Since Stigler’s (1971) seminal work, economists have explicitly recognised the possibility that regulatory agencies may be captured by those whom they are supposed regulate. That is, those public sector employees who are ideally expected to do gatekeeping against the private companies in order to uphold the public interest may have legitimate economic incentives to act against such expectations, leading to pervasive conflicts of interest in regulation. Despite the now widely held consensus view among economists that public gatekeeping activity may end up serving private interests, our profession has been much more hesitant in recognising similar conflicts of interests that may exist in economics research and bias the scientific process towards powerful institutions with monopolistic access to confidential datasets and high-end job market prospects (Zingales 2013, Fabo et al. 2021).
Building on these issues during the 2nd London Political Finance (POLFIN) Workshop, Renee Adams (2021) delivered an insightful keynote speech based on her past experiences as a young economist at the Federal Reserve Bank of New York. Through an autoethnographical lens, she reflected on her correspondence with one of the top journals in finance while she was trying to publish a paper on the potential governance failures in the way that Fed regulated its member banks. Despite her serious attempts to target the concerns of the referees, it seemed that the gatekeepers – some of whom were seemingly well-connected to the Fed – were less than willing to accept the implications that her research could have had on the Bank and its top management. Disheartened by the potential conflicts of interest on the part of the ‘gatekeepers’, she left the project behind as a working paper. Unfortunately, this early experience went a long way to answer the question she posed in the beginning of her speech: “Why haven’t I written more papers about political finance?”.
Apart from its memorable keynote speech and the following fruitful discussion (which can still be watched offline; see the references for the link), this year’s POLFIN workshop brought together a set of high-quality research projects on this rather niche theme. Below we describe a short summary for a few of these papers and comment on the avenues that would benefit most from further research in the future.
Politics and finance
In “Power, Scrutiny, and Congressmen’s Favoritism for Friends’ Firms”, Kieu-Trang Nguyen and co-authors question the standard wisdom that “power tends to corrupt and absolute power corrupts absolutely” (Do et al. 2020). Rather, using a Regression Discontinuity Design of close Congress elections in the US, they find evidence that a politician’s win reduces the stock value of his or her former classmates’ firms by 2.8%. This adverse effect is most prominent among younger candidates, when career concerns are arguably strongest. They explain this result by politicians reducing quid-pro-quo favours towards connected firms to preserve their career prospects when attaining higher-powered positions. While certainly a surprising result, this clearly underlines the need for further research on the role of scrutiny in restraining favouritism in politics.
In “Does Political Partisanship Cross Borders? Evidence from International Capital Flows”, Larissa Schäfer and co-authors gauge whether partisan perception shapes the flow of international capital (Kempf et al. 2021). Using data on syndicated loans and equity market funds, they show that the ideological alignment or distance of individual investors/lenders in the US (based on political contributions by banks and voter registration for fund managers) to foreign governments affects their capital allocation around the world. In particular, considering investment in the same country around the same foreign elections, the authors show that US banks reduce lending after an increase in the ideological gap between their own (Republican or Democratic) political stance and the political stance of the new foreign government and charge higher interests (while they do not face higher default). In a similar fashion, US mutual funds decrease portfolio allocation, again with no difference in performance. The authors also confirm the results for non-US investors (Canada and UK), even though this is done with less granular data. These quite striking results negate the old notion that partisan politics would stop at the water’s edge and invite further research on how political connections (and/or shared affiliations) across countries may end up influencing and potentially distorting private actors’ investment behaviour.
