Professor Luigi Zingales from the University of Chicago explains why it is important to study and research issues of political economy of finance
On 1-2 June, the Stigler Center hosted a first-of-its-kind conference focusing on the role of politics in finance research. In the last 20 years, political considerations have played an increasingly important role in financial economics: from the design of the rules that make financial markets viable to politically-motivated changes in bankruptcy law, from political connections in firms to the effects of political uncertainty on investments. Yet up until now, no conference has been dedicated to it.
We interviewed University of Chicago Booth School of Business Professor and Stigler Center director Luigi Zingales about the motivation behind it and the political economy of finance.
The following is a transcript of the interview, slightly edited for clarity:
Guy Rolnik: I was surprised to understand that, actually, there are not many conferences on the politics of finance.
Luigi Zingales: I would say none, probably. Not entirely dedicated to that.
GR: Why is it that there aren’t many conferences on the political economy of finance? You would think that politics has a lot to do with finance.
LZ: I think historically, people have not looked at that aspect a lot. I would like to divide the brief history of the academic field of finance into three periods: I would call the first one – that started in the late ‘50s – the Modigliani and Miller period. Modigliani and Miller, to simplify to the extreme, said that the way you slice a pizza does not change the size of the pizza. This is a period in which basically finance is irrelevant, and the only frictions that matter are probably only tax frictions.
Then, starting with the ’70s, people realised: “Wait a second. If you start to divide a pizza before you produce the pizza, maybe this will have some impact on how the pizza is produced.” This is what in jargon goes under “agency”, or “asymmetric information”. Essentially, the way you allocate the cash flows of the firm has some impact on the way the firm is run.
However, all this is in the context of, “The external rules are fixed. We’re in a very predetermined society and the rules are fixed. That’s what we do.”
Starting with the ’90s and then the 2000s, people realised that the rules are not fixed, that actually the changing nature of the rules is very important, and of course, political gain is what makes the rules change.
GR: So this is where the 2008 financial crisis comes in, and after the financial crisis people started to develop a lot of interest in the role of politics in financial crises and the role of politics in finance.
LZ: To be honest, I think things started before the financial crisis. I think probably the intellectual origin of all this is the theory of incomplete contracts developed by Grossman and Hart, where because the cash flow is bargain ex post, then the rules are more fluid. Then this call for renegotiation, or re-discussion, which is to a large degree about politics, comes into the game.
One of the early papers about this is a paper by Patrick Bolton and Howard Rosenthal – a finance guy and a political scientist – looking at how renegotiation of debt and the rules for bankruptcy change dramatically with the business cycle. Every major financial crisis in the United States (US) had the bankruptcy rules restated to some extent, or reshaped.
Traditionally, finance people thought about bankruptcy as a given. Now [they] realise it is not a given, that the rules change. How do they change? They’re politically determined. Of course, for the misbeliever, the financial crisis brought this to an attention that could not be ignored.
We’ve seen the work by Amir Sufi and Atif Mian and Francesco Trebbi looking at the political determinants of the intervention on TARP, and the work that Amit Seru and co-authors have done on the politics around regulation and how ineffective regulation is because of political constraints.
I think that by the beginning of the second decade of the twenty-first century, politics has become mainstream and was overdue to have a conference dedicated to it.
GR: Then in the beginning of the 2000s comes the beginning of your work with Professor Raghuram Rajan on “rules of the game”. You looked at who’s setting the rules of the game, who is influencing the rules of the game, and what we learn.
LZ: I think that in the late ’90s and early 2000, there was a big interest in why countries are not more financially developed. Thanks to the work of Andrei Shleifer and Robert Vishny and others, there was this importance of the law as a major factor.
Rajan and I asked the very simple question: if it is as simple as importing a code from another country, why don’t more countries do it? It cannot be just a lack of technical expertise. Lawyers are expensive but can be imported. In fact, Russia did import the best lawyers from the US. I’m not sure it was a big success.
