Policy by Design: The Role of Strategic Design in Financial Reform
By Krishen Mehta
Issue 10 Winter 2012
The most recent collapse of markets suggests a design failure requiring immediate action. This article is intended to encourage a conscious and disciplined reform of our financial system informed by strategic design intelligence rather than by partisan politics. We are all, in a sense, designers of the future. Policy makers could benefit from putting some post-its on a wall and imagining reform that renews and restarts an economy that is designed by the people for the people.
Policy by Design
Bruce Mau once suggested that, “design is invisible until it fails”.1
Good design is, in a way, transparent. It allows us to enter into an experience without feeling that we have been designed into that experience. While this may be less true of objects, it is more true of experiences. A forced experience is not usually a fun one. The best experiences are those which design allows us to choose what simply feels or seems right.
“Playing the market” is an experience. Most of our financial transactions are, in fact, designed experiences.
They enable us to take an abstract with a particular valuation and trade it, save it, invest it or spend it. Cool!
We watch as babies trade on e-trade and the trading experience seems, quite literally, like “child’s play.” Websites make it easy to search stock quotes and to “follow the markets.” The last few decades have not only encouraged our identities as consumers, but also, as investors.
But, we also have identities as citizens and we have an investment in that identity as well. Citizenship is an experience. It is also, in a way, an abstract with a particular valuation. Part of that valuation has to do with the financial viability and the security of the country. Our experience as citizens is, to some degree, dependent on the design of our financial system. Most of us do not question the design of that system until it fails.
While our financial system has not quite failed, the recent downturn in markets worldwide, following the collapse of 2008/9, suggests several design flaws which indicate that we need, not only financial reform, but also redesign. If, as William McDonough suggests, “design is the first signal of human intention”, 2 we must agree to the intention before attempting the design.
If our design intention is to create a more equitable, robust and secure financial future for citizens and to encourage cooperation among the citizens of this world then we will need to design this into our efforts at financial reform.
Designing Financial Reform
There is a notsofunny cartoon which depicts a man sitting by a fireplace in a mansion, teaching his son some lessons of life. The son is sitting on the father’s lap, and the father is saying to him: “It goes in cycles, son. Sometimes the rich get richer and the poor get poorer. And sometimes the rich get richer, and the poor stay the same.”
That cartoon is less and less a cartoon and more and more a stark reality. The poor and even the middle class are getting poorer. Today, in the United States, the top 20% of our population holds about 84% of the nation’s wealth. And the bottom 40% have about 0.3% of the wealth, basically zero. 3 How is this happening in one of the most affluent countries in the world?
Well, to some degree, it is a consequence of how we have designed our financial system. Arguably, what we think of as purely policy issues could also be viewed as design issues. Thinking of financial reform this way, may help to free it from partisan politics and hardened policy positions. If we want financial reform which does not encourage the rich to get richer and the poor to get poorer, we must design our policies to express that intention and generate that option.
While we tend to think of policy decisions as separate from design decisions, all policies have an intention and attempt to generate specific outcomes from that intention.
Policy, like design, reviews the past for ways to begin to shape the present to create positive outcomes in the near or long-term future for a community of user groups. The best policy, like the best design, is strategic in that the intention is built into the execution and can be experienced by the user.
Herbert Simon once said that “design is the systematic attempt to change the future.” 4 Most policymakers announce their new policies as attempts to do just that.
When we think of financial reform, we need to think of designing reforms that will shape our lives as a community of citizens and increase the valuation of and the experience of that citizenship. In this sense, citizens can be conceived of as user groups who use the financial system and who rely upon it. These user groups pay for their citizenship, sometimes with their lives, and always with their taxes.
Citizens, like consumers, expect and need predictable outcomes. They need well-designed financial policy. Policy they can depend on to help them make decisions and take action. Policy that does not lead to diminished expectations and decreasing returns for all but the very rich.
A tall order? Yes, but easy enough if we apply strategic design intelligence rather than re-use formulaic policy responses. Any country seeking to design a more equitable and robust financial future will need to strategically address six key challenges to financial reform that will be faced by every country to varying degrees: Designing Transparency In; Designing Illicit Funds Out; Designing Revenues In; Designing Speculation Out; Designing Innovation In; Designing Opinion Out. Let us look at how the US is currently doing with regard to these six challenges.
Challenge 1: Designing Transparency In
On August 5, 2011, NBC News reported that a Delaware company formed just a few months ago made a $1 million contribution to a political action committee supporting a prominent political candidate and then dissolved itself two months later.
The company filed a certificate of formation on March 15, 2011, with no information about the owners or the business purpose of the entity. On April 28, the LLC made a $1 million contribution to a political action committee supporting the same candidate.
