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Checks, Balances, and Audits

Wednesday, June 20, 2012

Here’s an approach that accepts the reality of the Administrative State while restoring the principle of checks and balances.

Our Constitution was designed to disperse power. The theory was that each branch of government would have its potential for abuses curbed by the other branches. This is the theory of checks and balances.

Our modern government has left the original model behind. We have what is sometimes called the Administrative State, in which power is exercised by independent agencies that are largely beyond the reach of the political process. Examples would include the Federal Reserve Board, the Internal Revenue Service, the Transportation Security Administration, and the Congressional Budget Office.

The impulse to create powerful independent agencies is strong. Under President Obama's new healthcare law, the Independent Payment Advisory Board has the potential to become the most powerful agency of all. The Dodd-Frank financial reform legislation created bodies responsible for consumer financial protection and systemic risk regulation. As politicians grope with issues posed by new technology, we can expect the idea of independent agencies to surface in areas like biotechnology regulation, surveillance policy, and cybersecurity.

Even if opponents succeed in abolishing one or two of the newer independent agencies, the vast majority of them will continue to exist. What I want to propose here is an approach that accepts the reality of the Administrative State while restoring the principle of checks and balances.

An independent auditor

Studies conducted by the Treasury Department have shown high error rates by IRS employees. Medicare suffers from a high rate of fraud, estimated by the GAO at $48 billion.

My proposal is to create a branch of government whose purpose is to audit independent agencies. An independent auditor has some obvious potential problems. On the one hand, it could be ineffectual if it turns out to be weak relative to the independent agencies, or captured by them. On the other hand, it might become too powerful, evolving into a sort of super-agency itself. Finally, it could become just another layer in the bureaucracy, not adding value but absorbing resources and adding to costs.

However, an independent auditor could also bring potential benefits. Government agencies have a tendency to stagnate, with internal problems that never get fixed. They get stuck in bureaucratic ruts (“that's the way we've always done things here”), and major mistakes result. An independent auditor could expose weaknesses in standard practices at agencies, putting pressure on them to reform.

Currently, the Government Accountability Office (formerly the General Accounting Office) comes closest to playing this role. However, the role that it plays is too modest. What I would like to see are hard-hitting audits that agency managers would feel obliged to address.

Many independent agencies have major weaknesses. For example, studies conducted by the Treasury Department have shown high error rates by IRS employees.1 Medicare suffers from a high rate of fraud, estimated by the GAO at $48 billion.2 The macroeconomic forecasts of the Congressional Budget Office and the Federal Reserve use methods that have long been discredited and that seriously under-predicted the severity of the current recession.3

Inbred culture

An independent auditor could expose weaknesses in standard practices at agencies, putting pressure on them to reform.

The Fed and the CBO also illustrate the inbred nature of these institutions. A look at the organization chart of each agency tells you that most of the senior staff positions are filled by career employees of the organization. Many top appointments at the Fed staff are names that I recognize from when I worked there, over 25 years ago. This produces a culture of conformity, where it is safer to follow the conventional wisdom down a path that leads to failure than to question the entrenched orthodoxy.

Ross Levine and colleagues blame the financial crisis on the stagnant thinking of these inbred regulators.4 Levine writes,

Senior officials repeatedly designed, implemented—and most importantly—maintained policies that destabilized financial markets. Regulators maintained these policies even when they learned that their policies were increasing financial system fragility. Moreover, the authorities acquired this information during the decade before the crisis, when they had ample time and power to adjust their policies under relatively calm conditions. Nonetheless, regulators did not adjust. The financial regulatory apparatus did not work in the best interests of the public.5

Levine argues that it is impossible for the public or political leaders to evaluate the quality of financial regulation. He advocates what he calls a “sentinel,” which would charge an agency with a responsibility to “continuously assess and comment on financial policies.” This fits in with what I call an independent auditor.

Reviewing the history of recent financial regulation, I found many instances in which outside experts predicted the adverse consequences of risk-based capital regulations that relied on rating agencies' designation of AAA securities.6 Had these criticisms been given institutional authority, perhaps the regulators would have taken steps to mitigate—or at least monitor—the risks that they were creating. However, absent a strong institutional check, the inbred culture at the Fed and other bank regulators was too sanguine about the safety and soundness of the practices that it was encouraging.

Absent a strong institutional check, the inbred culture at the Fed and other bank regulators was too sanguine about the safety and soundness of the practices that it was encouraging

It would be particularly dangerous to develop this sort of inbred culture in the field of homeland security. New technologies change the nature of threats and increase the opportunities to engage in domestic surveillance. A totally independent agency is likely to maximize its own comfort, which may mean overlooking key threats while infringing unnecessarily upon civil liberties. There are many security experts who are skeptical about the approaches of TSA and other security agencies. Many civil liberties advocates are rightly appalled by the growing encroachment on individual privacy and dignity. These views should be given institutional influence through the mechanism of an independent audit.

For an independent auditor to be effective, Congress and the president would have to be committed to paying attention to audits that find serious weaknesses, otherwise, agencies will have no incentive to pay attention to the auditor.  Another requirement for the auditor to be effective is that adverse audit findings must be a political liability for the administration, causing political leaders to put pressure on agencies to correct audit issues.

No system of checks and balances works perfectly. However, the original constitutional checks and balances have long since frayed. For better or worse, our government now relies on expertise embedded in agencies whose policies and procedures are difficult for the general public or elected representatives to evaluate. This gives agencies considerable autonomy, which can lead to stagnant thinking and lack of concern with the way that they impose costs or infringe on liberties of ordinary individuals. Under these circumstances, creating an independent auditor with a high level of prestige could provide a strong check against agencies that otherwise will follow policies for their own institutional convenience regardless of the public interest.

Arnold Kling is a member of the Financial Markets Working Group at the Mercatus Center of George Mason University. He writes for econlog, part of the Library of Economics and Liberty.

FURTHER READING: Arnold Kling also writes “Why We Need Principles-Based Regulation,” “Economics: A Million Mutinies Now, Part Three,” and “The Challenge of Achieving a Liberal Order.” Peter J. Wallison says, “Dodd-Frank's Liquidation Plan is Worse Than Bankruptcy.” Philip I. Levy reports “IPAB is No Fed, Will Fail.” Alex J. Pollock contributes “Founding Fathers Would Have Wanted to Keep CFPB in Check.”

Footnotes

1. See, for example Daniel J. Pilla, “IRS Error Rate Still High,” ;IRS Oversight Board, “FY2008 IRS Budget Recommendation Special Report.”

2. Kathleen King, “Medicare Remains at High Risk Because of Continuing Management Challenges,” Testimony before the House Subcommittee on Oversight and Investigations, March 2, 2011.

3. See Arnold Kling, “The Soothsayers of Macroeconometrics,” American.com, September 19, 2011.

4. See James R. Barth, Gerard Caprio, Jr., and Ross Levine, Guardians of Finance: Making Regulators Work for Us, MIT Press, 2012 (forthcoming).

5. Ross Levine, “The Governance of Financial Regulation: Reform Lessons from the Recent Crisis,” paper prepared for 9th annual BIS conference. Version dated March 2011.

6. See Arnold Kling, “Not What They Had in Mind: A History of Policies that Caused the Financial Crisis.” Mercatus working paper, September 18, 2009.

Image by Darren Wamboldt / Bergman Group

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