In “Political Polarization in Financial News”, Ryan Israelsen and co-authors find strong evidence of political polarization in corporate financial news (Goldman et al. 2020). Comparing the coverage in the Wall Street Journal to that in the New York Times over 30 years on the largest 100 companies, they document that newspapers are more likely to cover and write positively about politically aligned firms (as measured by campaign contributions by employees and corporate political action committees to Democratic and Republican Party candidates). For example, an article in the WSJ about a firm that donated only to Republican Party candidates in the previous election cycle uses 20% more positive words than an article in the NYT, while an article in the WSJ about a firm that donated only to Democratic Party candidates uses 10% fewer positive words compared to the NYT. And this different reporting also has implications for investment and trading. Specifically, there is more trading on days where there is more politics-induced disagreement in the reporting on a specific firm. Finally, matching granular data on individual investor trades from a retail brokerage database to newspaper circulation data based on the zip code location of the investors, the authors find that when news about a stock appears in the newspaper an individual investor is more likely to read, the investor trades more and in the same direction as other investors who read the same paper. This study, alongside other recent work showing how individuals may create their own reality bubbles based on the very same facts (Alesina et al. 2020), brings a new perspective to the micro-foundations of information asymmetries in financial markets and invites further thinking on what makes such subjective perceptions of the same financial reality survive in the long term.
Last, but not least, in “The Political Polarization of U.S. Firms”, Elisabeth Kempf and co-authors illustrate that executive teams in US firms are becoming increasingly politically homogenous, based on voter registration records for top executives of S&P 1500 firms between 2008 and 2018 (Fos et al. 2021). This trend seems to be driven by politically misaligned executives being more likely to leave, especially between 2015 and 2017 while the effect is stronger in states where there is no legal prohibition of political discrimination, in firms with lower institutional ownership and those led by CEOs with longer tenure. The authors also show that differences in executives' political views manifest in differences in beliefs about the company's future stock price performance after political events, such as the surprise win by Donald Trump in 2016, with Democratic executives having a significantly higher likelihood of selling the firm’s share than Republican executives of the same firm after this specific event.
The diversity of the research topics presented at the POLFIN workshop was more than representative of that of the field; however, none of the papers puts the mirror back to the face of our own profession (with a key exception of a recently published paper by Fabo et al. 2021). Going back to Renee’s keynote speech, there is certainly a bias in our academic community to ‘not rock the boat’ and a risk of getting too close to authorities such as central banks that provide us with data and consultancies. The good news is that unlike ten years ago, this is now being openly discussed; the bad news is that we have only taken the first (baby) step in addressing this problem. There is need for a much broader discussion on the biases current institutional setting in economics/finance may inflict upon the scientific output including the lack of diversity in journal editorial boards and concentration of the gatekeeping power in a few hands (Angus et al. 2021).
Adams, R (2021), “Gatekeepers: Real and imagined”, keynote address at the 2nd London Political Finance (POLFIN) Workshop, 24–25 June.
Alesina, A, A Miano and SS Stantcheva (2020), “The polarization of reality”, AEA Papers and Proceedings 110: 324-28.
Angus, S D, K Atalay, J Newton and D Ubilava (2021), “Editorial boards of leading economics journals show high institutional concentration and modest geographic diversity”, VoxEU.org, 31 July.
Do, Q A, Y T Lee, B D Nguyen and K T Nguyen (2020), “Power, Scrutiny, and Congressmen's Favoritism for Friends' Firm”, CEPR Discussion Paper No. 15141.
Fabo, B, M Jančoková, E Kempf and L Pástor (2021), “Fifty shades of QE: Comparing findings of central bankers and academics”, Journal of Monetary Economics 120: 1-20.
Fos, V, E Kempf and M Tsoutsoura (2021), “The Political Polarization of US Firms”, available at SSRN 3784969.
Goldman, E, N Gupta and R D Israelsen (2020), "Political polarization in financial news", available at SSRN 3537841.
Kempf, E, L Mancy, L Schäfer and M Tsoutsoura (2021), "Does Political Partisanship Cross Borders? Evidence from International Capital Flows", Mimeo.
Stigler, G J (1971), "The theory of economic regulation", The Bell Journal of Economics and Management Science, pp. 3-21.
Zingales, L (2013), "Preventing economists' capture. Chicago Booth Research Paper (13-81).