by Don Alexander, MBA
Associate, RSD Solutions Inc.
The Wall Street Journal of November 23, 2011, focusing on the demise of MF Financial, noted flaws in their risk management – the lack of accountability for decisions. The article noted that decisions made by MF Financial CEO Jon Corzine, on his European sovereign debt trades of $6.3 billion, lacked proper supervision. The typical trader would have position limits and require approvals from the head trader, the risk manager, chief risk officer, the CEO and eventual approval by the Board of Directors. In the case of Mr. Corzine, it was only the Board of Directors, and most likely, reviewed well after the positions were established or sometimes called the agency problem (conflict on incentives). The failure to implement an effective risk management system resulted in the demise of MF Financial.
The US bi-partisan Super Committee on deficit reduction failed to reach an agreement by the November 23, 2011 deadline imposed by Congress. The lack of a clear outcome and responsibility by politicians pose a special problem for risk management – the agency problem. The agency problem, or sometimes referred to the agency dilemma, attempts to address difficulties that may occur under periods of incomplete or asymmetric information when a principal (voter) hires an agent (congressmen), to address a problem of moral hazard (weak economy) with a potential conflict of interest. The problem is when the agent (congressmen) acts for their own self-interest rather than that of the principal’s interest (restoring economic growth). A recent example is the no-tax pledge made by Congressmen to Grover Norquist, of the lobbying group “Taxpayer Protection Pledge”. Mr. Norquist does not have any accountability to voters on the economy.
As a result, a number of automatic spending cuts are supposed to kick-in 2013. The nastiness of the cuts and their potential implications were expected to encourage lawmakers to strike a deal. It now appears that Congressional leaders will be unable to reach a compromise as special interest groups try to limit/offset the impact of mandatory spending cuts implemented in 2013. The question becomes how long will this impasse persist? It could last until the election looming in November of 2012.
Under the current incentive system, US Congressmen have little incentive to reach a compromise to tackle the debt problem and adopt policies to restore economic growth. It was noted in an earlier column in VOXEU on November 23, 2011 that the surge in political uncertainty comes at a cost. A recent note Policy uncertainty and the stalled recovery (Scott Baker, Nicholas Bloom & Steve Davis, VOXEU, October 22nd) address these issues. The authors distinguish between economic uncertainty and economic policy uncertainty, constructing an index to measure policy-related uncertainty and argue that reducing policy uncertainty would raise output and add dramatically to job creation. The authors noted that if their index for policy uncertainty was restored to 2006 levels, it could result in a rise of industrial production by 4% and the creation of 2.5 million jobs over 18 months. This may not be enough to create a booming economy, but it is a step in the right direction.
The lack of clear accountability of Congress (agent) to the voter (principal) will likely result in a stagnant economy through 2012. The failure to implement an effective risk management system for politicians has a cost for the US economy. Politicians need to learn the lessons on risk management from MF Financial.
A reference for the Baker, Bloom & Davis paper.
