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The Perennial Crisis in Governance

Raj Nallari's picture

What do we learn from the troubles of Goldman Sachs, British Petroleum, Enron, Satyam, and other modern day corporations? These are the most sophisticated corporations ever formed yet victims of their own governance failures.


Public sector governance problems are known from time immemorial. The first description of governance problems of the state in the form of bribery, corruption, and other mis-governance is attributed to Patanjali who lived in India around 53 A.D. Corporate governance problems are relatively recent. With the industrial revolution came the need for a corporation to organize and manage capital and labor. The Board of Directors by law is given the full authority in a corporation. In the initial days of industrialization, the family-owned corporations had family members on its Board. However, over time as the corporations became more complex, the management team of chief executive officers and financial officers have managed to gradually erode the power of the Board and made the Board an ‘overseer.’ This is the problem of principal-agent, where the agent (management team) usurps power from the principal (Board of directors and share holders). Even this function of overseeing has been diluted because of complexity of business transactions and provision of inadequate and often ‘obfuscating’ information by the managers. In addition, more and more Boards are stacked with ‘insiders and friends.’ As a result, we have reached a stage in several ‘big and small’ corporations where there is a crisis in corporate governance. The recent financial crisis is but one manifestation of this corporate crisis, where complexity is deliberately created under the name of financial innovation, just to deliberately obfuscate information to Board of directors, stakeholders and public at large.

The financial crisis has unveiled not only the complexity of mortgage backed securities and credit default swaps but the opaqueness of information and greater ability of banks and financial firms to obscure developing problems and taking of exorbitant risks due to the lack of internal controls, and due to ‘greed and fear’ and destabilize the entire financial and economic world. Boards have to re-assert their authority and focus on ‘managing the managers’ and assessing and managing risks to the corporations, share holders and general public. The shadow financial system that was developed prior to the recent financial crisis in US is an extreme example of how to obscure risks, with the alleged consent of internationally-reputed accountancy firms and credit ratings agencies.

The crisis in corporate governance is compounded by the public sector governance, where politicians and bureaucrats ‘kow tow’ to the large corporations. How else can one explain, the former US Treasury Secretary, Hank Paulson, calling his former colleagues from Goldman Sachs, three times more often in the days prior to the run-up to the collapse of the Lehman Brothers in September 2008, which triggered a financial meltdown first in US and later in Europe. How else can one explain, the rush to convert investment banks to commercial banks in a matter of hours, so as to facilitate these large investment banks to access the large ‘bailout’ facilities from the US federal Reserve and US Government at little or no cost to these corporations?

State capture could be defined as the efforts of affluent individuals or groups, private firms, or oligarchs, to shape the laws, public policies, rules and regulations of the state to their own advantage. This ‘shaping’ may be done not only by the private firms or richer elites (top 20% on the income distribution scale) but in some countries by ethnic groups or powerful economic groups. As such, to fully understand the dynamics of state capture, the analysis must be based on winners and losers not only in terms of income groups but also in terms of powerful groups and vested interests, including bureaucracy. In other words, state capture and re-distributive conflicts are part of the same spectrum of good-to-bad governance. In almost all the countries this argument of state capture by a small group of corporations or elites appears to hold because these elites have been colluding with politicians and with the help of bureaucracy extracting rents rather than investing in productive activities (which Eifert et al 2006 call ‘low-level political equilibrium’). The only difference in ‘weak states’ of several low-income countries is that private sector is uncertain that the state being weak can ensure ‘rents extraction’ and therefore the private sector in such countries will try and avoid tax payments and do not undertake investment (as the future is uncertain), In contrast, stronger states, despite rhetoric of ‘limited government’ and ‘constrained executive’ such as in OECD countries, tend to have higher revenue/GDP ratios and invest in public goods because elites in these countries are confident that rents can accrue to them now and in the future. Private investment and growth is higher in stronger states that in weaker states and garnering of subsidies by the elites is relatively lower.

Countries that are ‘highly captured’ may exhibit capture of all or most institutions, such as parliament, political parties, the executives including ministries and public enterprises, judicial courts, and bureaucrats. The capture may take place jointly or separately depending upon the economic interests of the powerful groups or elites. Firms and groups that cannot compete with favored-firms or accommodated-groups, will go under or have no choice but to resort to ‘informality’ or ‘unofficialdom’ and ‘shadow financial system’. By choosing to be in the ‘shadows’, these informal enterprises are able to circumvent government regulations relating to property rights, labor laws such as minimum wages and workers’ safety restrictions, environmental regulation, price controls, and licensing, as well as avoid taxes and fees. To avoid the costs arising from detection and punishment for operating informally (usually illegally), the big corporations and informal enterprises operate through ‘trust’ in the form of transactions, based on reputation, amongst closed networks of customers and suppliers.

The above discussion provides a brief overview on state capture and the close association between public and private sectors, the ongoing collusion and obfuscation by both the sectors in developed and developing countries. What are the possible solutions? Stay tuned!
 

Comments

The perennial crisis in governance includes probably you and me too Mr. Raj Nallari… especially since it is not limited to traditional forms of corruption but includes intellectual corruption too, and we all fall often for the convenience of some all-solving dogmas. Indeed, much more dangerous than the capture of individual corporations and of individual sovereign states, is the capture of global regulatory entities like the Basel Committee, and whose utterly wrong or outright stupid financial regulations, I hold as the single most important cause for the current financial crisis. In 1999 I wrote the following: “The possible Big Bang that scares me the most is the one that could happen the day those genius bank regulators in Basel, playing Gods, manage to introduce a systemic error in the financial system, which will cause the collapse of the OWB (the only bank in the world) or the financial dinosaur that survives at that moment.” And 2002-2004 as an Executive Director I questioned, formally, over and over again, the excessive role assigned to the credit rating agencies, and the capital requirements that were biased against risk taking when risk taking is the oxygen of any development, and the weak financial models used when evaluating risk …all to no avail… and so let me ask anyone here (privately between you and I)…are you absolutely sure you have not been captured yourself? http://bit.ly/bIAyup

Submitted by Jayan on
I posted this question a few days back on the factual correctness of the line below "The first description of governance problems of the state in the form of bribery, corruption, and other mis-governance is attributed to Patanjali who lived in India around 53 A.D." But, my comment never got published nor was there any response with a clarification. So, I choose to post this comment again on this blog hoping that it will be published / facts are updated accordingly in the post. From research, Patanjali probably lived around 150 BCE or 2nd c. BCE and never wrote any political / administrative treatise.

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