For anyone paying any attention to any kind of press, there seems to be an unending stream of thoughts analyzing the financial crisis in the
While explaining the cause of this crisis seems complicated to even the best of minds, it seems a proximate cause for bankruptcies like AIG was excessive investment in instruments like credit default swaps that insured the debt of other institutions like Goldman and then sent AIG down-under once the housing bubble decided to burst.
The evolving consensus seems to be that taxpayers are now in the inextricable situation of having to bailout Wall Street for its own excesses (perhaps with the exception of Lehman), so as to prevent or soften the blow to the ‘real’ economy. Doing otherwise would presumably result in financial contagion leading to reduced investment and job creation, a reduction in lending leading to difficulties in financing mortgages and a whole host of other problems that result from the latter.
On the downside, the very people who caused this crisis are getting bailed out by tax-payers and only have to endure some bad press and corporate restructuring; the proverbial slap on the wrist. While a perhaps radical juxtaposition, these arguments remind me of the debate on the Indian Government's recent loan waiver program.
At some level of specificity, I’m sure it’s unfair to compare the following two situations, but narrowing the scope of our analysis to government (or any third-party) intervention in a principal-agent relationship, I can’t see much of a difference. To wit, the farmer who has used her loans unwisely is in a similar position to the investment banker who has imprudently invested in CDS’s or what have you. In each case, the agent (the farmer or the banker) has done a bad job of satisfying whatever contract that exists with the principal and is therefore unable to make good on the promised return, be it to an MFI or the shareholders at Lehman.
In the case of the farmer, we acknowledge the desperation of the situation but still make the argument that a loan waiver could affect long-term lending and ‘credit discipline’ more broadly. (See V. Mahajan in CMF Policy brief.) As for the banker, we must similarly acknowledge that by bailing him out, we run the risk of a further moral-hazard type problem by essentially insuring him against his own incompetence, but at the same time to not do so would result in even worse consequences.
Two questions occur to me from this exercise. Firstly, what criteria do we use to decide on the appropriateness of government intervention in financial markets? Do we simply base our decisions on historical contingency, or theoretical scenarios which – perhaps by virtue of their scale – have little or no ‘hard’ evidence, free of statistical qualms.
Secondly, if there is good empirical evidence to support non-intervention – perhaps the IRDP experience is an example – but a democracy wills that the humanitarian consequences are even more dire, perhaps what we should be focusing on is learning how to design institutions which are capable of responding to such a situation, together with capacity-building and financial-literacy efforts to prevent such problems in the future?
4 comments:
In 1969 and in the 1970s, when banks were nationalized in India, one of the stated objectives was to encourage banks increase their lending and outreach. Here, the government is assuring all account-holders with PSU banks that their deposits are safe no matter what. That was seen as a socialist move, keeping in line with the policymaking mood in India at that time. It is strange/interesting to see socialist policy instruments bailing out institutions that suffer from unsustainable capitalistic greed.
The loan-waiver in India throws up interesting similarities with the financial crisis which indicate how great a leveler this crisis has been - The millionaire CEO is in reality as unaware of factors beyond his control as the poor farmer is. What the farmer knows about the monsoon, pest attacks and sale prices is exactly what the I-bankers and the whizkids know about portfolio quality, futures valuation and market trends.
The farmer is not rational in his expectations - he will farm even if he knows outputs and prices are falling and he has no chance of surviving if he depended only on agriculture - their counterparts being eternal optimists, who believe people can live off credit, a stream of expected future income, never mind what the reality is; and curbing their risk-taking instincts is sacrilege.
Farmers in India are a political constituency - only they vote - and corporates in USA, on the other hand, are a constituent of the government, riding on the millions that fund campaigns.
So what is the solution? Educate the farmers, tell them how to manage their money, teach them other skills, teach them how to farm and everything else that we presume we know better. What about their friends in the west? Ah - let them take their bonuses home, lets bail them out and wait for an encore!
Principal-Agent Theory
To relate to Nilesh’s first question, I will examine the theoretical scenarios of the principal agent framework and how it may be valid in some cases and not in others. Government intervention in the current financial turmoil, under the principal-agent (PA hereafter) framework is notably complex. I will briefly outline (in a weak fashion) what could be a PA application to the current crisis and highlight the problems.
However all is not lost. It may be useful to further examine the theory and briefly (probably naively) develop some of the potential trajectories of PA application. One such application relevant to development is analysis of IMF conditionality
I would argue even trying to think about the financial crisis (viewing agents as banks or anything that could be bailed out and principal as government with the power to use taxpayers money to bail-out) weakens the PA strength – its simplicity and ability to attempt to quantify incentives that enable sound contracts to be created between principal and agent.
Let us set the basic idea up.
The principal-agent framework could be interpreted as one of a ‘principal’ who attempts to align the ‘agents’ behaviour, through conditionality/incentives etc, to fulfil the principal’s interest or goal. In the formal sense, the agent will attempt to maximise their function subject to constraints (designed by the principal). Applying the framework to financial crises that involve bail-outs of numerous banks is complex.