The company then dissolved itself on July 11, leaving no trail of the real people behind the political mega-donation. Lawrence Noble, former general counsel of the Federal Election Commission, has called this a “roadmap” for how people can hide their identities and hide their political contributions. A corporation such as this, which was created for the sole purpose of laundering political contributions, highlights the need for a bill that was just introduced in the U.S. Senate.
This technique used by certain groups with ample financial resources to ‘buy their candidate’ would be stemmed if Congress acts on a bipartisan bill that was introduced on August 2, 2011. This bill would require states to collect information about who really controls corporations and limited liability companies that are formed in their jurisdictions. Senators Carl Levin (D-MI) and Chuck Grassley (R-IA) introduced the Incorporation Transparency and Law Enforcement Assistance Act (S. 1483).
Such a bill would not only effect political contributions that seek to influence or subvert our political process, but would also affect the large inflows of illicit money that come into our economy due to the current lack of transparency. These illicit flows result from corruption, trafficking, environmental crimes, money laundering, and many other means, and easily flow into our economy because the current system does not require clear identification of the true owners. One of the major flows of illicit money from abroad into the US economy, with little or no accountability, is the flow that comes into the real estate sector. As a consequence, properties can be bought and sold and can be used to launder and liberate illicit monies.
Challenge 2: Designing Illicit Funds Out
Illicit funds are generated by illicit activity. They ought to be designed out of our financial system. Instead, we seem to welcome them. One example, under current US law, foreigners who bring their money into the US pay no taxes on their income and their accounts are not even reported to the US government. Unlike most of us who would be subject to such taxes, foreigners can bring as much money as they want, open bank accounts here, and they are not subject to any federal or state income taxes. This is the current law which has as its fundamental purpose the objective of welcoming funds from abroad, whether licit or not. What makes it even worse is that there is not even a reporting requirement of these accounts to the IRS unless they are required to file an income tax return.
The US Treasury Department, under Secretary Timothy Geithner, has acted courageously to introduce proposals that would require US banks to report the accounts of foreign citizens who have deposits in US banks. This new requirement would simply shed light on who has what deposits in this country. It would dampen the flow of illicit money coming into our economy, while still welcoming the flow of legitimate money. It is a step in the right direction.
But politicians have their own designs driven by the needs of their particular constituencies. A few weeks ago, two U.S. Representatives introduced a bill aimed at demolishing the Treasury’s plan to require such reporting. These legislators do not want such information to be disclosed to the IRS, for fear that such disclosure will ‘shut the tap’ on deposits coming into this country. They are quite correct. While the proposal might not shut the tap, it might reduce it to a manageable trickle and this would have implications for the economy. And, we do need to design in a way to ‘shut the tap’ on illicit, criminal, or tax evading money coming from abroad. It will not affect the perfectly legitimate money that flows into the country. And we can do without the illicit money anyway, which hurts other countries and ultimately complicates our trading and security relations with other states.
This is ultimately, not only a political question, but also one of design intent. If our design intention is to grow the economy, we must decide how we want that economy to grow and how we might best attract the kind of investment capital that is consistent with our values and our national security. Illicit funds often come from illicit sources and tracking such funds is an important national security imperative.
National design policy of any sort must balance the needs of the few and the many. As of now, the Treasury proposal is on hold. Doing nothing is also a design decision.
Challenge 3: Designing Revenues In
Tax abuse is designed into our system. According to the Business and Investors against Tax Haven Abuse, over the last two decades there has been a marked increase in the use of international tax havens for the principal purpose of tax avoidance. Several hundred U.S. multinational banks and corporations utilize tax havens to reduce or eliminate their taxes. This has the effect of shifting tax responsibilities onto the backs of domestic businesses and individual taxpayers.
Fifty years ago, corporate income taxes accounted for 23.2% of federal government receipts. Today, the U.S. Office of Management and Budget estimates corporate tax receipts will account for just 7.2% of federal revenues. The Business and Investors group believes that one significant reason for this shift is the ability of large corporations to shift income to offshore subsidiaries in tax havens. For example, according to this group:
- In 1999, TransOcean, owner of the Deepwater Horizon oil platform that exploded, killed 11 workers, and devastated the Gulf of Mexico, moved its incorporation from the United States first to the Cayman Islands and later to Switzerland, with the stated purpose of lowering its taxes.5
- In 2007, Citigroup had 427 tax haven subsidiaries, Morgan Stanley had 273, Bank of America had 115, the collapsed Lehman Brothers had 57, JP Morgan Chase had 50, Goldman Sachs had 29 and AIG had 18.6
- In 2008, Goldman Sachs, with 29 subsidiaries located in offshore tax havens, reported profits of over $2 billion and paid federal taxes of only $14 million, an effective tax rate of just one percent. This was less than one third of what they paid their CEO Lloyd Blankfein ($42.9 million).7
2008 was an unusual year financially for many companies; the intent is not to target any company, but to ensure that the use of tax havens by them is legitimate and not inconsistent with the public interest. Senator Carl Levin, Democrat of Michigan, introduced a bill in July, 2011, that would stop offshore tax abuse. It provisions would help restore about a $100 billion per year drain to the US Treasury.
