Sunday, March 15, 2015

Moral hazard and commitment

There is a common thread behind many microeconomic problems (with macro implications) in modern economies: moral hazard when threats or explicit contracts are not credible. That was supposed to be a problem of planning economies where firms where under the grip of the public sector. It was called the "soft budget constraint:" managers knew that they would be bailed out and behaved correspondingly in a not responsible way. With the hegemony of capitalism this was supposed to be a problem of the past. However, we have seen that “too big to fail” was a big problem in the last financial crisis. Banks’ managers probably anticipated that they would be bailed out and they relaxed their credit standards. But the same moral hazard is seen in PPP contracts, whereby private contracts may anticipate in some countries that they will be bailed out if there is insufficient demand for their services or if the costs turn out to be higher than expected (these are liabilities that lie off public budget when they should be in). The same happens in soccer or other sports clubs or events that expect that the public purse will be there if things become financially strained. The term moral hazard is the same used to analyze the problem in insurance whereby insured agents may relax their behaviour to try to prevent adverse outcomes that will be covered by the insurance company. And it is of course the same concept as the one used in agency theory (principal-agent problems) where unless there are high powered incentives (that is, some risk), agents will not work with a high effort. The are all hidden action problems, as opposed to hidden information ones. The orthodox solution to these problems is to commit to not to prevent bad consequences for agents when they do not achieve outcomes that are satisfactory enough. That is, the solution is to commit to extrinsic incentives, and also to resort to bureaucratic mechanisms that make sure on a day to day basis that the agents will not slack. A similar problem shows in the literature on federalism. The best federal systems are those where the federal level is able to commit not to bail out the federated units, so that these behave with discipline (and also, the federal level commits not to trespass the competences of the federated units). Perhaps a common perspective could help better analyze all these problems.

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