“Economic Analysis and Cost-Benefit Analysis: Substitutes or Complements?”
Summary of Remarks by
This is a summary of Dr. Spatt’s comments, which, he emphasized, reflected only his views and not those of the Commission or members of the SEC staff.
Dr. Spatt’s presentation emphasized that economic analysis can be of great help to decision makers and drew on his experiences as Chief Economist at the SEC. Dr. Spatt explained that his presentation was related to the recurring debates on how the federal government should assess the impact of proposed rulemakings and how that assessment affects decision-making.
As a starting point, Dr. Spatt argued that economics provides a valuable structure for understanding resource or quantity allocations and pricing processes. Accordingly, economic analysis can influence policy debates and clarify the choices open to decision makers.
In carrying out an economic analysis, economists use economic theory, i.e. the principles of economics, as a foundation for cost-benefit analysis. Thus economic principles and the analysis of costs and benefits are complementary. In this light, in assessing actual and potential effects of a regulatory decision, potential unintended consequences must be considered – this point was a recurrent theme in examples presented (see below). Moreover the cost-benefit calculus must not be limited to quantifiable factors but, also qualitative considerations must be included.
Dr. Spatt explained that while he had heard the concern that economic analysis might “tie the hand” of regulators, a more precise perspective is to see economic analysis as an aid for clarifying choices. Accordingly, economic analysis can be extremely useful in considering policy alternatives. In this context, Dr. Spatt noted that the economic analysis of a rule should reflect not just why a proposed rule is better than the status quo, but also why the proposal would be an improvement over the relevant alternatives. The relevance of economic analysis notwithstanding, Dr. Spatt was careful to point out that there might be instances where economic cum cost--benefit analysis might not be central: an example would be when the details of rule-makings are guided by statutory imperatives.
Dr. Spatt explained that his office applies economic analysis to advise the SEC on the likely impacts and net benefits of adopting regulations under consideration. He then illustrated his previous points with examples that also show how economic analysis has helped in SEC decision making.
Regulation SHO: This relates to the regulation of short selling. When the SEC evaluated the possibility of removing pricing restrictions such as the "up tick" test, it decided to set up a natural experiment in which these restrictions were initially removed on 1/3 of the Russell 3000 securities. A stratified sample made it possible to do within-sample analysis as well as a before-and-after analysis. In order to facilitate an analysis of short-sale pricing restrictions, market centers publicly disseminated short-sale data in conjunction with the high frequency trades and quotes data that are used by academics in evaluating market structure questions. The SEC’s Office of Economic Analysis and several independent academic teams undertook analyses of the impact of short-sale pricing restrictions, which concluded that removing the pricing restrictions would not create substantive difficulties. Relying upon these analyses, the Commission issued a formal proposal to remove the pricing restrictions. At a public roundtable, distinguished participants viewed the approach to rule-making as a model for incorporating data and economic analysis. Of course, the nature of the context made it especially conducive to the very powerful approach of structuring a natural experiment.
Options Expensing: This example showed how the SEC’s Office of Economic Analysis helped to develop implementation guidance for options expensing. Dr. Spatt explained that while the appropriateness of expensing is widely agreed upon by economists, it had been a very controversial subject in Washington D.C. He remarked that, interestingly, some of the very same companies that used option grants intensively in their compensation programs argued that they did not know how to value the options.
Dr. Spatt indicated that, given the efficiency of U.S. financial markets, he would not expect options expensing to lead to substantial changes in the valuation of companies that have significant option programs. Regarding criticisms leveled at the modeling of employee stock options, Dr. Spatt indicated that the valuation cost to the employer of the resulting liability can potentially be assessed. He explained that, for example, the market for mortgage-backed securities offers a useful reference point. This analogy is instructive because of the lack of transferability of the mortgage obligation and the importance of the mortgage borrower's risk preferences. The employee’s stock option is not readily hedgeable and most employees are risk averse, Dr. Spatt explained. Interesting predictions about exercise and forfeiture behavior can be obtained from the mortgage-backed securities perspective and the use of arbitrage principles and the valuation tools of modern financial economics can be adapted to the employee stock option context.
Dr. Spatt commented that just as modeling approaches have been very successful in the context of mortgage-backed securities, he would expect that analogous tools for employee stock option valuation that take into account the relevant frictions would be similarly successful. Nonetheless, he noted that firms need not rely explicitly upon models for the purposes of determining the expenses of employee stock valuation. In this connection, Dr. Spatt elaborated on the possibility of using valuations from liquid markets were these to arise, and underlined that he welcomed the development of relevant new designs and innovations as option grants are important to the cost structure of many firms.
