Wednesday, September 17, 2008

A failure of ownership

An interesting article by Chris Dillow in The Times concerning the current financial crisis: form of ownership has caused a crisis, and another hasn't. The reason for this lies in what economists call the principal-agent problem, and what everyone else calls the difficulty of getting your employees to act in your interests rather than their own.

Big, quoted companies have been unable to solve this problem. Shareholders - often, ordinary people with pensions - have little control over fund managers. Fund managers have little control over chief executives. And chief executives have had little control over trading desks, partly because they just didn't understand the complexities of mortgage derivatives.

I'll give you this for some lovely CDOs...

So traders were free to gamble with other people's money. They got multimillion bonuses if they did well, but faced almost no meaningful sanction if they failed: John Thain, Merrill Lynch's chief executive, is rumoured to be in line for an $11 million payout. The result was excessive risk taking.

This makes a lot of sense: free markets are powerful tools, but like many powerful tools they need to be carefully controlled, primed, and monitored.

Creating situations where the ownership of firms results in employees and owners having different aims and agendas is a recipe for this sort of failure.

Dillow refers to a book called The Subprime Solution by Robert Schiller:

The solution to our troubles, he says, is more markets, not fewer. He proposes the introduction of markets in livelihood insurance, so that people can buy protection against job losses, and better markets in house-price futures, so we can insure against falling house prices.
People need to learn to respect the free market: understand what it does, how it does it, and what its limitations are.

It isn't a case of more regulation and state control vs. less regulation and state control, it is a case of finding the appropriate levels of state control.

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