Sunday, February 20, 2011

Over-regulated

When the financial crisis hit, certain segments of the intelligentsia found, as they always do, that they were right. They had considered that the financial markets were a free-for-all where the only law was the law of the jungle.

When people started asking what had gone so grievously wrong, this group readily explained: the markets lacked sufficient regulation.

For people who did not trust markets to begin with, the crisis of 2008 was an intellectual windfall.

Those who had a low opinion of markets had a lower opinion of human nature. They did not see humans yearning to be free, but they saw only the dark side of the human spirit.

To them, humans were driven by an impulse to lie, cheat, steal, exploit, and oppress.

They concluded that invidious human impulses needed to be reined in, and the only force that could do it was the arm of the law.

As you might guess, many of the most prominent advocates of this position were lawyers or lawmakers or bureaucrats. Beyond the obvious fact that this theory produces an avalanche of billable hours for lawyers, it also places lawyers atop the social status hierarchy.

Above businessmen, entrepreneurs, bankers, and real estate developers were lawyers. They were the clever genies who needed to control the system.

Intellectual debate being what it is, framing the issue in these terms suggests that you, as citizen, are faced with a dire choice. Either you accept that the marketplace be even more regulated or you will see it descend into a free-for-all where the few cheat the many.

If that is your choice, then what would you decide?

But, if you allow the debate to be framed in terms of these alternatives, then you have lost the argument to the lawyers. Their Socratic method will have divested you of your powers of ratiocination.

Of course, we all fear anarchy, and rightly so. But we need to consider other ways to look at the problem of overregulation.

From a different angle, we understand that the calls for a Draconian regulatory system are based on a fundamental distrust of human motives. If you believe that you really want nothing more than to lie, cheat, steal, pillage, exploit, and oppress… will this belief motivate you to become more trustworthy and honorable?

What if we base our culture on the idea that human beings are more likely to want to do the right thing because it is the right thing to do than to do the wrong thing because they can’t help themselves?

Given a large measure of freedom over their own affairs, humans are perhaps more likely to behave as people of good character.

Of course, a culture that is based on good character needs fewer laws, fewer regulations, fewer lawyers, and, most importantly, fewer billable hours.

Longtime readers of this blog know that I have often drawn this distinction, between guilt and shame cultures. The former thinks the worst of you and believes that your behavior can only be controlled by explicit threat of punishment. The latter thinks the best of you and believes that you can control yourself because you want to build your character.

Besides having written a book, called Saving Face, about the topicc, I also suggested, in the distant past, that the mania toward increased regulation of the financial markets assumed that bankers were moneygrubbers, and that if that is the way the world sees you, then the chances are that you will not want to disappoint its expectations.

Now, I am happy to report that the topic has just received the Behavioral Economics Seal of Approval-- as I would put it-- from the hand and mind of Dan Ariely. Link here.

Ariely explains the cultural divide in terms of making a business deal: “Imagine that you and I meet at a party, and I tell you about my research on behavioral economics. You see opportunities to use the principles to improve your business and think we could work together. You have two options: You can ask me to collaborate, with a handshake promise that if things work out, you’ll make it worth my while. Or you can prepare a contract that details my obligations and compensation, specifies who will own the resulting intellectual property, and so on.”

Ariely understands that we live in a culture that prefers complete contracts, contracts that are drawn up to address all of the possible contingencies, all of the ways that things can go wrong in the deal.

In his words: “Indeed, firms try to make contracts as airtight as possible—specifying outcomes and contingencies in advance, thus lowering the chances for misunderstanding and uncertainty. But complete contracts have their own flaws, and business’s increasing dependence on (I would say, fetish for) absurdly detailed contracts in every situation comes with its own downside.”

As he explains, when people are too obsessed with complete contracts, or when they fetishize regulation, they are likely to try to follow the rules to the letter, regardless of whether it is better, more efficient, or makes any sense.

Nevertheless, Ariely writes, we all prefer complete contracts to incomplete contracts, the latter being symbolized in the deal that is contracted by a handshake.

In his words: “Incomplete contracts lay out the general parameters of the exchange (the part that we shake hands over), while the unexpected consequences are covered by social norms governing what is appropriate and what is not. The social norms are what can motivate me to work with you, and what would establish goodwill in resolving problems that might arise.”

What Ariely is calling social norms I am calling the assumption that each participant is honorable and trustworthy, and that each will try to fulfill his side of the contract, and therefore to effect a satisfactory business deal… because he will profit from the transaction, but also because he will enjoy keeping his word as a person of honor and will also enjoy dealing with someone whose word is his bond and who respects social customs.

When a company relies on complete contracts, unethical behavior is almost encouraged.

Ariely explains: “As for complete contracts, they too specify the parameters of an exchange, but they don’t imply the same adherence to social norms. If something is left out, or if circumstances change, there’s no default to goodwill—it’s happy hunting season for all. When we use complete contracts as a basis for working together, we take away flexibility, reasonableness, and understanding and replace them with a narrow definition of expectations. That can be costly.”

Worse yet, if you attempt to write down all the things that can go wrong, and all the things that people are not allowed to do, you are almost waving a red flag at your partner, saying that you dare him to find the one or two things that you forgot to write down. Since it is inevitable that you are going to miss something, you have, by relying too much on complete contracts, given license to violate the spirit of the agreement while remaining within the letter of the law.

3 comments:

David said...

A couple of things that drive businesspeople to want contracts as comprehensive as possible:

--liability concerns. There may be only 1 chance in 1000 that a liability-causing event may occur, but in the current litigious climate, the cost could be sufficient to destroy a substantial company.

--personnel turnover, especially at the executive level. You may have a good understanding with an individual negotiating partner...a year later, you may be dealing with a completely different individual.

Stuart Schneiderman said...

Thanks, David. Of course, those are crucial points.

The liability system makes it nearly impossible for a company to rely on anything less than complete contracts. It feels like the system has been gamed, though I do wonder how tort reform will influence this factor.

Second, it is good to underscore the fact that doing business on a handshake can only take place when the participants know each other, and know each other very well.

The Japanese are renowned for their disdain for contracts, but they would rather not do business until they get to know someone, and have enough time to gauge his character and to assure themselves that he will be sticking around.

In a corporate culture where people are constantly on the move, it is much more difficult to do business on a handshake.

Anonymous said...

as a random anecdote,I can offer that construction contracts for small scale projects that are excessively detailed and laden with
restrictions and conditions,
almost always result in higher- priced bids returned.

in contrast,clear communication,
with the minimum of boilerplate language, and the award of the contract to a known,skilled business results in a faster project delivery with fewer "change orders"/(cost extras),which are often the result of disagreements over small ommissions in the construction documents.