Principal-agent problem

In political science and economics, the principal-agent problem or agency dilemma treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent, such as the problem that the two may not have the same interests, while the principal is, presumably, hiring the agent to pursue the interests of the former. The “agency problem” is an inherent dysfunction in all principal/agent relationships, a dysfunction so powerful that such relationships can never fully achieve their stated objectives.  

Here is how Wikipedia defines this relationship:

The principal–agent problem or agency dilemma occurs when one person or entity (the "agent") is able to make decisions that impact, or on behalf of, another person or entity: the "principal". The dilemma exists because sometimes the agent is motivated to act in his own best interests rather than those of the principal. The agent-principal relationships is a useful analytic tool in political science and economics, but may also apply to other areas.

Common examples of this relationship include corporate management (agent) and shareholders (principal), or politicians (agent) and voters (principal).^[1] For another example, consider a dental patient (the principal) wondering whether his dentist (the agent) is recommending expensive treatment because it is truly necessary for the patient's dental health, or because it will generate income for the dentist. In fact the problem potentially arises in almost any context where one party is being paid by another to do something, whether in formal employment or a negotiated deal such as paying for household jobs or car repairs.

The problem arises where the two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agent is always acting in its (the principal's) best interests,^[2] particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest may arise. Indeed, the principal may be sufficiently concerned at the possibility of being exploited by the agent that he chooses not to enter into a transaction at all, when that deal would have actually been in both parties' best interests: a suboptimal outcome that lowers welfare overall. The deviation from the principal's interest by the agent is called "agency costs".^[2]

“Looting” is a reasonably violent word that conveys with some degree of accuracy the essence of principal-agent problem in financial sector. Attempts to constrain financial looting using laws and regulation, or at the individual level, by a sufficiently powerful moral conscience proved inefficient.

Criminal prosecution is difficult as top officers amass considerable wealth and can afford the best defense money can buy. At the same time Stalinism-style purges, while definitely effective contradict norms of the modern societies.  Changing situation via regulation is difficult as financial oligarchy controls lawmakers and, as Obama election had shown, also might well controls the nomination of presidential candidates from both parties. 

Recently Willem Buiter provided an interesting insight into agency dilemma based on distinction of  soft versus hard budget constraints about principal-agent problem in financial sector. He quoted commentary from Nobel prize winner János Kornai on one of his ideas of soft versus hard budget constraints (Buiter had invoked the idea in this post). A hard budget constraint means when you run out of something (dough, usually, but it could be other scarce resources) you are stuck. No magic fairy dust to rescue you. Kornai explains:

To simplify matters, a contrast is often made between the soft and the hard budget constraint. In fact there are grades between these two extremes. The budget constraint that corporate decision-makers sense may be very soft, moderately soft, quite hard and so on, depending on their subjective awareness of the probability of rescue….

Let us turn for a minute to the dawn of capitalism. A debtor unable to pay was threatened by the debtors’ prison. Business failure in the early period of capitalism was more than a fatal material blow, for it ruined the bankrupt’s moral reputation. The budget constraint in those days was still absolutely hard. The perilous results of loss and indebtedness forced entrepreneurs to be extremely cautious.

But the historical development of property relations and the credit system gradually brought essential changes. The principle of limited liability became legitimated, and joint stock companies based on that new principle appeared. At the same time, the hitherto close connection between the material and moral position of decision-makers and the financial state of their companies became weaker.

As property and management separated, so the relation weakened between the individual destiny, income and reputation of the managers making the practical business decisions on the one hand, and the presence or absence of financial destinies of their companies, on the other. Successive legislation on business failure provided some protection for firms caught up in a spiral of debt. These changes and others not mentioned here contributed to a steady softening of the budget constraint….Early capitalism rewarded success richly and punished failure fiercely. As time went by, the rewards not only remained, but in several countries increased dramatically, while the penalties became lighter. That disproportional change has weakened the incentive for business to pursue efficiency and adaptability to change. It encourages irresponsible decisions on borrowing, investment and expansion.

