Employees as Regulators

January 23, 2003. Below, an op ed by FPI senior economist Moshe Adler, New York Times.

At its first formal meeting, the new federal board overseeing the accounting profession proved George Stigler right. Mr. Stigler, who died in 1991, won a Nobel in economics for showing why regulated industries end up co-opting their regulators. At their meeting earlier this month, board members voted themselves annual salaries of $452,000 each, affirming that they are first and foremost interested in their own well-being. Perhaps we should dismantle the board before it validates Mr. Stigler’s theory.

The theory is simple: When the government regulates an industry, that industry can benefit enormously if regulators do not do their job. Of course, the public may lose more than the industry will gain. But it hardly matters, because the loss to each member of the public will be minuscule. According to the theory, malfeasance occurs when its benefits are concentrated and its costs diffused. In other words, regulated accountants will find a way to make the new oversight board complicit.

The conflicts inherent in the oversight of companies by supposedly disinterested private auditors have become apparent in the last year. But the solution is not a public oversight body. Instead, oversight of public companies should be entrusted to a group with a substantial interest in a given company’s long-term survival: its employees.

Shareholders usually have such a small stake in an individual company that they have no incentive to monitor either the company’s management or the independent auditors whose job is to keep management honest. But employees have a real stake in a company’s future. When executives artificially inflate stock values at the expense of the long-term health of the company, rank-and-file workers can lose their jobs.

It may just be that the best solution is to give employees representation on the audit committee of their company’s board of directors. They will then be able to participate in negotiations with auditors before the auditors complete their reports. When necessary, audit committees can also hire their own accountants to help them understand the issues involved.

To be sure, like government regulators, employee representatives may not always be faithful to those they serve. But the stake of each individual worker is sufficiently high that many of them are bound to be vigilant.

To the extent that boards of directors help determine employee compensation, employee representation on these boards may result in higher wages for workers – and may help to align executive compensation with corporate performance. Thus the overall cost to shareholders may even diminish. Most important, though, shareholders will be getting real value from employees – not only their labor, but also their vigilance.

Shareholders have long recognized that managers don’t always have the long-term interests of their company at the top of their agendas. But as George Stigler tells us, the government can’t solve this problem. The group that can best safeguard the long-term interests of a company is the group to whom they matter most: its employees.