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Regulating Finance: Expert Cognitive Frameworks, Adaptive Learning, and Interests In Regulating Finance: Expert Cognitive Frameworks, Adaptive Learning, and Interests in Financial Regulatory Change by Damon B. Palmer Department of Political Science Duke University Date:_______________________ Approved: ___________________________ Herbert Kitschelt, Co-Supervisor ___________________________ Karen Remmer, Co-Supervisor ___________________________ Erik Wibbels ___________________________ Bahar Leventoglu Dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in the Department of Political Science in the Graduate School of Duke University 2010 ABSTRACT Regulating Finance: Expert Cognitive Frameworks, Adaptive Learning and Interests in Financial Regulatory Change by Damon B. Palmer Department of Political Science Duke University Date:_______________________ Approved: ___________________________ Herbert Kitschelt, Co-Supervisor ___________________________ Karen Remmer, Co-Supervisor ___________________________ Erik Wibbels ___________________________ Bahar Leventoglu An abstract of a dissertation submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy in the Department of Political Science in the Graduate School of Duke University 2010 Copyright by Damon B. Palmer 2010 Abstract My dissertation seeks to understand how and why governments make major changes in financial sector regulations. I focus on two specific puzzles. First why is financial sector regulation not normally central to electoral competition and why are changes in financial sector regulation rare events? Second, why do we observe substantive intellectual debates and efforts of policy persuasion despite the conclusion of many researchers and observers that financial regulatory policy outcomes are driven by the preferences of powerful special interest groups? What are the mechanisms precisely by which ideas versus interests shape policy outcomes in a domain that is not often central to electoral politics? I investigate these questions through a formal game theoretical model of the regulatory policymaking process and through case studies of historic episodes of financial regulatory change in the United States which draw upon a wide variety of primary and secondary source historical materials. I conclude that financial regulatory change is most likely to occur when events of different types cause heads of government to perceive that the existing regulatory status quo threatens the realization of broader policy objectives. Heads of financial sector policy bureaucracies shape outcomes by providing cognitive frameworks through which leaders understand regulatory consequences. Interest groups influence policy outcomes primarily through their ability to act as veto players rather than by controlling the policy agenda. iv Dedication This dissertation is dedicated to the people who have loved and sustained me throughout this process: My mother Carolyn, my father Darwin, my brother Michael, and my wife Aurora, our beautiful baby boy Alexander and his brother and sister who will be born shortly after this is completed. v Contents Abstract ......................................................................................................................................... iv List of Tables ................................................................................................................................. xi List of Figures .............................................................................................................................. xii Acknowledgements .................................................................................................................. xiii 1. Understanding Financial Regulatory Change: Questions and Contrasting Approaches ......................................................................................................................................................... 1 1.1 Demand-Side Explanations of Financial Regulatory Policymaking ....................... 10 1.1.1 Interest group accounts ............................................................................................ 12 1.1.1.1 Economic interests and financial regulatory policy preferences ................. 15 1.1.2 Regulatory Capture Accounts ................................................................................. 19 1.1.3 Partisanship Accounts .............................................................................................. 22 1.1.4 Institutionalist Accounts........................................................................................... 23 1.2 Limitations of Demand-Side Explanations of Financial Regulatory Policymaking ................................................................................................................................................. 26 1.2.1 The Contingency of Interest Group Preferences ................................................... 27 1.2.1.1 Policy effects on the cost of capital generally. ................................................ 28 1.2.1.2 Policy effects on the cost of capital to specific sectors. ................................. 29 1.2.1.3 Policy effects on the volatility of capital markets .......................................... 30 1.2.1.4 Policy effects on the efficiency of domestic capital allocation ..................... 30 1.2.1.5 Policy effects on the ability of economic actors to hedge against risks ...... 31 1.2.1.6 Policy effects on the likelihood of financial crises ......................................... 31 vi 1.2.1.7 Policy effects on the level and volatility of returns to savers and investors .......................................................................................................................................... 31 1.2.1.8 Policy effects on corporate governance .......................................................... 32 1.2.1.8 Policy effects on the time horizons of economic agents ............................... 32 1.2.2 The Importance of Cognitive Frameworks to Policy Preferences ...................... 32 1.2.3 The Incentives and Capacity of Political and Bureaucratic Leaders to Act Autonomously .................................................................................................................... 35 1.3 Summary of Argument, Methodology and Research Design .................................. 35 1.4 Plan of the dissertation .................................................................................................. 40 2. Financial Regulatory Policymaking: Expert Cognitive Frameworks, Adaptive Learning, and Interests ............................................................................................................... 42 2.1 Financial Sector Regulation and Electoral Competition ........................................... 46 2.2 Episodic Attentiveness, Events, and Financial Regulatory Agenda-Setting .......... 53 2.3 Understanding the Influence of Specialized Financial Sector Bureaucracies and Policy Experts ........................................................................................................................ 66 2.3.1 The role of specialized financial policy bureaucracies in modern states ........... 67 2.3.2 Policy complexity and the role of expert cognitive frameworks ........................ 68 2.3.3 Adaptive learning and the evolution of cognitive frameworks ......................... 81 2.3.4 Cognitive Frameworks and Preferences ................................................................ 84 2.3.5 Policy importance and the ability of bureaucratic actors to take initiatives and to sanction ............................................................................................................................ 88 2.4 Money and Politics: Veto Points and the Influence of the Financial Industry Lobby ...................................................................................................................................... 93 2.5 Observable Implications ................................................................................................ 99 vii 2.6 Towards a Formal Model: Overview and Relation to the Theoretical Argument ............................................................................................................................................... 102 3. A Formal Model of the Financial Regulatory Policymaking Process ............................ 109 3.1 Formal Description of the Game ................................................................................ 109 3.2 Equilibrium Concept .................................................................................................... 112 3.3 Strategies and Equilibria.............................................................................................. 112 3.3.1 Equilibrium beliefs and strategy of the Financial Sector Veto Player .............. 113 3.3.2 Equilibrium beliefs and strategy of the Central bank ........................................ 116 3.3.3 Equilibrium beliefs and strategy of the President .............................................. 119 3.3.4 Equilibrium Beliefs and Strategy of the Treasury .............................................. 144 3.4 Summary and Conclusions ........................................................................................ 149 4. Regulatory Forays: Federal Financial Regulation Before the Depression ..................... 156 4.1 Financial Regulatory Policy Conflicts in the Early Republic .................................. 158
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