The 61 page Stop Tax Haven Abuse Act is the fifth time that Senator Levin has introduced a bill of this nature. In fact, in 2007, Senator Obama and Senator Coleman, were co-sponsors with Senator Levin of this important legislation which went nowhere in the political environment.
While it is often productive and necessary to have an offshore incorporated company, there are still instances where offshore subsidiaries are abused and used for illicit means. The use of tax havens by such companies enables them to promote a culture of risk – potentially leading to more widespread economic crises. Clearly, a company that is incorporated in a tax haven to avoid home jurisdiction taxes or to hide ownership is illicit and should not be allowed. That is one of the objectives of this proposed reform.
The US economy is in a critical state now. Its municipalities need revenues to help alleviate budget deficits that significantly impact basic services. We need to design a recapturing of revenues that are critical to rebuilding infrastructure and advancing innovation.
Challenge 4: Designing Speculation Out
Risk is built into any financial system. But the financial meltdown of late 2008 and the resulting recession showed how damaging risk-taking could be. We have designed a financial system that encourages the short-term view, and rewards speculative risk-taking with huge salaries and bonuses. The reward systems for the leaders of our financial institutions encourage speculative policies that put the wellbeing of our country and our world in jeopardy.
One of the problems with the current financial sector is that the amount that many people receive in bonuses far exceeds the value reflected in the appreciation of shares. When that happens, people focus more on bonuses which by definition depend on short-term revenue targets. One of the reasons that the US has such a vibrant technology sector is that the compensation in that sector is largely based on stock options vesting over multiple years. This has the effect of encouraging long-term thinking.
Congress attempted a re-design when it enacted the Dodd-Frank Bill in 2010 to rein in some of these excesses so that the public would be better protected from future actions of this nature. This bill was as important as the Securities and Exchange Commission (SEC) legislation that was adopted in the Roosevelt Administration after the Great Depression. Finally, there was reason for hope that people’s life savings, retirement benefits, pensions, would not be lost for speculative reasons.
But, the SEC, which has been charged with implementing the 2,300 page Dodd-Frank Bill, has constantly been prevented from implementing the new rules. Congress has not given them the resources to do the necessary work. To implement the provisions of the new law, and to issue the regulations that would govern various sections of the law, the SEC had asked for funds but, to date, has received little to nothing.
Some members of the current Congress have gone so far as to propose that every securities law ever passed, including laws passed in 1933 and 1934 which created the Commission in the first place, be subjected to a cumbersome and subjective review of their relative costs and benefits. This is unfortunate. Not only are the provisions of the new law intended to save us from future crisis not being enacted because resources have not been allocated, but the basic functioning of the SEC is being challenged.
Is this a design for another economic collapse? It is certainly not a design for a more secure future financial system.
We need to be careful that we do not eviscerate the SEC by underfunding and micromanaging it. If we combine this issue with the fact that hundreds of Treasury appointments remain unfilled because of blockages by Congress, we are designing failure into the very systems that are supposed to be helping us build more success into our markets and our economy.
Challenge 5: Designing Innovation In
As other countries seek an innovative edge in the development of alternative energy, The US continues to subsidize fossil fuel. This will not encourage innovation. This designs in a commitment to the power systems of the past.
In 2005, with oil nearing $60 a barrel, James Mulva, the head of ConocoPhillips, told the US Senate that his industry did not need the tax subsidies for oil and ethanol. The industry needs them even less when oil is at $100 a barrel.
The Big Five – ExxonMobil, BP, ConocoPhillips, Chevron and Shell – reported combined profits of $35 billion for the second quarter of 2011. In spite of earning $35 billion just from April to June of this year, the well paid defenders of the oil industry state that we would be, in fact, increasing taxes if we withdrew these subsidies.
The lobbyists and their supporters in Congress are taking the position that ending these subsidies would decrease production and increase prices at the pump. The Congressional Research Service has said categorically that ending the subsidies would have no effect on gas prices and a trivial effect on profits. Are giveaways that affect the financial obligations of our children and grandchildren a good design for our future?
What does a subsidy actually cost in terms of equivalent taxes? Let us take the example of just a $5 billion subsidy which is a small part of what is paid to many in our economy. That is equal to 500,000 hard-working Americans each paying $ 10,000 in taxes to the US government every year.
Imagine, as designers of a shared future, how monies liberated from this subsidy might be used to invest in social innovation.