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• 190329 : What are Agency Problem, Moral Hazards, & Conflict in Principal ... ( What are Agency Problem, Moral Hazards, & Conflict in Principal ..., )

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What are Agency Problem, Moral Hazards, & Conflict in Principal ...

I want to call to your attention, as we turn from crisis management to building more viable global institutions of financial intermediation, a sophisticated cynicism that opposes more resolute commitment to business ethics and corporate social responsibility.

I am not referring to the common mistrust of private enterprise on the grounds that working for personal profit is inconsistent with securing a greater good for society. This is the perennial tension posed by philosophers and religious leaders between the claims of virtue and the attractions of self-interest. Rather, I am referring to a more academically polished elaboration of that argument which is called "the agency problem."

Briefly put, the "agency problem" is said to be an inherent dysfunction in all principal/agent relationships, a dysfunction so powerful that such relationships can never fully achieve their stated objectives.

The "agency problem" exists on the agent side of the relationship: agents can't be trusted to be diligent or faithful. They are always out for themselves and are constitutionally unable to put loyalty and service to their principals above their self-interest.

Thus, any business structure that relies on agency will always be a substantial risk to a principal, putting principals on their guard and forcing them to use tactics of fear and greed to keep their agents responsible.

The problem with this approach, however, is that the remedy feeds the disease.

Using self-interest to overcome self-interest has its limitations.

As long as we believe that the "agency problem" exists and is insurmountable, we have placed before us a conceptual roadblock to corporate social responsibility. Business is no more than a complex network of principal/agent relationships. Owners of corporations are principals to the boards of directors who manage them; senior company officers are agents of the boards and the companies; all employees are agents of their employers; banks, insurance agents, accountants, investment managers, lawyers are all agents to some degree for others. If the "agency problem" exists, then every relationship in this network is infected with the risks of negligence and betrayal. Social Darwinism or dog-eat-dog would seem to be the only rational approach to a life in business. It would be foolish or worse to expect such an environment to ever promote responsibility to the common good.

Advocates of corporate social responsibility must presume something other that the "agency problem" as an immutable fact of business life. Corporate social responsibility, corporate philanthropy, corporate citizenship, all ask of business and business decision-makers a showing of responsibility to others. Usually the responsibility of business is stated as having respect for the interests of stakeholders: customers, employees, owners, creditors, suppliers, competitors, and communities, including the environment.

The problem of faithless agents

If we want a more moral capitalism, we have to solve the "agency problem" or, at a minimum contain its virulence. Modern capitalism generates wealth through specialization of function and division of labor. This fact was Adam Smith's great insight into the origin of the 'wealth of nations" as he called it. But, as labor is more and more specialized, each component sub-unit of the economic system becomes more and more dependent on all the other parts. In today's world of high technology, dependency on specialized machines and the skills of professional experts is higher than ever in human history. Our modern world is also completely subservient to reliable flows of electricity.

The Turkish Airlines plane that recently crashed short of the runway at Schiphol Airport outside of Amsterdam did so because its altimeter was faulty. Nine people died as a consequence of the pilots' relying on a mechanical device for guidance in landing.

If the "agency problem" is all powerful and all pervasive, then modern capitalism is constant at risk of failure because the dependency relationships that flow from specialization are prone to abuse on the part of those who dishonor the reliance and trust placed on their competence and their integrity.

A market place of lying sellers and conniving buyers will never grow very prosperous. When faith and trust evaporate, so does capitalist wealth. The current meltdown of global financial markets is a good case in point.

But, the seriousness of the "agency problem" has been overstated. If it were truly dominant in the business world, modern capitalism with all its relationships of interdependency and mutual benefits would not have emerged to produce the wealth that we enjoy today – even in these months of a serious global recession. Thus, we can infer that there are some countervailing forces that nibble away at the "agency problem".

What can we do about faithless or negligent agents?

The problem is not a new one. In the Judeo-Christian tradition, the prophet Samuel warned the leaders of tribes of Israel not to put their faith in kings, for, as he predicted, kings would turn against their trust and abuse power for their own selfish advantage. Later, Jesus stated that one could not serve both God and Mammon.

