The Principal-Agent Problem & AIG

The employees have gone wild!

I think that's the root cause of this current financial crisis. Basically, employees at financial institutions like AIG took on some big risks in hopes for a huge payday if the bets turned out well. If bets went sour, then the shareholders (or taxpayers) are left holding the bucket.

If we're going to rehabilitate the economy, we need to reaffirm the core capitalist principle - businesses exist to enrich their shareholders, not their executives. Just because asset prices are rising, employees have very little entitlement to share in the upside.

Economists describe this problem as the "principal-agent" dilemma. Owners hire managers to run their businesses. Managers, however, tend to promote their own interests above those of the owners when unchecked. In scenarios where shareholders have weak control over the management, the management inevitable will misbehave by:

1. Taking on excess risk
2. Creating excess volatility
3. Benefiting from the upside of these risks
4. Leaving equity holders or the government to cover downside

Shareholders need to assert their rights over irresponsible management to prevent the inevitable re-occurence of these financial bubbles. When the Obama administration tries to strip AIG derivatives traders of their bonuses, I view this as a fundamental reaffirmation of our capitalist system that prizes equity-holders rights above managerial compensation.