Checks and Balances and the Debt Ceiling Crisis

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As the country (and the world) watches the ongoing brinkman-ship over the budget negotiations and the debt ceiling, many observers are asking how it could have come this far. There are many explanations for this highly unnecessary crisis, from the surge of the Tea Party to positioning for the 2012 presidential elections. Of course, down-to-the-wire budget negotiations are nothing new to the U.S. political landscape. Most of the time the worst consequences are avoided, but sometimes bad outcomes result, such as the the 1995 shutdown of the U.S. federal government. As a consequence of that shutdown, passports and visas were left unprocessed, national parks closed, and veteran services curtailed.

There is confidence (shared by the financial markets) that a default on U.S. debt can and will still be avoided, in part because the consequences would be catastrophic. But this has not stopped extensive delays, walks away from the bargaining table and other negotiation theatrics. As in any bargaining setting, none of this is unusual.

When there is uncertainty about the resolve of the other side, delays and the willingness to walk away can credibly signal toughness. (This is well known from many negotiations, such as the NFL talks.) And when the parties finally agree after mutual damage has been inflicted, many observers wonder why they could not have agreed in the first place. Game-theoretic models of  bargaining point out that the pervasive uncertainty in negotiation agreements may be difficult to reach, as both sides believe they can reach a better deal. But the costs associated with strikes and delays also reduce incomplete information over time, making an agreement possible. That said, in many settings negotiations can break down permanently even after long negotiations.

Through its extensive set of checks and balances the U.S. Constitution was designed to force policy makers into these bargaining situations. The need to find common ground between the President and Congress aims to ensure moderate policies with broader support. Other democracies, such as Great Britain, lack this structure, as parliamentary democracies encourage unity between the executive and its supporting majority in Parliament.  There are pros and cons to each structure.

A British Prime Minister can make far-reaching decisions without periods of extensive bargaining. This was last seen in the austerity measures passed in October 2010, which implemented far more radical cuts in the UK budget than discussed in the current U.S. debate.  On the other hand, the possibility of radical change can lead to highly disruptive policy changes as different parties assume power, as seen in the waves of nationalization and de-nationalization of British industry in the 70s and 80s.

Such inefficient policy shifts are far less likely in a system of checks and balances, but in addition to the usual bargaining shenanigans known from any negotiation, there are unintended consequences  that make the current situation particularly severe. In a paper with Roger Myerson, the 2007 Nobel Laureate in Economics, we have argued that a system of checks and balance can create the incentives for Congress to create inefficient decision structures. The argument goes as follows: In a bargaining situation each chamber wants to get the best deal for its members and their constituents. By creating internal veto players that need to sign off on any deal the chamber, can secure a better outcome for itself.

We are all familiar with this phenomenon when buying a car at a dealership. The salesperson first has to talk to the boss who takes a tougher line and so forth.  In the car dealer case we may recognize these tactics as bluffs that can easily be circumvented.  A good way to counter this is to have only one person go to the dealer and then consult the absent spouse over the cell phone who, of course, is conveniently  busy and does not really want to buy the car, etc. Now we are again on equal footing. In the car dealer case we look at these tactics as bluffs lacking credibility. To give them credibility they need to be ingrained as institutions.

In Congress such internal veto structures can take many forms: strong committee chairs, a decentralized leadership, or super-majority voting rules like the filibuster in the U.S. Senate. The problem is that having more players who need to agree makes a deal less likely.  By setting up internal veto players to get the best deal each chamber creates an externality for the other chambers.  The consequences are fewer agreements, and an inability to pass tough policies and gridlock.

Increased partisanship makes this problem more severe, but not its root cause; it is a feature of our system of governance. What can be done? First, anything that creates bonds across chambers will be a positive step, whether these are joint committees or strong personal relationships. Second, voters that hold members of Congress accountable for failure to reach agreement change the incentives to engage in intransigent behavior. Third, moving from a system where all chambers have to agree with the President to one where only one chamber needs to sign off would create incentives to remove internal hurdles and lead to more efficient bargaining while maintaining the quintessential features of checks and balances.

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Political Versus Corporate Crises

Can political instinct be helpful when managing corporate crises? Not always–and here’s why.

Nowhere is effective communication as important as it is in politics. It is therefore not surprising many corporate crisis management and communications experts have earned their credentials in the contact sport of politics, whether in electoral campaigns and as spokespersons for the executive branch or agencies. Naturally, they will apply their political instincts and frameworks to the corporate world. Yet, a simple knowledge transfer can be perilous, especially in a crisis.

