a broader viewpoint.

Let's try another example, one that is familiar in the decision-making literature – the Cuban Missile Crisis.  Briefly put, the US discovered that the Russians were building missile bases 90 miles from our shore.  It was a challenge that could not be ignored.

A team of advisors presented information and options to President John F. Kennedy.  For those of us who are old enough to remember, this event was the closest we came to nuclear war.  It was important.

(An aside — Art Cashin uses this as a training story, since he was then a rookie trader.  The question was how to trade the crisis.  The answer was to buy, since if it was not solved, trading longs would not matter!)

The Air Force advisors recommended a "surgical air strike."  Further evaluation showed that the strike might not be as precise as hoped.

The Army thought that an invasion of Cuba was called for.

The Navy recommended a blockade, preventing further delivery of missiles and material.

The State Department sought a political solution.  They thought that the Russians were bargaining about Berlin.  They suggested that we might give up our Turkish missile bases, something that was no longer really relevant for US strategy.

Political advisors thought that a quid-pro-quo in Turkey would be a sign of weakness.  If we did this, it should be through a back channel.

Please note that all of these advisors were very intelligent and had great knowledge.  They were all good — very good!

The public policy problem was to reconcile the differing advice.  The actual decision — a "moving blockade" giving Khrushchev time to respond and to allow the back channel to work –is hailed as an example of excellent Presidential decision making.  We did not go to war, and the missile bases were removed.

Implications for FASB

So what does this have to do with the Financial Accounting Standards Board (FASB) and the mark-to-market decision?

The first thing to understand is that the SEC, which has the decision about where to vest accounting rules and oversees FASB, is not a branch of government, like the Supreme Court.  It is an Independent Regulatory Commission.  There is insulation from normal politics, since it is not wise for routine politics to govern accounting rules.  The SEC must have at least two members from each party in a five-member commission.  The President has the power to appoint, but not to fire members.  There is significant insulation from routine politics, but it is not like the Supreme Court.

The Problem

The mission of FASB is accounting.  The intelligent and expert members of this group make very good decisions, but they look at the world from the perspective of accountants.  They want to force companies to reveal information to investors.  It is their mission, and they do it well.

The current problem is that FASB instituted FAS 157 at the worst possible time.  It was a new rule and probably a good one.  The implementation of this rule led many accountants to take the most conservative view of assets held by financial institutions.  While the rule provided some flexibility in implementation, most accounting firms in the post-Enron era chose a conservative course.  Many had the government-dictated death of Arthur Andersen and the loss of accumulated partnership interests at the forefront of their thinking.  Why take such a risk?

Meanwhile, the problem was much broader than the accounting question.  The new rules might have been implemented quite safely a few years ago.  Accountants could learn the rule and also the exceptions.

Instead, the implementation came at the worse possible time.  The forced write downs of assets contributed (did not cause, but contributed) to a death spiral.  Capital was subtracted from firms faster than the government could add TARP money.  Private capital was frightened away by the threat of further write downs.

Some misguided pundits and bank analysts have seized upon the continuing losses as evidence that they were right.  In fact, the rules were designed to make them right.  Had the rules been addressed in a timely fashion, the death spiral might have been stopped.

Enter Congress

Many in Congress noted that there was a wider public interest, something extending beyond the strict notion of accounting rules.

Congress, as part of the original TARP legislation, mandated a study of these rules within 90 days.  Former SEC Chair Christopher Cox and company conducted the study.  There was plenty of evidence, including some from us.  The Cox group made a finding, just before the door hit them on the way out.  Their conclusion was that the FAS 157 rules were not that important for bank failures.  This conclusion, an official finding by the SEC, is rightly viewed as biased by many of us.  It is nevertheless cited by many in supporting the current rules.

Unhappy with this outcome, a sub-committee of the House Financial Services Committee held hearings and expressed some displeasure.  There was some tough questioning of SEC and FASB leaders.

Is this political pressure?  Of course.  It is a completely appropriate exercise of Congressional oversight, warning FASB that thei
r viewpoint was too narrow for the circumstances.

There is absolutely nothing wrong with this Congressional action.  There was not even any legislation — just some nudging in a public hearing.  This is precisely what Congress should do — focusing attention on the broad public interest.

The Outcome

The result of this political "pressure" was a very modest tweak to the FAS 157 interpretation, much less than many thought was needed.

The pundit reaction to this has not been accurate.  Various opponents of change claim that FASB caved in to political pressure.  This is an easy story for journalists to write and for pundits to criticize.  None of them exhibit any understanding of how the American political system works.  They are writing to a receptive audience, which shares their pre-conceptions about how government should work.

