"In fact, it sounds more and more like commercial banking, in a world where risks are priced and capitalized properly, is a world of modest profit and modest returns for shareholders. Doesn’t that sound like a utility to you? ..."
"... The Treasury and the Fed are propping up so many different markets that it is estimated some 30% of all finance comes from Washington now. Chase is one of the selected vehicles for channeling all this money, and it is allowed to take a generous transaction fee on every dollar. This is no longer banking, but rentier finance for a few institutions granted monopoly rights – again, the classic definition of a public utility."
What is called for is a highly regulated industry considered critical to common good that is in return guaranteed monopoly: essentially the concept of a public utility. It is worth, then, providing a related piece that is opposed to the idea that regulation is lacking. This piece is of the opinion that regulation was in place to deal with the instruments that led to the crisis; instead, what was lacking was enforcement of these regulations, which resulted in fraud.
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I want to point out that the use of term "moral hazard" is unclear.
ReplyDeleteEconomist defines it as follows: (http://www.economist.com/research/Economics/alphabetic.cfm?LETTER=M#moralhazard)
One of two main sorts of MARKET FAILURE often associated with the provision of INSURANCE. The other is ADVERSE SELECTION. Moral hazard means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for.
From this definition, it is clear that government bailouts have created a moral hazard since big banks know that they will get bailed out in case their risky bets go against them.
Similarly, if we bail out those who took large housing loans and are now underwater, we will create moral hazard in that future borrowers will take bigger risks than they should.
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Moral hazard is a special case of information asymmetry as explained in wikipdedia: (http://en.wikipedia.org/wiki/Moral_hazard)
Moral hazard is a special case of information asymmetry, a situation in which one party in a transaction has more information than another. The party that is insulated from risk generally has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information.
Moral hazard arises because an individual or institution does not take the full consequences and responsibilities of its doings, and therefore has a tendency to act less carefully than it alternately would, leaving another party to hold some responsibility for the consequences of those actions. For example, a person with insurance against automobile theft may be less cautious about locking his or her car, because the negative consequences of vehicle theft are (partially) the responsibility of the insurance company.
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Information asymmetry in markets lead to market failures. This is a very fundamental issue in economics. In fact, the 2001 Nobel Prize in economics was given to Geroge Akerloff (Berkeley), Michael Spence (Stanford) and Joe Stiglitz (Columbia) for "for their analyses of markets with asymmetric information".
ReplyDeleteThe Nobel prize page (http://nobelprize.org/nobel_prizes/economics/laureates/2001/public.html) on this award contains a cogent explanation of the information asymmetry problems. I think it is one of the more stunning achievements in economics.
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From the Nobel prize page:
Akerlof's 1970 essay, "The Market for Lemons" is the single most important study in the literature on economics of information. It has the typical features of a truly seminal contribution – it addresses a simple but profound and universal idea, with numerous implications and widespread applications.
Here Akerlof introduces the first formal analysis of markets with the informational problem known as adverse selection. He analyses a market for a good where the seller has more information than the buyer regarding the quality of the product. This is exemplified by the market for used cars; "a lemon" – a colloquialism for a defective old car – is now a well-known metaphor in economists' theoretical vocabulary. Akerlof shows that hypothetically, the information problem can either cause an entire market to collapse or contract it into an adverse selection of low-quality products.
Akerlof also pointed to the prevalence and importance of similar information asymmetries, especially in developing economies. One of his illustrative examples of adverse selection is drawn from credit markets in India in the 1960s, where local lenders charged interest rates that were twice as high as the rates in large cities. However, a middleman who borrows money in town and then lends it in the countryside, but does not know the borrowers' creditworthiness, risks attracting borrowers with poor repayment prospects, thereby becoming liable to heavy losses. Other examples in Akerlof's article include difficulties for the elderly to acquire individual health insurance and discrimination of minorities on the labor market.
A key insight in his "lemons paper" is that economic agents may have strong incentives to offset the adverse effects of information problems on market efficiency. Akerlof argues that many market institutions may be regarded as emerging from attempts to resolve problems due to asymmetric information. One such example is guarantees from car dealers; others include brands, chain stores, franchising and different types of contracts.
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Spence worked on "signalling theory" -- a truly remarkable idea. Again from the Nobel prize page:
Spence asked how better informed individuals on a market can credibly transmit, "signal", their information to less informed individuals, so as to avoid some of the problems associated with adverse selection. Signaling requires economic agents to take observable and costly measures to convince other agents of their ability or, more generally, of the value or quality of their products. Spence's contribution was to develop and formalize this idea as well as to demonstrate and analyze its implications.
Spence's pioneering essay from 1973 (based on his PhD thesis) deals with education as a signal of productivity on the labor market. A fundamental insight is that signaling cannot succeed unless the signaling cost differs sufficiently among the "senders", i.e., job applicants. An employer cannot distinguish the more productive applicants from those who are less productive unless the former find it sufficiently less costly to acquire an education that the latter choose a lower level of education. Spence also pointed to the possibility of different "expectations-based" equilibria for education and wages, where e. g. men and white receive a higher wage than women and black with the same productivity.
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On Joe Stiglitz (he is the most highly cited economist of all time!)
ReplyDeleteOne of Stiglitz's classical papers, coauthored with Michael Rothschild, formally demonstrated how information problems can be dealt with on insurance markets where the companies do not have information on the risk situation of individual clients. This work is an obvious complement to Akerlof's and Spence's analyses by examining what actions uninformed agents can take on a market with asymmetric information. Rothschild and Stiglitz show that the insurance company (the uninformed party) can give its clients (the informed party) effective incentives to "reveal" information on their risk situation through so-called screening. In an equilibrium with screening, insurance companies distinguish between different risk classes among their policyholders by offering them to choose from a menu of alternative contracts where lower premiums can be exchanged for higher deductibles.
Stiglitz and his numerous coauthors have time and again substantiated that economic models may be quite misleading if they disregard informational asymmetries. Their common message has been that in the perspective of asymmetric information, many markets take on a completely different guise, as do the conclusions regarding appropriate forms of public-sector regulation. Stiglitz has analyzed the implications of asymmetric information in many different contexts, varying from unemployment to the design of an optimal tax system. Several of his essays have become important stepping stones for further research.
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Well, I think I have gone way beyond moral hazard!
I should posted this stuff on moral hazard in response to the first blog. Oh well!
ReplyDelete