Tuesday, March 03, 2009

Transaction costs, Fair and Free Markets

I am a believer in fair capitalism not free capitalism.  I don't have any issues with firms and individuals earning unfettered returns to their talents - I myself have benefited from this ability to monetize one's own capital - intellectual or any other form.  However, I also think that there are reasons why oversight is needed, by insitutions, so that free capitalism results in unfair capitalism.

All of us have an incentive to deviate from rational behavior when 1) we realize there is no penalty to such deviance and 2) when there is a loophole that offers us cover to such deviance.  Given this inherent opportunism - something that firms like AIG exhibited so blatantly with a cost not just to the firm but to the entire networked economy, I don't see how rational calls for oversight can be shot down. To believe that firms/individuals will not run amuck and will stick to rules, is utopia. The market disaster reeking with corporate greed and consumer stupidity has more than eloquently established that oversight may not be a bad thing.

I belive that when there are disproportional returns to be made through deviant behavior - they will be made, by any means possible.  Whethere it is the CEOs of Citi, AIG and Countrywide making millions a year based on short-term profits or AIG's income division operating a hedge fund with its principals' money, it is clear that agents will deter from their expected behavior.  Additionally, all these agents who were supposedly acting on the behalf of their principals where only "acting" and in reality they were looking out for themselves.  The average shareholder has lost thousands of dollars whereas the average wall-street employee has made the same thousands in bonuses. Why shouldn't then, the principals call for more monitoring so as to reduce the harm caused by these agents?  The oversight has a name " transaction costs", and no matter how vilely the fiscal conservatives try to describe it - this word has an economic basis to it and is at the heart of all economic activity.  Transaction costs come in many forms and the reason they exist is because contracts between two parties - e.g., agreement betwen CEO and the shareholders, cannot be fully specified ex-ante and therefore require a certain degree fo monitoring to ensure that the agent does not deviate from expected behavior. 

If we think of oversight as a bad thing - are we arguing that contractual agreements between parties are frictionless? Isn't that utopia? The only way that I see one can shoot down the need for oversight is by establishing that all economic entities will be 1) rational and 2) not be opportunistic - things that go against all that we know about humans.

Too much rambling....


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