We are still awaiting the actual new guidance from FASB, but it seems to be pretty tame.

The delay in addressing this issue has been a failure of the political system, which moves slowly and must deal with those in power.  Had the issue been raised eariler, or if the crisis had come later, the outcome might have been quite different.


We have had many emails from accountants.  Please note what we are not saying. Accountants are  intelligent and serving their mission.  Like the Air Force in the Cuban Missile Crisis they are good — very good!

The problem is that their perspective is too narrow.  We need rules that provide information to investors without crippling the US economy.  Since concern about declines in regulatory capital is not their defined mission, they do not make it part of their decision.

FASB is not elected by anyone.  FASB should not run the economy.  That is what we mistakenly allowed to happen.

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  • Russ Wood April 9, 2009  

    Prof wrote:
    “The implementation of this rule led many accountants to take the most conservative view of assets held by financial institutions. While the rule provided some flexibility in implementation, most accounting firms in the post-Enron era chose a conservative course. Many had the government-dictated death of Arthur Andersen and the loss of accumulated partnership interests at the forefront of their thinking. Why take such a risk?”
    I continue to believe that Sarbanes Oxley, which made over-optimistic estimates a criminal offense, regardless of intent, is the main reason for the overly conservative implementation of accounting rules. No amount of tweaking of FAS 157 can remove this risk to corporate executives.
    However, the Prof is correct that it is in the public interest to improve the FASB rules. At a time of unprecedented intervention by Congress into the daily decision-making processes at public corportations, it seems silly for critics to say FASB bowed to pressure from Congress to relax rules on corporations. Congress is tightening their grip on corporations, not relaxing it.

  • Mike C April 9, 2009  

    Excellent food for thought, and from a perspective I wouldn’t have normally considered. That’s why I read regularly, even though we often disagree.
    Your point is well taken that those from different backgrounds all of whom are intelligent and knowledgeable can have different opinions and “solutions”. Still, I would think there are “more right” and “more wrong” solutions that “are what they are” rather then the result of interplay of political negotiations.
    A blogger you and I both read recently posted that accounting rules don’t affect cash flows, and investors are not stupid. They will apply a substantial haircut to the book value of companies where the financial assets are being valued in a less then accurate and transparent manner.
    I really don’t have a strong opinion on this issue because it is definitely outside my “happy zone”. However, there are a few “pundits” (some of who have strong academic credentials) who unlike most have generally been dead on accurate with respect to the economy and stock market the past 18-24 months who lay out specifics of what they think should and should not be done.
    It would seem to me that from a broader economy/public policy perspective the regulatory capital issue could be addressed separately from the marking of the “toxic” assets. Still, a spade is a spade, and if institutions are essentially insolvent, then covering our eyes and pretending otherwise just probably delays and stretches out the inevitable.
    Some would suggest we are just playing “hot potato” here, and that many of these issues are just playing games on the periphery, and that the real fundamental issue is that debt which is essentially not able to be repaid at current levels must be restructured in a way that allows realistic levels of cash flows (such as incomes for wage earners) to actually be able to service that debt on an ongoing basis. Everything else is just a bunch of heat not producing useful work.

  • Jeff Miller April 9, 2009  

    You are correct in spotting the pattern. No attention to a potential problem, a crisis or big event, over-reaction. It is not just political. It is human nature.
    Thanks for taking time to comment.

  • Jeff Miller April 9, 2009  

    Mike C — I agree about the regulatory capital issue. Frankly, anything that allowed normal and sensible lending would be a big help, as I have often written.
    As to the academic experts who have been so right — Some of them advocated pumping money into banks or nationalizing instead of dealing with distressed assets. This was a stop-gap and a source of delay. The wrong-headed public policy about distressed assets and the decision to allow Lehman to fail both helped to make these predictions come true.
    The key question is whether those who correctly predicted this are lucky or good.
    Some of them are now contending that any opinion they ever had on any subject has been proved correct. Does this make any sense?
    Just wondering….