The Common Law of England over the centuries fashioned many legal responses to minimize the effects of the "agency problem". These rules and practices constitute what is called the law of fiduciary duties. Also, the English courts of Equity contributed to fiduciary law with their own set of procedures and requirements designed to remedy abuse of legal power and prevent fraud and oppression in the marketplace.

The basic device used by the Common Law to minimize the effects of the "agency problem" was to define what was expected from agents as duties to their principals and give principals specific remedies for breach of those duties. This was a practical approach that sought to structure incentives so that agents would be more inclined to stick to the punctilio of their responsibilities and principals would be induced to assume the risk of trusting agents. Other words used in the Common Law to resolve the agency problem were fiduciary, trust, and beneficiary of the fiduciary trust. The fiduciary or the keeper of the trust was, in effect, the agent and the beneficiary was, in effect, the principal.

First, the agent was burdened with duties of loyalty and due care. When the self-interest of the agent was suspected of causing harm to the principal, the burden of proving loyalty was placed on the agent. The agent had the burden of coming forward with sufficient evidence to prove his or her loyalty. With respect to negligence on the part of the agent, the principal had the burden of proof but could hold the agent accountable when an objective standard of care had not been observed in management of the business consigned to the agent.

The Common Law thus turned the relationship of principal/agent into a status for the agent. Agency was an office; so was being a partner, a trustee, a corporate director, etc. With office came specific responsibilities. Failure of performance was transformed from a difference of opinion between agent and principal into a notorious setting of public expectations. The behavioral theory used by the Common Law judges appears to be a conviction that when we are made accountable in public, our pride tends to keep us more scrupulous and diligent than when we can act in secret. Principals could deny their own liability for acts of the agent when the agent had acted contrary to the terms of the trust, leaving the agent exposed to face the consequences.

Exposure and transparency were devices used to reduce agency problems.

Second, in its courts of Equity, English jurisprudence fashioned a number of rules that principals and beneficiaries could use. They could seek an accounting of monies had and received, with the burden on the agent to account for every penny received; principals could ask for the imposition of a constructive trust on money and property in the agent's possession and name when fraud and abuse had occurred; agents had to have acted with clean hands if they sought to recover from principals on their agency contracts; agents could be prevented (estopped) from entering claims and evidence in their favor if they had acted inequitably.

Use of self interest

A second basket of remedial responses to the "agency problem" lies in self-interest. It is in one's best interest to avoid faithless agents. Over time, therefore, faithless agents will not find employment as their reputation for negligence or disloyalty becomes generally known. This is why reference checks are so frequently relied upon. Generally, market based solutions to the "agency problem" rely on this mechanism of self-help. But it can be of limited utility where agents or those upon whom we rely for professional expertise have market power or are polished performers adept in the arts of lulling our suspicions with their smoke and mirrors – like Bernie Madoff to his investors.

Use of character

The third approach to minimizing the "agency problem" is to promote good character, the habits of living up to the virtues of trustworthiness, integrity, diligence, transparency and reliability. This agenda for securing better prospects for corporate social responsibility and business ethics – for avoiding asset bubbles and financial bubbles – and for putting in place the cultural foundation for specialization of function and division of labor operates at the level of the individual.

We must engage individuals to act as we would want if we want responsible and faithful agents. Such socialization, obviously, begins in the family, continues in school, and is finished in conditions of social engagement. We are concerned for the "presentation of self" in everyday life and Irving Goffman wrote about our dysfunctions in organizational settings. We want a good self to be presented, not a greedy, abusive, stupid or negligent one.

Having good character is one reliable ground for good stewardship behaviors. The moral sense within us is a public good in that it promotes trust in our communities and reliance on our business performance. Trust and reliance form the substructure of successful modern capitalism.

That human persons possess a moral sense that distinguishes them from beasts and other earthly creatures is increasingly a postulate of evolutionary studies, neuro-science, and brain research.

Thus, we must not presume that the "agency problem" is intractable and a permanent obstacle to responsible business decision-making. Rather, we should assume in us all an inherent capacity for reliable agency performance.

Set the bar high and we will tend to jump higher; set it low and we will slack off and get away with poor performance.

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