Thursday, 1 December 2011

New Governance Research - Your Questions Answered

by Professor Simon Deakin, Programme Director CBR.

1. Why is governance research of interest at the moment?

There is a growing realisation that markets need governance and they need regulation in order to work. There is not a straightforward conflict between markets and governance; markets need governance and we have to get governance right. Policy makers and social scientists realise that if we want to make a market economy work, producing a competitive national economy and sustainable companies, we need to think about governance. The term governance includes regulation and law, but also self-regulation by industry and through contract. We need to look at how self-regulation by the industry works and how that fits together with the legal system - these are critical issues.

2. Was the financial collapse of 2008 a defining moment for governance?

The debate about governance goes back further to the financial crisis of the early 1990s. Financial crisis does make people think hard about governance systems. Back in the early1990s the response to the financial crisis then was not to halt the wave of privatisation and deregulation which began in the 1980s, but to harness the forces of the market, particularly the capital market, along with self-regulation by industry, to the goal of better governance. This was the emerging model of corporate governance. It produced some good results but that particular model has probably exhausted its possibilities. The idea that shareholders will perform a monitoring role and that the capital market will work efficiently to allocate resources has failed. The financial crisis of 2007 and 2008 was not only not prevented by shareholder monitoring; there is also quite a lot of evidence that the excessive focus on short term shareholder returns was responsible for aspects of the financial crisis. We need to think about a new paradigm for corporate governance after the crisis.

3. What areas of governance work will the Centre for Research be looking at in the future?

The really critical issue for us now is whether institutional investors and other shareholders can support investment in other long term projects which are needed to promote a competitive economy and sustainable economy. This means pension funds in particular thinking about their contribution to complex long term projects that involve innovation, are risky, but are vital to the long term competitiveness of the UK and other economies and also for long term sustainability. Can we set up an investment regime that enables long term risks to the environment and social risks to be internalised and factored into these decisions? This is a critical issue for us.

There are many things we can do to create an investment climate that would make this possible. We need to think carefully about company law, and also about aspects of tax law, and we need to think about the way that pension funds are structured and governed. We need to think about the role of boards of directors and also about employee voice and the voice of other stakeholders in corporate decision making. We need to look at how other countries do this, at mainland Europe and in particular Germany, and also Japan, which has a corporate governance system different to ours, and which has arguably produced better results, greater competitiveness, and more successful manufacturing innovation. We also need to think about the strengths and weaknesses of the American model which has produced Silicon Valley and the financing of innovation through venture capital.

4. Is there too much regulation for business today and are there new ways of looking at these same problems in organisations?

There is no such thing as "no regulation". Sometimes we say that governments should intervene or the legal system should do something, as if there was no regulation or governance in the first place. In fact there is no situation in a modern market economy where there is no regulation. The legal system provides a basic framework of property rights and contract rights which are needed for the market to function. The State, the government, or the legislature has to regulate to deal with externalities and market failures, and if we don't do that, markets won't work. The issue is always: can we regulate effectively and properly? That means identifying what regulation by government can do and what self-regulation by industry can do.

We need to think about the link between government action and self-regulation and the constitutionality and legitimacy of self-regulation by industry in a situation where much of what industry does produces both costs and benefits for third parties. Should the voice of those third parties be factored into industry self-regulation? If we don't get this right then there will be serious regulatory failures, which means that the public or collective goods on which we all depend for markets to function just won't work, they won't deliver.

There is never "too much regulation", it is not something you can measure in this sense. It could be that for a particular firm there is sometimes too much regulation, but if you deregulate in one area you are redistributing the regulatory burden onto somebody else. If we say firms are regulated too intensively in the labour market and there needs to be deregulation of employment law, then the burden of that deregulation will simply fall on third parties, possibly other firms, and other workers who are not receiving skills training, for example. Consumers may be adversely affected by deregulation of product markets, so again there is no such thing as reducing the overall "burden" of regulation; the distribution of that "burden" is a critical issue. The question for government and the issue for us is: what overall mix will work for the good of the economy and hence the general interest?

5. How can what you call 'institutional design', improve social and economic wellbeing, and can we really measure equality?

We can measure some of the effects of regulatory interventions through statistical analysis and also through more qualitative fieldwork-based research. The purpose of focusing on 'institutional design' is to point out that many of the benefits of free markets only come about because institutions have been designed in order to make it possible for the self-interest of workers, employers and consumers and others to be reconcilable with the overall general good. The market is itself an institution which is partly the consequence of deliberate design and partly the result of an evolutionary or spontaneous process. We ignore at our peril the role of conscious design of the institutions that make market economies work, and this is what the phrase 'institutional design' is getting at.