Executive Compensation and Disclosure: The key point illustrated by Dr. Spatt’s references was that changes in effective relative pricing among alternatives can lead to distortions and substitutions in the resulting quantities. As an example, Dr. Spatt mentioned the effect of the surtax on non-contingent compensation over $1,000,000 enacted in 1993 in an attempt to restrain compensation. A consequence was that firms substituted alternative compensation in order to be able to offer prospective employees their equilibrium compensation levels. Moreover, the 1993 surtax may have had the unintended consequence of increasing executive compensation. Given the high tax price on salaries above $1,000,000, such a result might have come about through the substitution to risky compensation (equity-based payments such as stock options and stock) for salary (non-contingent compensation) over the $1,000,000 threshold. Given executive’s risk aversion, more than one dollar of expected risky compensation would be required to substitute for one dollar of fixed (salary) compensation. Thus a tax to reduce executive compensation would in fact raise such compensation.
Dr. Spatt illustrated analogous substitution with unintended effects with examples relating to disclosure requirements. In these cases, the byproducts of certain disclosure requirements may have been the use of forms of compensation with less transparent required disclosures and an increase in the equilibrium structure of compensation.
Mutual Fund Governance: Dr. Spatt used this example to underline how the U.S. Court of Appeals of the D.C. Circuit reflects the importance of economic analysis and such considerations as efficiency, competition and capital formation in the rule-making process. The example related to the SEC’s rule requiring an independent chairman and 75 percent of independent directors. Dr. Spatt stated that the Commission released for public comment a pair of papers prepared by staff of the Office of Economic Analysis that review existing relevant literature and analyzed the statistical properties of mutual fund returns and potential limitations inherent in any empirical analysis designed to identify a relationship between mutual fund returns and fund governance.
Daylight Savings Time: Dr. Spatt used the shift in the timing of the start and end of the daylight savings time in the United States to remark that, just because one can quantify potential costs and benefits using strong assumptions, such does not justify making such costs and benefits the sole focus of cost-benefit analysis. An underlying issue was the lack of proportion between the magnitude of the shifts (relatively small) and the (large) beneficial results attributed to such shifts. Moreover, he once again pointed to unintended consequences.
Questions and Answers:
How are the relations between economists and non-economists, accountants and lawyers for example, in issues such as the ones covered by the presentation? There are good working relations on a broad range of issues relevant to the SEC.
There is sometimes fear that economic analysis limits the discretion of the regulator. On the other hand, economic analysis can be seen as helpful. What guidance can be offered in a context of uncertainty? While the perspective of economics is frequently important and helpful, not every rulemaking benefits from economic analysis to the same degree. In instances where economic analysis is relevant, sometimes simple theoretical reasoning can be very useful.
Can you provide examples of the role of ex ante applications of economic analysis? Regulation SHO is an example of ex ante analysis.
Can you refer us to literature on the points made? You made reference to a Circuit Court decision. Could you be more precise? My presentation with a number of bibliographical references is posted on the SEC website. The reference to a Circuit Court decision related to a 2006 ruling on an SEC rule regarding mutual fund governance by the District of Columbia U.S. Court of Appeals. The case involved the U.S. Chamber of Commerce and the SEC.
Can you expand on the importance of transparency in regulatory analysis? It is important that details of models used and/or assumptions be available. Such information is often provided through the rule-making process. One has to bear in mind that, although generally we try to make data available, it is not always possible to provide access to the data, for example, because of confidential business information, investigatory files, licensing issues or other reasons.
One could argue that even in economic analysis there are value judgments. What are your thoughts? The key point is that economic analysis can provide a useful tool for explicitly taking into account trade-offs and for framing the context for specific issues.
Chester Spatt joined the Securities and Exchange Commission as Chief Economist in July 2004. He is the Mellon Bank Professor of Finance at the Tepper School of Business at Carnegie Mellon University and Director of its Center for Financial Markets, where he has taught since 1979. He earned his PhD in Economics from the University of Pennsylvania and his undergraduate degree is from Princeton University. The full text of Dr. Spatt’s remarks is available at http://www.sec.gov/news/speech/2007/spch031507css.htm.
Rapporteur: Juan Buttari