Tuesday, September 23, 2008

Information Asymmetry and the Financial Crisis

As the credit crisis continues it is becoming increasingly difficult to figure out what exactly is going on. Like most people, I am not an expert in economics so it is difficult to understand what is really causing the problem, how to fix it, and what to do next.

Last Friday, Treasury Secretary Paulson was arguing that the sky was about to fall unless intervention happened immediately. Said Paulson:

“There will be ample opportunity to debate the origins of this problem,” he said. “Now is the time to solve it.”

On Sunday he reiterated his point on a number of morning shows, arguing that there could be no time for debate and urging Congress to rush through a "clean" bill as fast as possible, although even then Congress was already beginning to push back a little.

Nonetheless, if you were like me last week, you were buying the urgency.

However, as a new week dawned, it started to become apparent that the deal may be as much a welfare package for banks as it was an emergency stopgap. Leading economists such as Paul Krugman were questioning why Paulson was seeking so much money and power in deal that gave so little to the taxpayer. By today, it seems Congress got properly skeptical. Charles Shumer even asked Paulson why not just $150 billion as opposed to $700? This evening I even read one journalist ask why - if credit is so "dried up" - is he still being offered plenty of loans? What gives?

If you are asking, "So, what is actually going on with the economy?", I don't know the answer. That wouldn't be so terrible if it also wasn't true that most people don't know the answer. As sophisticated a thinker as I might like to think I am, trying to fathom - never mind de-tangle - the inner workings of the financial markets is way beyond my abilities or training so I am left reading other experts, trying to figure out who to trust, and then coming to an educated - though variable - position.

Even though I am not sure what is exactly going on with the financial crisis, I am able to give a much stronger answer to the question, "What's going with Secretary Paulson and Congress?".

The answer to this problem lies in understanding the principal-agent problem.

The principal-agent problem has its origins in Economics but has been slowly imported into mainstream Political Science. Here is how it works. Often people want things done but may not posses the time or the skill to be able to do them themself. As a result, they employ an agent. The agent is hired to preform the job on the principal's behalf. But there are two elements which can negatively affect this relationship (at least for from the perspective of the principal): conflicting goals, and information asymmetry.

Consider the following example. One morning you get up, go out into the snow, and get into your car. When you turn the key in the ignition, nothing happens. You try again; nothing. You get out. You open the bonnet. You look inside. You touch a wire. You wonder can you electrocute yourself by touching a wire. You get back in the car. You get out again. You wander around the car. You curse. You have a small and very undignified tantrum. A neighbour sees you. You go back inside and call a mechanic to come tow the car.

A few days later you head over to the garage to see what happened to your car. You are obviously eager to get it back as fast as possible and as cheaply as possible. This is your goal. Unfortunately for you, this is not the mechanic's goal. His goal is to be able to charge as much as possible for repairing your car. So, conflicting goals.
Compounding this issue is an information asymmetry. You don't know what's wrong with your car. The mechanic does. This means it is difficult for you to asses for yourself whether the agent is doing his best for you. Furthermore, the mechanic knows it.
Voila: a principal-agent problem.

This is a popular concept in Poli Sci and appears a fair bit. Some examples:
Principal(s): The nations of the UN; Agent(s): The UN.
Principal(s): Citizens; Agent(s): Elected representatives.
Principal(s): The State; Agent(s): Bureaucracies.

So in this instance it breaks down as follows:
Principal(s): Taxpayers; Agent(s): Paulson (plus Bernanke).

It is clear from the get-go that Paulson had more information. When the crisis first struck last Thursday, Paulson ushered in leaders of both parties and painted a stark picture of what would happened if his counsel wasn't heeded:

"The room got very serious, very quickly," said a House Democratic aide who attended the session.
"When you listen to them describing this, you gulp," said Sen. Charles Schumer, D-N.Y. He said he felt the weight of "history hanging over them" in the room.

Now, less than a week later, the same Schumer is starting to question Paulson. Why? Because he spoke to other experts. Importantly, he spoke to experts who had no stake in the outcome. It's the same logic that has you give a car-expert friend twenty bucks for coming to look at the new car you're about to buy. Once he has his twenty bucks, he has no reason for you to buy a dud. If anything, the twenty bucks as an incentive for him to give you accurate information (as you may ask him next time too).

So with the information asymmetry somewhat reduced, Congress is now more skeptical of a plan drawn-up by an ex-CEO of one of the investment banks that got us into this mess; a plan which would have allowed him to keep distributing golden parachutes to his chums while Joe Michigan gets his house pulled up from under him.

Perhaps Congress are wondering if the Agent has the same goals as the Principal.

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