There is a very important issue here about how much inequality a market system can wear. For the past 30 or 40 years most economists were worried about too much equality in markets, they were worried about the effects of progressive taxation blunting incentives and the effects of job protection regulation. We can now see that deregulation and reregulation of the labour market has produced more inequality, and the results of that inequality are now to be seen in the under-utilisation of capacity in the economy. There is a waste of resources implied in casual employment, and low pay, because employment like that does not generate investment in skills and capacity. Inequality hurts the market economy at a fundamental level, and that is why many social scientists are now thinking about the costs of inequality when they think about institutional design.

Part Two:

6. Why are you looking at complex infrastructure projects are the problems of governance more difficult to comprehend and enforce?

A complex project like Heathrow Terminal 5 is governed by the set of contracts put in place by the main client and the various tiers of contractors and subcontractors. These contracts are a mini constitutional code for that project. The contracts set out the terms upon which the different parties will deal with each other. They also set out the terms upon which risks and costs are allocated between the parties, and, critically, they put in place procedures and processes for dialogue between the parties to resolve them in a way which will allow the different stakeholders to make an input into decision making.

Terminal 5 was successful not just because it was well designed by far sighted people, but also because of processes put in place for dialogue and deliberation between the different stakeholders. Talking and communication between the parties really helps to ensure that coordination in a very complex project like that works in reconciling the different interests, in resolving problems and in allocating risks.

T5 is a great example of industry self-regulation. This wasn't done by the government or by the legal system coming in, it was done by industry itself learning from its past mistakes. The construction industry learnt from its past mistakes with the Wembley Stadium Project and the Jubilee Line extension project. These lessons were embedded through the learning process in the contractual design of T5. This is a great example of what can be achieved. It is also a good example of patient long term investment by the City in the Terminal 5 project. When it was being set up, the main client BAA, effectively sold the idea of this huge capital investment project to its own shareholders on the basis of the long term returns they would get. In the UK context, it is a myth that we always think of the short term; capital can be "patient", it can be stable and long-term.

We can be like Germany or Japan if we want: we can incorporate some of the good aspects of their systems. We don't necessarily need government to tell us how to do it, but the wider lesson of T5 is that some of the successes of that project were not sufficiently well embedded for them to be repeated on a continuing basis. This is where government can come in and can capture the wider benefits of projects likeT5. It can help embed this learning into longer lasting enduring institutions - this is the facilitative role of the State.

7. Can Capital have human characteristics?

We need investors to factor in long term costs and benefits more effectively than they currently do. At the moment a lot of investment is short-term, shareholders often do benefit from short term share price movements. Much of it is churning, a lot of it is about decisions taken in milliseconds by computers about whether to buy or sell shares. This is fine, this will always go on in the City and there is some benefit in terms of liquidity to be had from these processes, but we also need the other type of investment, where investors understand and factor in not just long term costs, but also the benefits of long term projects like T5. There is a lot of evidence that we don't do enough of that long term planning at that investment stage in the UK.

8. Do innovative enterprises require specific State frameworks to work in or should they operate without regulation?

Innovation is based on learning, and learning is an evolutionary process whereby we learn from our failures and we embed that learning in institutions, and then the benefits are more widely spread across the whole economy. That is what we mean by institutional learning. It is not the State dictating the right answer to industry, it is industry learning from its own experience what the right answers might be, and the State assisting by disseminating that learning, often through putting incentives for disclosure in place. We may need more disclosure, but we also need to encourage deliberation and dialogue. So there is a division of labour between the State and the private sector: they need each other to make this work, it is not a simple question of the State versus the market.

9. Should Pension Funds be encouraged to invest in infrastructure projects?

Pension Funds must invest for the very long term because their beneficiaries want to be receiving their pensions in twenty or thirty years' time. On the one hand, they should have a natural long term focus because of this, but on the other hand they also have short term pressures, they have to balance risk and returns over both the short term and the long term, and it would be naïve to believe that just because the beneficiaries of a pension fund themselves have long term interests, that those long term interests are automatically, costlessly and seamlessly translated into action by those pension funds. It is not an easy set of choices for pension fund trustees or the asset managers who they empower to take decisions on their behalf to make. So what we need is a system whereby there is better information exchange and there is more disclosure, but also more transparency about long term benefits and costs. Pension fund trustees have a fiduciary duty to get the best return for their members after taking account of risk and a need for diversification, so government should not dictate how or where they can invest. However, the government can say to pension funds: it is in your enlightened long term interest to support an innovative and competitive British economy as well as investing globally; you need to do both. At the end of the day the beneficiaries of these pension schemes are British workers and British households with insurance policies and saving policies, and UK governments have an interest in getting pension fund governance right as part of ensuring a sustainable and competitive British economy.