There would inevitably be multiple ‘agents’. It is noteworthy that domestic or national banks are emboldened in this crisis not to mention the hedge funds, SIVs etc. We could also presume that the government in our framework is the ‘principal’ – checking and attempting to apply stringency to the market to fulfil its criteria - stability and growth.
One problem is that the ‘agents’ are inter-connected through the modern tools of international finance. For example, SIVs and the like may have hundreds of ‘agents’ which makes the principal’s job impossible. This increases information asymmetries for the domestic government in question (the principal) to monitor the agents involved. Further, modelling this according to the PA framework would be extraordinarily arduous. You would have a principal monitoring interconnected agents with numerous financial contracts going in both directions.
Another problem is the issue of the ‘agent’ being to big too fail and in the financial crisis case, the agent’s involved essentially make up the financial system. They are not a single rouge bank or an imprudent country attempting to default on its debt. These, examples I argue below would be easier to analyse.
Other problems are evident. Extending the theory to capture the financial system, the principal’s (countries or governments) hold less sway than the agents in question (i.e. nearly all major financial institutions operating in the market). The goes against the PA framework. Furthermore, it is not clear that the principal is really the ‘principal’ as evidenced in the bailout discussed so frequently in the press. Therefore viewing the incentives and interests of principal and agent within the PA framework is a little hazy.
Without going overboard with more detail, the principal could be considered to be owned by the ‘agents’ through their election funding so distinguishing the principal is problematic. Additionally, clearly the economy intrinsically depends on the financial institutions that are going through such trouble (naughty ‘agents’ like AIG, Merril Lynch. Lehman etc) which means the principal will always protect the majority of ‘agents’ to ensure stability. Again the PA framework is a minefield.
Another theoretical frameworks could be a bargaining model between two actors, one being the government and the other being a number of identified banks. The bargaining powers would be assigned to each group and certain equilibrium could be attained. Though, I am not sure how it would explain the current crisis and if it would go any further than the PA setup.
However, the PA framework is far from being useless. In thinking about microfinance lending, as mentioned in blog above, and World Bank/IMF conditionality PA may be more rewarding.
I will briefly focus on application on conditionality. For example, using the PA framework to analyse IMF/WB conditionality on their stand-by-agreements (loans) provides fruitful analysis. IMF researchers have examined such models Khan (2001) and Ivanova. Through PA we can analyse what conditions were not met and monitor the developing country’s (agent) motivations and capability on say the labour reform conditions of its agreement with the IMF. Designing a contract/conditionality that aligns the interests of principal (maybe repayment of the loan and potential reform/liberalisation) and agent (using loan to mitigate of balance of payments crisis and maintain political power or attempting to pass through reforms under the auspices of a Bretton Woods institution, for example) could be useful.
There have been theoretical advancements. Allan Drazen has looked at the difficulties faced by the IMF through formal use of the PA by modelling the tension within the ‘agent’. The ‘agent’ which we assume is country A, is represented by the government but faces conflicts of interest internally. While the government in power of country A will most likely agree to the IMF’s demands, such as tighter fiscal policy, an understanding of the agent’s ability to carry out such reform extends way past the government’s promises. The institutional barriers to reform and the opposition parties (or veto players) need to be considered and evaluated. This is useful because it tackles the central tension of conditionality, how far can a ‘willing’ government carry-out the planned development trajectory without actually correctly ‘owning’ the policy (owning would mean that the entire state is behind the reform). So the agent (the government) has to maximise subject to certain constraints in the form of veto powers and the additional reform requirements put forward by the principal.
The PA framework is a great way to look how conflicts of interests of actors can be formulated, particularly in development paradigms concerning lending. But thinking about the current bailout in the principal agent form is difficult, particularly at modelling the interactions of the government and those actors we call ‘agents’.
Alastair,
Much of your analysis hinges on mistakenly specifying the government as a principal. I do not consider the government to be the principal in either case (see paragraph 4 of article).
Rather, the purpose of the allusion was to consider, in isolation, a third-party intervention in PA relationships.
In the case of the farmer, he is the agent, and his repayment is contracted for by whoever lent the money (MFI, money lender etc.., the principal in this case). If the farmer reaps a poor harvest (for whatever reason) the principal is worse off by way of default, and so is the farmer, by way of constraints on financing future consumption, stress, suicide and also consumers, higher prices, less variety in supply etc..
The banker on the other hand, raises money through capital markets and is ultimately accountable to the shareholders of the firm or whoever acts on their behalf (the principal). In this case, we contract for the banker's marginal contribution to whatever surplus value (or profit) he is able to contribute. In the bad state of the world (now), the banker messes up and gets fired, shareholders lose money, and other folks (like depositors and investors) lose money via. contracts the bank is unable to honor.
Without any intervention, maybe the farmer uses different crops or favors an alternate contractual specification for loans, and perhaps the banker adopts different types of derivatives or a different attitude to risk.
The question is on what basis we (or the government on our behalf) decide to act, and what criteria we judge appropriate in justifying intervention.
And yes, I think Suvojit makes a good point in thinking about the relative bargaining power of the actors concerned, as probably being an important determinant of intervention rather than any concern for what is socially optimal.
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