Making Unelected Power Legitimate

Through what administrative means should a democratic society in an advanced economy implement regulation? In practice, democratic governments opt for a variety of solutions to this challenge. Historically, these approaches earned their legitimacy by allocating power to elected officials who make the laws or directly oversee their agents.

Increasingly, however, governments have chosen to implement policy through agencies with varying degrees of independence from both the legislature and the executive. Under what circumstances does it make sense in a democracy to delegate powers to the unelected officials of independent agencies (IA) who are shielded from political influence? How should those powers be allocated to ensure both legitimacy and sustainability?

These are the critical issues that Paul Tucker addresses in his ambitious and broad-ranging book, Unelected Power. In addition to suggesting areas where delegation has gone too far, Tucker highlights others—such as the maintenance of financial resilience (FR)—where agencies may be insufficiently shielded from political influence to ensure effective governance. His analysis raises important questions about the regulatory framework in the United States.

In this post, we discuss Tucker’s principles for delegating authority to an IA. A key premise—that we share with Tucker—is that better governance can help substitute where simple policy rules are insufficient for optimal decisions….

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Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

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Adverse Selection: A Primer

Information is the basis for our economic and financial decisions. As buyers, we collect information about products before entering into a transaction. As investors, the same goes for information about firms seeking our funds. This is information that sellers and fund-seeking firms typically have. But, when it is too difficult or too costly to collect information, markets function poorly or not at all.

Economists use the term adverse selection to describe the problem of distinguishing a good feature from a bad feature when one party to a transaction has more information than the other party. The degree of adverse selection depends on how costly it is for the uninformed actor to observe the hidden attributes of a product or counterparty. When key characteristics are sufficiently expensive to discern, adverse selection can make an otherwise healthy market disappear.

In this primer, we examine three examples of adverse selection: (1) used cars; (2) health insurance; and (3) private finance. We use these examples to highlight mechanisms for addressing the problem....

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Opportunities in Finance

“We’re really only at 1% of what is possible, and probably even less than that. […] We should be building great things that don’t exist.”     Larry Page, Google I/O 2013 Keynote

With the summer coming to an end, professors everywhere are greeting a new group of students. So, our thoughts turn to the opportunities and challenges that those interested in finance will face over the course of their careers.

Like many important activities, finance is constantly evolving, so the “facts” that students learn in classes today will almost certainly change rapidly. With that in mind, we always strive to find a set of core principles that will endure, so that students can build a career based both on a set of specialized skills and on a broad capacity to imagine where finance and the financial system are heading...

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The World of ETFs

The first U.S. exchange-traded fund (ETF)—the SPY based on the S&P500—began trading in 1993. Since then, the number of such funds has grown dramatically, so that by mid-2016 there were more than 1,600 ETFs on U.S. exchanges valued at roughly $2.2 trillion. This means that ETFs are now roughly one-sixth the size of open-end mutual funds. And, with this ETF growth has come a broadening in their scope and character. Today, there are ETFs that include less liquid assets such as corporate bonds and emerging market equities, and there are funds that provide inverse or leveraged exposure to the underlying assets.

Given these trends, it is no surprise that ETFs have attracted regulators’ attention (see, for example, here and here). Should they be concerned? Is this a consumer protection issue? Do ETFs contribute to systemic risk? Or, is their design stabilizing? Might financial stability even be served by the conversion of all open-end mutual funds into ETFs? ...

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