Challenge 6: Designing Opinion Out
A reasonable argument can be made that Standard and Poors’ (S&P)’s willingness to give an AAA rating to the securitized mortgage backed assets contributed to the financial crisis in 2008 and 2009. S&P gave Lehman Brothers, whose collapse triggered a global panic, an A rating right until the time of its demise. And then when the A rated firm went bankrupt, S&P issued a report denying that it had done anything wrong.
Before downgrading the US debt, S&P sent a preliminary draft of its press release and economic analysis to the US Treasury which spotted a large error in S&P’s calculations. After discussion, S&P conceded that its assumptions could be subject to challenge, but downgraded the US anyway after removing some of the economic analysis from its report. One has to wonder why.
After the fiasco of ’08 and ’09, when many people lost their hard earned savings, legislation under the Dodd Frank Bill tried to bring about some changes and hold the rating agencies responsible for their opinions. The Bill proposed more disclosure and regulation of the agencies, and recommended steps to reduce any possible conflict of interest. Ever since then, the agencies have been fighting to have those provisions modified or reversed. “It’s just an opinion”, they say, “and we should not be held liable for them”.
So far the provisions in the legislation that affect rating agencies have not been made part of the law, and no regulations have been issued.
We have already seen the effect that S&P’s recent ‘opinion’ has caused to the global economy. The power of rating agencies and their opinions is apparent in their ability to exercise pressure. This is not to condone US government spending which we all would agree is unsustainable over the long-term. But it is also clear that opinions without accountability must be designed out.
Financial reform requires strategic design intelligence as well as political leadership. This article suggests that the above six challenges can be understood and addressed as strategic design challenges that should impact policy decisions.
For example, if part of the design intention of financial reform is to close the deficit, then ending tax haven abuse and reducing subsidies that are no longer critical to our economy could add about $1.5 trillion to the US Treasury over ten years.
Designing transparency in would make room for more legal capital flows and make it difficult for the US to become a haven for illicit funds from abroad. The latter may add to our economy but also threaten our national security. Designing to empower the SEC to implement laws that have already been enacted would design in a safety net for current and future generations.
Tax policy can be understood as a design for collecting necessary revenues. If we let the tax cuts expire by the end of 2012, we would have another $3.8 trillion over the next decade to reduce our deficit or to allocate to education, R&D, or other long-term investments. We could design a future full of promise rather than one full of debt obligations. And, as a nation, we could address the high level of income inequality which has an important bearing on our future.
The philosopher, Blaise Pascal counseled “The scales of justice must be brought together, so that whatever is powerful may be just, and whatever is just may be powerful.” Not a bad way to begin to build a design brief for financial reform.
– The past few decades have encouraged our identities as investors, not just consumers.
– The economic collapse beginning in 2008 and 2009 suggests several flaws which indicate that we need not only financial reform, but also redesign of the financial ecosystem.
– In order to design financial reform, we must shape our lives as a community of citizens, and increase the valuation and experience of that citizenship.
– Financial reform will require strategic design intelligence as well as political leadership.
STRATEGIES IN ACTION:
Apply strategic design intelligence rather than re-use formulaic policy responses to address key challenges to financial reform.
Design in: transparency, revenues, innovation
Design out: illicit funds, speculation, opinion
Grow the economy by attracting the best kind of investment capital that is consistent with our values.
About the Author:
Krishen Mehta is Co-chairman of the Board of Advisers of Global Financial Integrity, Center for International Policy, in Washington, DC. Prior to that he was partner with PwC, serving in their NY, London, and Tokyo offices. Krishen is also on the Asia Advisory Council of Human Rights Watch, the advisory board of the Business and Society program at the Aspen Institute, and a Trustee of the Korbel School of International Studies at the University of Denver.
1 Mau, B., Leonard, J., & Boundaries, I. W. (2004). Massive change. (2004 Phaidon Press Limite ed.). New York, NY: Phaidon Press.
2 Braungart, M. (2002). Cradle to cradle: Remaking the way we make things. (1st ed.). New York: North Point Press.
3 Solman, Paul (2011). Land of the Free, Home of the Poor aired on PBS August 16, 2011. Retrieved on August 17, 2011 from: http://www.pbs.org/newshour/bb/business/july-dec11/makingsense_08-16.html.
4 Simon, H. (1996). The sciences of the artificial. (3 ed.). MIT Press.
5 David Kocieniewski, “As Oil Industry Fights a Tax, It Reaps a Subsidy,” The New York Times, July 3, 2010. http://www.nytimes.com/2010/07/04/business/04bptax.html
6 International Taxation: Large U.S. Corporations and Federal Contractors with Subsidiaries in Jurisdictions Listed as Tax Havens or Financial Privacy Jurisdictions; U.S. General Accounting Office; GAO-09-157; December 2008; http://www.gao.gov/new.items/d09157.pdf
7 McClatchy News five-month investigation of Goldman can be found at: http://www.mcclatchydc.com/goldman/