Solve the horizon problem: Don’t let Big Tech escape regulation

The short-term orientation of governance tends to result in tighter rules for finance than technology

SIDDHARTH PAI

is co-founder of Siana Capital, a venture fund manager.

Many professors at my alma mater, the University of Rochester, were legends in the field of financial economics for a variety of reasons. The main reason was that the University was very well-endowed during the heyday of companies such as Eastman Kodak Company, Bausch & Lomb and Xerox Corp, which were all headquartered in Rochester—and thriving—when I studied there in the late 1980s. For decades, they contributed heavily to the funding of the University and its research projects. When the decline of these firms began in the mid-1990s, the University lost an important source of funding for several years, before finding a new source in the fact that it owned patents that are vital for both human papillomavirus (HPV) vaccines available in the market. HPV vaccines are used to protect women against cervical cancer, and are becoming de rigueur. Since HPV can also cause throat and anal cancers, it’s advisable to administer it not only to teenage girls (by the recommended protocol), but also boys.

While some of my professors moved to greener pastures during the University’s leaner years to well-endowed named chair professorships at other schools, many stayed on despite Rochester’s bitingly cold winters. Clifford Smith, a singularly gifted teacher, is well known for his seminal research on the trading costs for listed options. Ross Watts gained fame for his ability to predict changes in accounting standards long before they occurred. His collaborator, Jerold Zimmerman, worked with Watts to form an entire body of study called the ‘positive theories of accounting,’ which sought to understand the costs and benefits of various accounting procedures. Ray Ball was among the first to identify anomalies in the efficient capital-markets theory, which had first been propounded by his doctoral supervisor, the Nobel Laureate Eugene Fama.

But the two who were more most impactful in the area of practical applications of finance were William Meckling and Michael Jensen. They gave the world a seminal paper called ‘Theory of the firm, managerial behaviour, agency costs, and ownership structure’ (bit.ly/4901fWX), which clearly showed that there were agency costs involved in the running of a firm (or any large enterprise), and that managers, being agents, were unlikely to run enterprises in the best interest of its principals (i.e. share-holders), since they had agendas of their own. The solution that these two worthies gave the world was the use of stock options in managerial compensation as a way to align the interests of managers with stockholders. Managers were therefore incentivized to make decisions in the best interest of owners, since their own wealth was now influenced by the firms’ stock price. The use of options in managerial compensation became common in the 1990s, when acceptance of Jensen and Meckling’s work was at its zenith. Today, stock options are a regular part of most corporate and startup pay packages.

We don’t have these schema in the world of government and politics, however. Agency theory suggests that while agents have a legal and fiduciary duty to act in the best interests of the principal (whether a stockholder or a voter), the separation of stockholders or the electorate from managers or policymakers creates conditions that can lead these agents to act in their own interest and not always in that of their principals. This is a fundamental problem that exists in any country, especially those that are democratically driven, and it directly impacts our lives today in a technology driven society. I shall explain why.

An example of the agency issue is the horizon problem. A firm always has owners (who would prefer decisions made both in the short- and long-term interests of the company), just as a citizen would prefer policies made for now and also the future. But managers and policymakers prefer short-term actions, since these tend to showcase their managerial or populist policy skills. Why is this a problem? Well, if a manager were to switch companies, or a politician were to be pushed out of office by the next election, s/he doesn’t stay around long enough to suffer the impact of short-termism. In all cases, agents favour the demonstration of their short-term skills, which may well impair the firm or state/country’s long-term interests.

This horizon problem is what causes governments the world over (except non-democracies like China) to be lackadaisical in the regulation of technology and aggressive in their regulation of finance. Given one-party rule in China, the Chinese leadership isn’t anxious about its electoral performance. This is in stark contrast with countries in the democratic world, where leaders face elections every four or five years. China built its ‘Great Internet Wall,’ which over a 15-year span has helped home-grown Chinese companies like WeChat not only monopolize domestic markets, but also become world leaders—as in the case of TikTok.

Every other government has been too late to address the excesses of Big-Tech firms, which could now be seen as the digital era’s equivalent of Industrial Age ‘robber barons,’ as they were called. Whatever little we see in terms of active regulation of these firms comes mainly from the EU, which as an entity outlives the governments of its member states. Until we come up with a way for politicians to think longer-term about tech issues, all we will have are band-aid solutions put together too late by governments the world over.

This article fist appeared in print in Mint and online on Livemint. For this and more, see below:

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