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.

Takeaways

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.