The conclusion was, no, it’s lack of political will. We started to open the debate for, say, “Look, finance does benefit most people, but hurts others.” So there is a political economy even with [the] introduction of financial laws.
GR: For decades, economists and other scholars dedicated a lot of intellectual energy to look at the relationship between companies, shareholders and executives, and between shareholders and boards. Maybe there’s not enough intellectual energy going into the question of who sets the rules of the game that determine the outcomes and the dynamics in finance?
LZ: I think that the role of conferences like the one here at the Stigler Center is to bring together scholars who work in a certain area, and also give confidence that this area is important, and attract more research.
You’re absolutely right, people tend to research where the data are. The famous old joke about economists, that they look where the light is, not where they lost the key, has some element of truth. In finance, there are things that we can observe very well and compensation is one. You’re going to have a lot of papers about managerial compensation.
But I think what is important is that even data are endogenous, in a sense. Compustat ExecuComp, which is the primary data source to study this stuff, was created in the early ’90s as a result of academic interest in executive compensation.
Going back in history, CRSP, the Center for Research in Security Prices here at Chicago, which is the main data source for security prices research, was created by Jim Lorie, a faculty here, who saw people like Eugene Fama and others interested in this topic and said, “We have to create a data set to analyse”.
The role of academia is, in a sense, to open new avenues and then have a data provider follow.
GR: When it comes to politics, many times data are much more complicated and debatable, and ambiguous in many ways. When you deal with numbers and with asset prices, maybe it’s easier to go with the data than when you go into the realms of politics.
LZ: There are two aspects: one, there are fewer data coming from the political world than from the asset pricing world, even from corporate finance. Even those data tend not to be disclosed and available as much as data on companies. Data on lobbying now start to be widely available. Data on campaign contributions start to be available. The data on corporate donations tend to be more difficult. They’re not as established.
Then there is a more difficult problem to tackle: in a sense, politics is much more fluid. Whenever data are available, the deals move somewhere else. As researchers, we’re always fighting the last war because we look at what happened in the past, but politics run ahead.
GR: Let’s talk a little bit about the research that will be presented in this conference. I’ll start with the most politically-sensitive paper that we have, a very interesting paper looking into the Obama administration and more than 2,000 meetings that president Obama and his chief aides had with businessmen over the last eight years. I don’t know if you could call it crony capitalism, but whatever is happening out there didn’t start in the Trump administration.
LZ: Certainly. I think it’s actually very healthy, and one of the goals of this conference is to bring this research from analysing foreign countries to analysing the US. It’s much easier to point fingers toward other people. When Ray Fisman wrote the first paper on the political connections of Suharto, everybody clapped. Why? Because it’s Indonesia and corruption in Indonesia is something that we think is granted.
Now, when people apply the same technique to the US, a lot of people [are] up in arms and say, “Oh, it’s impossible. This is not corruption.” But if it worked as a technique for Suharto, why can’t it work for Trump, or for Obama, or for people before?
I don’t think that these results are specific to the Obama administration. I think that the data are better in recent years, and so, the paper analysed that rather than analysing George W Bush, or Bill Clinton.
GR: Another paper looks again at the US and the way that decisions on bailouts of banks were decided after the financial crisis. Can you elaborate a bit on that?
LZ: Again, I think that it’s not surprising to international scholars that the allocation of aid, the allocation of credit, and particularly the allocation of bailout credit to banks is very politically-determined.
This research is showing that surprise, surprise, without a doubt, in the US the same happens. I think it’s a good example [that] what we’ve learned analysing countries around the world can be applied to the US.
GR: We do look internationally at this conference, and we have an interesting paper on Chile. Chile is a very interesting case for many reasons. One of them, of course, is that for many decades, Chile was the “poster child” of a successful market economy in South America. Recently, people have been looking into the details of what’s happening in this economy, and they see some other perspectives on Chile that were not as salient as before.