  • Mike C April 15, 2009  

    “The wrong-headed public policy about distressed assets ***and the decision to allow Lehman to fail both helped to make these predictions come true.***
    The key question is whether those who correctly predicted this are lucky or good.
    Some of them are now contending that any opinion they ever had on any subject has been proved correct. Does this make any sense?
    ***Just wondering….***”

    Since you are wondering… 🙂
    Just an opinion, but I’m skeptical of the view/thesis that what we’ve seen unfold in both the global and U.S. economies and stock markets the last 12 months is *mostly* a result of wrong-headed public policy about distressed assets and the Lehman decision (although that may have exacerbated the situation). I think it was inevitable, although getting the timing right was tricky and many looked like stupid “permabears” for a long time (where is the line between being early and being wrong, I do not know).
    “and the “very poor track record” of Jeremy Grantham.”
    I think the Hyman Minsky view that “stability is unstable” captures the reality of what has happened more accurately. What did we have? Unsustainable debt levels across the board (consumer credit, mortgage credit). Too much leverage (IBs at 40:1 leverage). Corporate profits at an unsustainably high percentage of GDP (and some had repeatedly pointed out that profit margins are the most reliably mean reverting item in capitalist economies). Stagnant wage growth with consumers going into debt and relying on MEW to make up the difference in their living standards and consumption. Residential housing prices at bubble levels. Substantial imbalances in exports/imports.
    I think it was just a matter of *when* not if the entire artifice came crumbling down, and if it wasn’t Lehman that set the ball in motion, it would have been something else on a slightly different timeline. The unsustainable cannot be sustained indefinitely.
    In 1998-2000, we had a *stock valuation* bubble. With the S&P 500 at 25-35x earnings, anyone with a brain and a smidgen of knowledge of history recognized that. In my view 2005-2007 was *much trickier*. We had a *credit bubble” where the second derivative effects were a *global economic activity/corporate profits* bubble and thus gave the illusion of cheap stock valuations. Few recognized this and those that did generally were ridiculed and derided.
    I think we are in transition mode now to something that hopefully is more sustainable in the long-term (the next decade+, lower debt levels, lower consumer spending, more saving, affordable housing relative to wages, etc.), and hopefully public policy decisions ease that transition so that we do not overshoot and have GD2. I don’t think anyone wants that except uber-bears who want to see the world implode and cash in, but I think there are very legitimate arguments/points that concern me that we are going in the wrong direction on public policy, and this is way too important to get wrong.
    “But I can live with $50 trough earnings, say many. And at historical multiple of 14-16 times trough earnings, the S&P should stop its downside in the 700-800 range. But the point is, they’re not trough earnings, ****they are the “new normal.” ***And in the current “slow” (zero or worse) growth environment, a trough P/E of 6-8 times earnings is more likely. Put another way, we are about to get the worst of all worlds; below trend earnings, below trend growth from a depressed base, and below trend P/E, after having gotten the best of all worlds, astronomical P/Es on above-trend and rapidly growing earnings, about a decade ago. Warren Buffett now agrees, saying that we will get “almost the worst of all possible worlds…”
    The bears-turned-bulls have taken the latter stance because the market now reflects at least a severe recession. One such commentator likened the recent market to 1938-1939, and feels that the latter represents a bottom. But the 1930s bottom was 1932, not 1939, which is to say that the market probably has further to fall. Having correctly dodged the “overvaluation” bullet earlier, the new bulls pin their hopes on the prospect that the current market represents everything bad short of the 1930s Depression. Unlike us, they aren’t willing to grasp the nettle that the current crisis will likely be as bad as anything including the Great Depression.”

    To your other points, I absolutely agree that just because someone might have gotten certain aspects of what has unfolded correct, that certainly doesn’t mean they are omniscient on everything else. I think your “happy zone” idea is applicable.
    As to the key question of lucky versus good, I don’t think one can generalize across everyone. No doubt, some were lucky. Others like Grantham clearly outlined well in advance in archived writings what the issues were (home prices, credit bubble) and how it all would end, although obviously they were early by a few years (lesson to self is NEVER underestimate how far an unsustainable trend can go before it finally ends). I’m not sure how any unbiased lookback could conclude anything but good/solid analysis that got it right but with poor timing.
    At this point, all that is history, and my primary concern is forward analysis (although I think revisiting the past is useful just like sports teams watching game film to see where mistakes were made), and it seems to me the million dollar questions are “what is normal”, “what is sustainable”. What are sustainable debt levels? How much deleveraging must occur? What are sustainable corporate profits to get a handle on whether the market is actually CHEAP or just fairly valued?
    FWIW, I want to close with reiterating that I find your commentary useful and valuable which is why I am a regular reader. One of the reasons I leave lengthy comments like this is that writing forces one to think about and sharpen one’s own views and it is the dialogue and pushback that creates further sharpening. An echo chamber where everyone agrees 100% is not useful at all, especially if “everyone” is holding on to the wrong view.