Knowing and Making

I heard an astonishing fact yesterday at the LJDM seminar . Or is it a fact? I'd be grateful for confirmation. Apparently, if you move into a new bed in a British prison, you become responsible for the debts of the person who was there before you. The opportunities this offers for abuse or gaming of the system are immense. If you know you're going to be moving out, you have every incentive to run up a huge debt before you leave. Is there a credit checking system? Gambling is rife in prisons and this system allows you to borrow, gamble in the hope of winning big; and if you don't, stick some other poor sap with the losses. In fact, now that I put it that way...it reminds me of something similar in another world . There must be more to this. Who is doing the lending in this system? What about the sucker who moves into the bed? Do prison officers influence who gets which bed? What are the amounts at stake - is the debt 20 cigarettes, £3 or £3000? What is £3 in prison w...

Tyler at MR has been asking recently whether the structure of bankers' pay caused (or contributed to) the financial crisis. Matt Yglesias also has something to say about it (via the above link). I agree with the general skepticism about this - it is a bit too easy as an explanation. Limited liability on the other hand is definitely a contributor - shareholders' interests are actually almost the same as those of employees: take lots of risk as the upside is much higher than the downside. If a bank makes $100 billion, shareholders and employees get to share it out. If it loses $100 billion, shareholders lose their whole stake, employees lose a large part of theirs, but creditors are likely to lose many times more. Or if the creditors in question are insured depositors, the taxpayer loses out instead. Ultimately, banks manage much more of their depositors' and other lenders' money than shareholders' money. So this had some impact on risk-taking. But I am starting to c...

I intended to mention this little tussle between Felix Salmon and John Carney a couple of weeks ago. As it happens, it's provoked an idea on a solution to the eternal problem of bankers' pay. Carney points out that we don't actually want traders to take the minimum possible risk in all circumstances. If they did, they would never make any returns at all. Instead, we want them to take the right level of risk...at the scale of the whole economy, this is the socially optimal level; at the scale of an individual company, it's the optimal level of risk for shareholder value. He says that without guaranteed bonuses, traders will take less risk than shareholders want them to, because they will need to retain some amount of guaranteed upside to pay their mortgages. Felix's argument against this is interesting, because he doesn't quibble with the theory. As various people have pointed out, because shareholders have limited liability, they have an incentive to get th...

Sir David Walker has been asked by the Chancellor to lead a review of corporate governance in the banking and finance sector. Sam Robbins and I, for the  Intellectual Business  think tank, have co-written a submission to this review which examines the moral hazard created by limited liability, and how bounded rationality interferes with ordinary market discipline to create risks specific to the sector. One particular conclusion is that the principal-agency problem that has supposedly led to bankers taking advantage of their innocent shareholders is nonsense. In fact, the nature of bank equity holdings specifically encourages risk-taking, and bank executives who made high-risk investments were acting precisely how their shareholders wanted them to. Interested readers are very welcome to download a copy of the document: Download Walker Review submission It's a little more dry and technical in tone than some postings here, but is intended to be quite readable. Your feedback would be ...