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2017-02-14 11:25:53
Once you rely on agents, you create conflicts of interest. And you have to rely
on agents
THE problem is as old as mankind. The Roman author Juvenal encapsulated it into
a phrase Quis custodiet ipsos custodes or Who guards the guards themselves?
It was neatly illustrated in the classic BBC series I, Claudius . The infirm
Claudius wants the return of the Republic. But the Praetorian guard, set up by
his relatives, needed an Emperor to ensure their special status. So on the
murder of Caligula, they drag Claudius from his hiding place behind a curtain,
and make him Emperor.
Throughout history, dictators have faced this problem. They can surround
themselves with men with swords or guns. But it only takes one guard with a
sword or gun to turn into an assassin or to seize power for himself. The Shah
of Iran had a huge army in 1979 but it did him no good; the soldiers had more
sympathy with the revolutionaries than with the Shah himself.
In business and finance, this is known as the principal-agent problem.
Shareholders employ managers to run a company; investors use fund managers to
look after their savings. That makes sense. It allows us to take advantage of
the expertise of others, and of economies of scale in fund management (it costs
little more to look after $10m than $1m). But it is extremely hard to align the
interests of principals and agents exactly.
Before the 1980s, the worry was that business managers would worry more about
expanding the company (and increasing their power, pay and perks) than in
shareholder returns. So share options were dreamed up to align the interests of
the two. However, share options are a one-way bet; very valuable if they get
exercised but costless to the executive if they do not. (And the exercise
prices are often rewritten in the latter case.) The overall effect has been to
ratchet up the pay of executives, ultimately at the expense of shareholders. As
the Financial Times reports, some efforts are being made to rein this back in
the most egregious cases, but progress is slow; the cost of executive pay is
spread very widely while the benefits go to a few.
In effect, this is a bit like the subsidies paid to raw materials producers in
some economies. Those who receive them make out like bandits but the cost is
spread among a large number of consumers. Indeed this is another example of the
principal-agent problem. Legislation is left to our agents, the elected
representatives. But they tend to respond to the concerns of those who lobby
them. Those in receipt of million-dollar benefits are likely to lobby harder
than consumers who pay a few pence more for a given shopping item.
In investment, fund managers are paid through ad valorem fees, a percentage of
the funds invested. In a recent article, Paul Lewis, the BBC presenter, jokes
that ad valorem is Latin for rip-off. Again the ad valorem approach sounds like
it ought to work; if the asset value goes up, then so does the pay of the fund
manager and the wealth of the client. But if the market stays flat, the fund
manager still earns money while the client is worse off (to the extent of the
fee). And if the market goes up, the fund manager s fee will rise, even if he
or she underperforms the index. Performance fees do exist in the hedge fund
industry but those are on top of annual management fees. If managers were
really confident of their skills, they would surely take all their earnings in
performance fees; say 50% of everything above the benchmark but not a penny for
anything less.
Investors are catching on to this problem; around half of all fund flows last
year went to Vanguard, the low-cost index-tracker. But a lot of money is being
earned by mediocre fund managers. As with executives,the problem over the last
30 years is that the agents are getting faster much more quickly than the
principals.
A further problem with modern finance and business is that affairs are
extremely complex; so there is an information asymmetry between the clients
and the agent. The latter understands far more and thus knows which loopholes
to exploit. Incentivise executives with an earnings per share target, for
example, and it is relatively easy to run the business towards meeting that
target rather than focus on things that create long-term value such as capex.
That suggests a broader requirement such as the fiduciary principle, something
which the Trump administration wants to water down (read the piece by Jack
Bogle of Vanguard on this, headlined Putting Clients Second ).
The problem that links business, finance and politics here is trust. Trust is
easier to deal with in small communities where one can deal with each other
face to face; this was even true of the Athenian democracy. Once our
relationships with our agents are more remote, and our transactions more
complex, we have to rely on incentive schemes and these are ripe for
exploitation.
The trust problem is particularly difficult in politics where a large
proportion of the public no longer trusts mainstream leaders. In part, this is
because some have shown themselves untrustworthy. But it is also because the
incentive structure of the system (particularly in America, where funding is
such an issue) teaches politicians to ally themselves with the powerful. And it
is also because the problems they face are not amenable to easy solutions; as I
ve remarked before, important issues are global and complex but politicians
get elected by focusing on simple and local answers. When those answers fail,
cynicism increases.
The irony is that, as Edward Luce writes, that Americans have elected a leader
who is replete with conflicts of interest at every turn. When his promises
disappoint, cynicism will only climb a further notch. Indeed, the issue of
checks and balances seems all the more important today; who guards a country
against its elected leaders?