10. Why do knowledge intensive labour markets need regulation? It is going to be very hard to pin down what belongs where? Isn't it in a global world?

There is already regulation of labour markets both nationally and globally, but often the regulation doesn't work. We have a big problem with casual labour and self-employment, so how do we regulate to avoid that? How do we create the conditions for self-employment to be a pathway to entrepreneurial activity for many individuals, but also for self-employment not to be abused or mis-used for tax avoidance and casualisation? This is a very difficult set of problems.

There may not be a straightforward answer to this, but my point is that there is a public interest in getting this right. The way we regulate low paid employment, what rules we have on dismissal, how we tax employment: these all have critical implications for firms and for workers. It is not just a question of firms versus workers. Both employers and employees have an interest in creating a situation where we can invest in capacity, we can invest in human capital, we can invest in skills and training, and often that can only be done by getting the regulatory framework of tax law and employment law right.

At the moment in the UK we are having a big debate about unfair dismissal - on the one hand it is probably the case that some aspects of employment law give rise to an excessive amount of paperwork and procedure for firms, but on the other hand, we don't want to create a situation in which we entirely lift the so-called burden of regulation for firms, as that would be a further invitation to the casualisation of employment. The result of casualisation would be less investment in human capital.

11. Is a cross disciplinary approach important to the work of the CBR and if so why and how are you going to set about it?

We at the CBR are bringing to the social sciences what the sciences have always done. There is an appreciation in physics and chemistry and biology and the engineering disciplines that real progress is made in interdisciplinarity, so we have to bring together the insights of different disciplinary teams. In our case it means bringing together the insights of economists, management specialists, sociologists, and legal specialists, they all have knowledge and combining that knowledge is not an easy task. They should be working together, with deliberation and dialogue between the different disciplinary teams to get value-added from the research.

12. You will also be creating new data sets at the CBR for the analysis of legal and institutional phenomena, why are these datasets of importance?

We have been creating new datasets and that means a lot of survey work, interview work and collating data about trends in the economy concerning corporate governance and small and medium size enterprises in particular. We are also creating new data and measuring for the first time things which often haven't previously been well measured. Thus one of the things we have done through the use of innovative methodologies is to try to quantify institutional phenomena like the rules made by legal systems. We are trying to get a better grasp quantitatively of how legal rules work in practice, through a combination of legal analysis, survey work and economic statistical analysis. This is a new area of social science that we have called 'leximetrics' to signify the use of quantitative methodologies originally pioneered in the hard sciences and economics to understand legal phenomena. The underlying approach that we have taken here is to say that we cannot very well understand these complex institutional phenomena without getting a better quantitative and statistical grasp of how they work. We need to apply some of the techniques of the mainstream sciences to get a better understanding of how they operate.

13. Is there going to be new Governance regulation that takes into account the global world and new technology?

There are some difficult questions about the relationship between technology and the regulatory or institutional environment. We are living in a context where markets change very quickly. Technology reshapes the entire structure of markets, so established markets, like media markets, are "merging" because of new technologies derived partly from the internet. We see market barriers breaking down and existing patterns of economic relationships fundamentally changing. When that happens the regulatory framework has to adjust. It isn't a question of it being endlessly flexible as it has to provide a stable framework for economic activity, but it has to be capable of adjusting to these very turbulent technological conditions. So a lot of this is about learning again.

We need to study and understand from technologists themselves how the particular features or structures of a given technology, like the internet, shape economic relationships and create new opportunities but also new blockages and new distortions. The technological requirements, which are initially often only understood by engineers, create new market structures which then become an issue for wider economic and social analysis. We can bring together computer scientists and engineers who have this knowledge of the way certain technologies work and we can then put that knowledge to use in the context of economic models and social models which explain how regulatory systems work. At the CBR we are bringing together these different disciplinary approaches to get an integrated understanding.

14. Can new operating frameworks increase co-operation and stability across disciplines and across borders on governance issues and thereby improve effectiveness for firms and workers?

This is what economists call a "collective action problem". Sometimes people know what they should do but it is not in the interests of any one individual or group to do what is necessary, creating a "tragedy of the commons". Often we end up with a less than ideal situations because what is needed is political action or regulatory intervention or maybe the action of an influential player in a particular market to move things along, but there is no guarantee that this will happen or we can get to the right answer even though we can all where we might want to get to. This is the situation we are now in. We have had a financial crisis; we are living in a period of technological turbulence where market boundaries are shifting all the time. There is an ever greater need to understand what is possible through institutional design to solve "collective action problems". This means we need more social science research to understand these issues.

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