Market Failure Due to Asymmetric Information - Adverse Selection and Moral Hazard

In the book based on an inquiry into the nature and causes of the 2008 Global Financial Crisis entitled "FREEFALL - Free Markets and the Sinking of the Global Economy", Economics Nobel Prize Laureate (2001) and Columbia University Professor Joseph E. Stiglitz wrote:

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"Finding root causes is like peeling back an onion. Each explanation gives rise to further questions at a deeper level: perverse incentives may have encouraged shortsighted and risky behavior among bankers, but why did they have such perverse incentives? There is a ready answer: problems in corporate governance, the manner in which incentives and pay get determined. But why didn't the market exercise discipline on bad corporate governance and bad incentive structures? Natural selection is supposed to entail survival of the fittest; those firms with the governance and incentive structures best designed for long-run performance should have thrived. That theory is another casualty of this crisis."

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Market failure is a common term in microeconomics to reflect the need for some form of regulations and accountability of agents (consumers and producers) in the unfettered free market when externalities, imperfect information, socially undesirable market dominance etc arise. In the area of perverse incentives in the market place, two forms of asymmetric information can be associated with such possible market failure. One, adverse selection; and two, moral hazard. To simplify the understanding of such market failure, let's take two simple examples.

For moral hazard, a similar example in day to day economic activities is that of motor insurance. Why is moral hazard considered a form of market failure and thus socially undesirable? This is because no insurance company can be certain, at the point of underwriting the motor insurance of any driver, of the future behaviour of the driver. Motor insurance companies would be OUT of Business if there is no way of ensuring the responsible FUTURE behaviour of drivers insured under them. Thus, there is this concept of CO-PAYMENT known as "EXCESS" or "DEDUCTIBLES" mechanism built into a motor insurance agreement. For example, if the excess of a motor insurance is $3,500, then any accident repair amount below that sum is fully borne by the driver/ owner of a vehicle. By having the co-payment mechanism built-in, motor insurance become feasible in the market place and minimise the moral hazard of reckless FUTURE behaviour.

In the banking sector where executives take undue risks for short term gain (such as those causing the 2008 GFC), inherently similar moral hazard exists but DOES NOT seem to be mitigated by any "co-payment' mechanism in the {perverse} incentive packages they receive.

In 1970, another Economics Nobel Prize Laureate (2001) Professor George Akerlof (husband of former FED chair Professor Janet Yellen) of University of Berkeley, California published a paper entitled "The market for 'lemons': quality uncertainty and the market mechanism" which led to the growth and research in the field of asymmetric information. This publication subsequently led to the enactment of the "Lemon Law" in many countries including the United States, Canada, Australia, and in recent years Singapore {Consumer Protection (Fair Trading) Act} where it addresses the market failure arising from adverse selection in the used car market and other consumer goods.

Now, market failure due to asymmetric information arising from moral hazard and adverse selection in different sectors of an economy is CERTAINLY NOT NEW as it can be traced as far back as 1970 which is almost half a century ago.

ALAS, in the field of banking, unfortunately and mostly, moral hazard in the area of excessive risk taking is left to the free market mechanism (as what happened during the 2008 GFC). There does not seem to have any material "co-payment mechanism" to keep the market failure of moral hazard in check. What were the consequences?

Professor Joseph Stiglitz wrote in his book "FREEFALL":

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"In the great recession that began in 2008, millions of people in America and all over the world lost their homes and jobs. Many more suffered the anxiety and fear of doing so, and almost anyone who put away money for retirement or a child's education saw those investments dwindle to a fraction of their value. A crisis that began in America soon turned global, as tens of millions lost their jobs worldwide -- 20 million in China alone -- and ten of millions fell into poverty.'

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What is the lesson learned?

Quoting from Professor Stiglitz again: "We have to be wary of too facile explanations: too many begin with the excessive greed of the bankers. That may be true, but it doesn't provide much of a basis for reform. Bankers acted greedily because they had incentives and opportunities to do so, and that is what has to be changed."

In short, could perverse incentives be the ROOT CAUSE?

Professor Stiglitz made the following observations in the same book: "In peeling back the onion, we need to ask, Why did the financial sector fail so badly, not only in performing its critical social functions, but even in serving shareholders and bondholders well? Only executives in financial institutions seem to have walked away with their pockets lined -- less lined than if there had been no crash, but still better off than say, the poor Citibank shareholders who saw their investments virtually disappear."

Could it be the skewed structure of "perverse incentives"? Despite technology disruption and what not, this so called supposedly modern economic system and technological advancement in this age of AI (artificial intelligence) seems to be at a loss (and clueless) in the field of building in a mechanism of accountability and "co-payment" when potentially rogue high pay executives run amok and threatened to bring down the entire system, just as what happened in the 2008 GFC (Global Financial Crisis).

Leo 81