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Monday, September 19, 2011

Principal-Agent Problem Meets the Public Sector

Government isn't like business.

What works for business should work for government, right? Not necessarily.

Law professors Frederick Tung of Boston University and M. Todd Henderson of the University of Chicago recently asked that question about the banking industry. They propose that bank regulators should receive incentive pay linked to banks’ performance. They argue that giving regulators a stake in the success of the firms they regulate will motivate them to make better decisions. Freakonomics blogger Matthew Phillips commented that Tung and Henderson “are essentially proposing giving regulators stakes in the banks they oversee, by tying their bonuses to the changing value of the banks’ securities. . . . The proposal would completely change the role of the regulator, from antagonist to partner.”

While this particular study is new, the idea is not. Every so often academics rediscover the superior incentives that private companies provide to ensure their employees work to advance the central mission of the organization – to overcome what is known in management parlance as the principal-agent problem.

The principal-agent problem occurs when individuals in a department of a firm face incentives to pursue departmental goals that conflict with the overall goals of the firm. For example, environmental compliance officers have an incentive to please environmental lobbyists and EPA regulators. In other words, they face a strong temptation to, as diplomats say, “go native.” Firms need incentive structures to motivate employees to resist and overcome that temptation.

Tung and Henderson seek to quantify and duplicate how private companies accomplish this so that public agencies can adopt similar structures – to advance the “public interest” rather than institutional self-preservation and advancement.

Big Difference

This may sound like a good idea at first, but there are inherent differences between the private and public (government) sectors that hinder its successful adoption by government.

Private firms have a clear objective – to maximize profits for shareholders. This requires managing risks and planning for the future. For example, a loan officer’s job is to not only make loans but to ensure that those loans are profitable. They must balance the risks of overly strict lending standards against the risks of overly lax ones. When government rushes in with explicit and implicit guarantees, this balancing task is distorted.

The problem with trying to adapt business-like incentives to a government agency’s overall focus is . . . government. Government cannot utilize market mechanisms because it is a monopoly by definition, and that creates incentives unique to State actors. In government the distortion is built in.

Perverse Incentives

Public Choice theory helps explain the incentives faced by those working in government. As Nobel Prize-winning economist James Buchanan, one of the founders of Public Choice, points out, “[T]here is no center of power where an enlightened few can effectively isolate themselves from constituency pressures.” In other words, actors within the bureaucracy cannot operate away from the political pressures of trying to please politicians and the voters who elect them. Thus institutional self-preservation wins out.

The government’s clumsy response to the financial crisis made the shortcomings of State regulation evident, but the problem is not new.

In fact this lesson should have been learned during the savings and loan (S&L) crisis of the 1980s and early 1990s. The Federal Savings and Loan Insurance Corporation (FSLIC), which was expanded greatly during that crisis, ensured that “smart money” was attracted to poorly managed S&Ls willing to offer high interest rates. The managers of these S&Ls recognized their bankrupt status, but they were being kept alive by a government guarantee.

A government-guaranteed entity isn’t really allowed to die until the government says it can. Until that time (which rarely arrives), the risks were transferred from the S&Ls and the depositors to the taxpayer. Indeed, S&L management shifted from small-town bankers to some of the world’s most, well, “creative” financiers. As a colleague at the time, Catherine England, noted, no system was better designed to attract “crooks, scalawags and sharp dealers” than the then-existing regulatory structure.

Responsive to Politics

Why didn’t regulators do their duty? Because the FSLIC was more responsive to its political leaders than to financial reality. House Speaker Jim Wright (D-Texas) argued zealously that Texas banks were not insolvent but illiquid.

Sound familiar? Zombie S&Ls stayed open far longer than they should have, and the S&L crisis was the result – with over a thousand failed institutions and an estimated cost to taxpayers of $124 billion.

Do Tung and Henderson believe regulators would have done a better job if their rewards for doing so had been greater? The rewards of government service are not necessarily economic. Avoiding trouble with lawmakers is a strong motivation on its own. So when asked to solve zombie S&Ls’ “illiquidity,” regulators could be counted on to bend to political pressure.

Wright left Congress many years ago, but his successors are doing as much damage today. The bureaucrats enforcing the slew of new regulations – from Dodd-Frank to Obamacare to CAFE on steroids – will face the same incentives as did the staffers at the FSLIC.

Markets work by rewarding the success of individuals who, at their own risk, venture forth and succeed – whether by brilliance or luck – in fulfilling unmet consumer needs. Bureaucrats, by contrast, are risk-averse and respond to political incentives. No “bonus” for making the right decision can change that.

  • Fred L. Smith, Jr. is the founder of the Competitive Enterprise Institute. He served as president from 1984 to 2013 and is currently the Director of CEI’s Center for Advancing Capitalism. He is a member of the FEE Faculty Network