Among the many differences, two stand out. First, there is an important difference between the dynamics of attention in a corporate crisis and those in a political crisis. A common tactic for surviving a political crisis is to “wait it out”. In other words, media attention will soon move to a different topic, and by Election Day, voters may have long forgotten about this particular incident. The 2004 Abu Ghraib scandal, for example, played no role in the subsequent U.S. presidential campaign, and was never mentioned during the candidate debates between President Bush and Democratic challenger John Kerry.

“Waiting things out” works in politics for many reasons: Voters only cast ballots every few years, they have fewer choices on the ballot and, most importantly, voting decisions are driven by numerous considerations, including expectations about future policies and conduct. In this choice process, even a significant crisis is only one factor among many, and is perhaps only dimly remembered by voters when they cast their vote. More important, the “wait it out” approach works so well because the public pays constant attention to politicians, especially during a campaign. Since one story quickly follows another, any particular story is less likely to take firm root in the public’s imagination.

This approach does not work equally well in the corporate context because customers rarely pay a consistent, high level of attention to a company’s actions. When they do, however, they do so with heightened focus, so the impact on the company’s reputation can be profound and permanent. Imagine the Abu Ghraib scandal occurring in a prison operated by a private contractor. It is highly unlikely that the CEO would have survived such an incident.

Second, the fundamental experience of political competition is partisanship: government versus opposition, left versus right, Republicans versus Democrats. This experience is most pronounced during a campaign when for weeks and months, the gain of one side is the loss of the other. Thus, any damage to one’s preferred candidate’s public standing is immediately interpreted as the consequence of a negative campaign tactic employed by the other side. Of course, these fears are well-founded as evidenced by the history (and success) of negative campaigning. But the same dynamic is rarely at work in a corporate crisis.

Consider a familiar problem, say a recall of unsafe toys due to lead contamination used by a supplier. In this case, the toy manufacturer can expect hostile media coverage quickly followed by public concern from safety advocates, regulatory and legal action, and congressional oversight hearings. It is natural to feel attacked on all fronts, especially if the company feels it bears little responsibility for the incident. But notice the key difference when you compare this crisis to one during a political campaign: There is no “other side” on the issue. Toy safety is a universally held standard; it is not contested as the work of different political platforms during a campaign. Rather, the issue is whether the company fell short of the standard and, more generally, how toy safety can be improved—an outcome where the general public and, in most cases, the industry benefits. Using the language of game-theory, while political campaigns are zero-sum games, quality issues in an industry rarely are. While the exact trade-offs and welfare implications are complex, they typically are best understood as non-zero sum games.

A particularly tempting type of reputational challenge is an activist campaign, such as when aggressive NGOs such as the Rainforest Action Network or Greenpeace target a company for its alleged irresponsible environmental practices. Senior managers and boards frequently feel singled- out unfairly or misunderstood (and yes, this is usually the case). But even in the most confrontational of reputational challenges—an activist campaign—non-zero sum gains can be found.

One surprising instance is an analysis by my colleague Tim Feddersen and Tom Gilligan, Dean of the McCombs School of Business at the University of Texas, Austin. They argue that in industries with “credence goods,” activists can perform an important function as an information intermediary.  Credence goods, by the way, are characterized by the attributes customers care about, but that cannot be experienced in the act of consumption. Dolphin-safe tuna, fair-trade, child labor and environmental standards all fall into this category.
These attributes may lead customers to switch to competitor products, but they cannot verify such allegations on their own.  Customers need some assurance that buying the product is OK and companies are not always credible sources of such information. Why not? Because providing the standard preferred by concerned customers is typically more expensive. So, profit-maximizing firms have an incentive to conceal the facts of how the product is provided. Even if they tell the truth, they may not be believed. This “profit paradox” creates the need for trusted intermediaries that can be filled by the media and even activists. Feddersen and Gilligan show that the presence of such activist intermediaries can be welfare enhancing.

In a current project with my Kellogg colleague David Besanko and Northwestern economics graduate student Jose Abito we show a different mechanism where activists can create welfare improvements. The idea of the model is to show that companies that have an incentive to invest in their reputation for corporate citizenship will eventually have an incentive to “coast”, i.e. invest less and less as their reputation for social responsibility grows. I will discuss these ideas in a future posting. Stay tuned!

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