LZ: I will distinguish two things: First of all, I think that Chile is a fantastic example of the difference between being pro-market and being pro-business. I think that Chile has been very much pro-business, but there is no doubt that it was a huge success in terms of growth. On the other hand, I think there is not enough antitrust policies, or attention to political connections. The result is that the income distribution is extremely unequal, and this really puts, in my view, bounds on future growth.
I think one needs to reconsider the limitations of looking only at micro-measures of market flexibility, and not at the political economy of the country.
In addition, like in many countries, [in Chile] we have a phenomenon where privatisations on the one hand improved efficiency – because the government is not very good at running things – but were probably done to the benefit of some people. One of the major mines was sold to the then son-in-law of Pinochet who now, ironically, was found to [have] actually [paid] money to the son of the current president, [Michelle] Bachelet. This shows that it’s not right or left, it is basically crony capitalism.
GR: And China?
LZ: China is a phenomenal example. There is a very exciting paper looking at the way loans are made, and the political incentives, not only the economic incentives, that are present in China.
We tend to look at China with too much of a Western view, not realising that in China, in every major company there is a representative of the Communist Party which basically oversees the company. These guys tend to have political incentives that are different than the standard market incentives. I think understanding better the interaction between the two is a fascinating topic.
GR: To sum up our discussion: politics is key when it comes to finance, and we should research the relationship between the political world and finance more. Are there any specific things that you think are under-researched today, or over-researched? From a societal point of view, what would be the right research agenda when it comes to finance today?
LZ: First of all, it’s very difficult to ask an academic what is the right research agenda because most of the people will answer what they’re doing this moment, so I don’t want to fall into this trap. In general, the connection between finance and politics has been under-researched for years, and the goal of this conference is precisely to motivate more research. I think there is a need to apply more creative and different approaches.
I think that generally in academia, what tends to be overdone is research that’s based on data that are easily available, with techniques that are fairly well-established, because the cost of production is low, the value added is also low, but also, the risks tend to be low.
I think that what good researchers should do is to be more ambitious, take more risks – especially after you get tenure, there is no justification not to take more risks.
GR: Do economists need help from other disciplines when they’re going into the realm of political economy of finance?
LZ: I think economists need help in other disciplines regardless. There was a long period in which economists were sort of colonialists, and they were moving to other fields, ignoring, or not really understanding the other fields, but just trying to grab some of those questions.
I think that those times, by and large, are gone. I think there is a lot of good research interacting psychology with economics. I think that is less so, for example, in sociology. I think that sociologists and economists tend to not interact a lot, and I think there are great opportunities there.
I think also with political scientists, there are more economists acting as political scientists – there is a bit less of an integration. I think that would be helpful, especially in areas like finance. I think if you are in the political economy section of an economics department, you naturally interact with political scientists.
When you come to business school, and you do finance, or you do IO, you tend to be less well-integrated.
GR: Some economists shy away from politics for many reasons, but correct me if I’m wrong: the deeper we go into the political economy of finance, we’ll see that politics has a lot of influence on the outcomes of the financial markets, and it will force us to think much more about politics.
LZ: I would also say the opposite. I think that economists, and academics in general, have a huge impact on what happens in the political world. Not immediately, not individually, as they had in academia by themselves, but the academic thinking is a crucial part in shaping politics.
It’s very hard to do lobbying without some ideas to support the lobbying. My fear is that academics are not sufficiently aware of their impact. Jean-Paul Sartre used to say you cannot not choose because not choosing is choosing not to choose. I would like to paraphrase and say you cannot ignore politics because ignoring politics is choosing a particular political perspective of ignoring it. You are announcing a particular view, you’re not abstaining from it.
The attitude of many academics that say, “I do science, I have nothing to do with politics” – they are doing politics in another way.
GR: When you’re ignoring politics, the outcome many times would be to give more power in the market of ideas and in policies to vested interests, to the powerful?
LZ: I think that that could be an outcome. It’s not necessarily an outcome, but that could be an outcome. I’m just saying that you should be aware of the consequences of your actions because not acting is an action.
GR: Luigi Zingales, thank you very much.
LZ: You’re welcome.