May 19, 2009

Agency Problems for Firms and Banks

On April 2nd, 2009, the leaders of the G20 group of developed and emerging economies gathered in London to combat the economic crisis.

Their goal was to “rewrite the rules of global finance and reshape the world’s financial institutions” because since their last meeting last November, “the global economy has fallen off a cliff. Consumers have cut back their spending. Companies have slashed production, postponed investment and laid off workers in their millions. The financial system remains dysfunctional. Trade flows are shrinking at the fastest rates since the second world war.”
(Retrieved from the article “Be Bold”, April 2nd, 2009, from The Economist Website:

Representing member states from 5 different continents, the G20 faces challenges from the start to create a common solution for the economic crises. The most difficult to combine, were the soltuions of USA/Great Britain and France/Germany.

The US/UK solution includes the call for more stimulus spending. According to the Washington Post, U.S. President Obama statet in his international debut that the "voracious" U.S. economy can no longer be the sole engine of global growth. Major European powers are firmly resisting calls to further open their coffers and cut taxes to spur the global economy. Obama and Brown suggest a higher government spending for each of the member countries to boost the sales and therefore the economy. Higher spendings result in higher investments and reflect a growth potential for both, consumer and financial markets.

On the other hand, Europe and Asia do not agree with the US/UK stimulus package. France and Germany consider it a big mistake for the governments to spend more on the economy without stabilizing the financial system.
”German and French leaders have shunted aside the president's call for increased government spending to stimulate their economies. The Czech Republic's prime minister even characterized the U.S. proposal as charting "the road to hell.” Instead of more stimulus spending, European and Asian leaders want more government regulation of the financial system. And they have been openly skeptical of Treasury Secretary Timothy F. Geithner's regulatory plans, suggesting they don't go far enough.”
(Retrieved from the article “Obama at G20 Summit”, March 30th, 2009, from The LA Times Website:,0,
“President Nicolas Sarkozy and Chancellor Angela Merkel said Europe had done a lot already to provide economic stimulus. What was needed was far tougher regulation, whose targets would include banking transparency, hedge funds, traders’ pay, rating agencies and tax havens. Another problem for firms and banks arises out of the interactions between the owners and managers.”
(Retrieved from the article “Be Bold”, April 2nd, 2009, from The Economist Website:

Since all of the other arguments basically involve macroeconomic analysis, I would like to describe the last one within a microeconomic context. According to the principal-agent-theory, there is a conflict of interest between the owners and managers. In economics, the principal-agent problem treats the difficulties that arise under conditions of incomplete and asymmetric information when a principal hires an agent. The theory is concerned with resolving two problems that can occur in agency relationships.

The first is the agency problem that arises when (a) the desires or goals of the principal and agent conflict and (b) it is difficult or expensive for the principle to verify what the agent is actually doing. The problem here is that the principal cannot verify that the agent has behaved appropriately. Therefore it is likely that the manager tries to achieve short-term profits to maximize his outcome while the company’s interest focuses on long-term success and survival.
The second is the problem of risk sharing that arises when the principal and agent have different attitudes towards risk. The problem here is that the principle and the agent may prefer different actions because of the different risk preferences. Because managers benefit from the firm’s short term profits by a premium and still receive their full salary even with bad decisions, they are less risk-averse than the owners.

These problems can lead firms into a crisis and contribute to the current economic downturn.Therefore I think it is important, that this argument was mentioned and that firms generate solutions for this problem. Various mechanisms may be used to try to align the interests of the agent with those of the principal, such as incentives like piece rates/commissions, profit sharing, efficiency wages, the agent posting a bond, or fear of firing. In my opinion, these do not prevent the short-term orientation of managers. I would rather suggest the concept of a bonus bank. An instrument that pays managers only a certain percentage of their incentives, leaving the remain in their bonus bank account and distributing it over the next few periods. However, if the target achievement of the managers in the following year is lower or even negative, a negative credit can offset their credit account in the bonus bank. This way the interests can be aligned and the managers have incentives for long-term orientation. It would help the company’s efficiency and long-term success which could stabilize the economy.

This was an analysis of only one out of few arguments mentioned, to solve the global economic crisis with the hopes that the G20 group can compromise and develop a common and successful stimulus package.

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