Wednesday, 21 March 2012

A terrible example. A moral hazard created by parliament

The principal agent problem is one of the most important breakthroughs in economics. Simply stated, A principal wants the agent to do something, but he has less than perfect information in whether the agent is effective. Hence the agent can get away with cheating the principal, since he has better information but very different incentives (the principal was the agent to work hard, the agent wants to get paid without working hard). One needs to align the incentives of the principal with the agent in order to achieve the best social results.

This idea in economics was forcefully introduced by George A. Akerlof, who used it to explain:
1) Why you often get a bad car (called a lemon in the US) in the second hand market...
2) Because of the risks of asymmetric information (i.e. the agent knows more than the principal)...
3) And as a result the prices of cars in the secondary market are way lower than for a new car.

This idea introduces the problem of Moral Hazard: moral hazard is a tendency to take undue risks because the costs are not borne by the party taking the risk. The principal wants the agent to perform well, but the agent knows that if he fails he will be aided by the principal, who does not want to see his business fall. As a result the agent takes huge risks: He can keep the returns (since he can hide the risk from the principal) and be sure that the principal will bail him out if the risky returns do not work out.

This Moral Hazard underlies most of the moves to help banks in the EU and the US; However in Cyprus the Hazard has been brought in by parliament not to help banks managers but to help investors!

Despite warnings by the central bank that this law will create the a very negative precedent, parliament (legal section not economic committee) has gone ahead and discussed the possibility of a relief towards those who took risky investment loans to speculate (a fancy word for gamble) in the stock-market during the large stock market bubble in 1999-2000 in Cyprus.

A reminder: The stock-market bubble of Cyprus was the largest rise and fall of a stock exchange in a year in recoded history of the world. Many people lost their money, but others made a fortune on the upside by borrowing massively, and refused to pay the banks what they owned them when all came crashing down.

This law is a typical example of creating Moral Hazard: it tells agents that investing in the stock-market is risk free, since the parliament will make sure the risks of the speculation not working will be borne by the Principal (in the case the banks). Its only result would be to further severely limit credit for stock-market activities, depressing further a very anaemic market.

In fact i would say that the whole law "smells". The banks have not been paid since 2000 on these loans, and hence the law seems to try and stop legal proceedings which are ongoing and that they must be reaching their end. It appears that this law is trying to save some big "boys" which are close to finally having the retribution for their investments (if they have not hiding everything away already. We must re-introduce the "let the buyer beware" principle, that keeps principals on their toes and agents, as much as possible, straight and not crooked. This law should not go through.

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