Belmont Club

Up the sleeve

Here’s an example of the Principal-Agent problem.  Bloomberg repored on Nov. 10 that “the Federal Reserve is refusing to identify the recipients of almost $2 trillion of emergency loans from American taxpayers or the troubled assets the central bank is accepting as collateral.  Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson said in September they would comply with congressional demands for transparency in a $700 billion bailout of the banking system. Two months later, as the Fed lends far more than that in separate rescue programs that didn’t require approval by Congress, Americans have no idea where their money is going or what securities the banks are pledging in return.”

The Principal-Agent problem, for those who forgotten it, describes the situation that arises when there is an information asymmetry between the principal — the US taxpayer — and the agent — the Treasury. The Treasury is supposed to be acting in the interests of the taxpayer. But how do we know that it is not acting to support friends of Treasury officials? The problem with not having any information, the problem which the Bloomberg story is about, is that we don’t know.

This is the case to some extent for all contracts that are written in a world of information asymmetry, uncertainty and risk. Here, principals do not know enough about whether (or to what extent) a contract has been satisfied. The solution to this information problem — closely related to the moral hazard problem — is to ensure the provision of appropriate incentives so agents act in the way principals wish. In terms of game theory, it involves changing the rules of the game so that the self-interested rational choices of the agent coincide with what the principal desires.

But when the amounts being disbursed are so vast, what conceivable system of incentives could be implemented a priori to ensure that Treasury officials will act in the public interest. But the availability of information on the agent’s interests and actions can itself can act as a disincentive to misbehavior. If Treasury officials know that their actions can be observed, they will refrain from engaging in anything which might expose them to criminal or civil liability. The principle is familiar from the old episodes of the old Maverick TV show, which dealt with the adventures of a riverboat gambler. With the cards in plain view all attempts to cheat to run the risk of .45 blast from underneath the table. Therefore while all the players at the table may themselves be cheats, information transparency can make the game as honest as a friendly game between relatives.

But right now the Treasury has dimmed the lights. And while we can’t presume to know what’s going on, the Principal-Agent analysis suggests the public would be better off if we switched them on.

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