Information, Risk, and Economic Policy: A Dynamic Contracting Approach

University Of Wisconsin-Madison, Madison WI

Investigators

Abstract

Abstract Proposal No: SES - 1326951 Principal Investigator: Williams, Noah Title: Information, Risk, and Economic Policy: A Dynamic Contracting Approach This project studies the implications of asymmetries of information in dynamic relationships. In particular, the investigator applies relatively new continuous time contracting methods to study issues in economic policy, risk management, and firm and financial intermediary dynamics. The first area of study is optimal unemployment insurance over the business cycle. The project follows the previous literature in analyzing the moral hazard problem resulting from unobservable job search effort. While most of that literature has focused on constant job finding rates, these vary substantially over the business cycle. Further, unemployment insurance systems typically include extended benefits during recessions. This project analyzes optimal unemployment insurance when workers put forth unobservable search effort and the economy may alternate between expansions and recessions. The next area of research considers the implications of unobservable risk-taking behavior. One aspect of the recent financial crisis was that some firms seemed to take on excessive risk, surprising both regulators and shareholders once the actual extent of liabilities was uncovered. The investigator develops a model where a manager faces a classic moral hazard problem, where effort on the job is indistinguishable from random shocks. In addition, the manager can take unobservable actions which yield current certain payoffs, but expose the firm to larger risk. For example, the manager could sell insurance against unlikely events, pocketing the insurance premiums but exposing the firm to large liabilities if the event occurred. The project shows how standard pay-for-performance contracts, which are typically beneficial in the case of moral hazard, may lead the manager to take on excess risk. The investigator then develops optimal contracts which provide incentives to both put forth effort and to manage risk. The final area of research focuses on long-term financing contracts. Because of the recent economic experience, financial frictions are at the forefront of much current research. However most existing models use short-term contracts, and have had difficulty in generating significant amplification and propagation of shocks. However with long-term contracts, the value of the relationships among borrowers, lenders, and intermediaries changes over time, and changes in these values may lead to more persistence in the propagation of shocks. The project shows how contracts propagate shocks among households, firms, and financial intermediaries, and give rise to interesting firm and intermediary dynamics. This project has implications of direct importance in policy discussions. For example, the application on unemployment insurance is directly aimed at a policy question of current relevance. During the most recent recession, unemployment insurance benefits in the US have been extended several times as labor market conditions have deteriorated. This research determines the optimal structure of unemployment insurance benefits over the business cycle, and analyzes the potential gains from reforming the existing system. The other applications touch on policy questions as well, addressing issues at the heart of the recent financial and economic turmoil. The project on financing contracts directly analyzes financial frictions and the role of intermediaries, which were crucial in the financial crisis. The hidden risk application focuses on one channel which may have contributed to the severity of the financial crisis, as many banks incurred large losses due to excessive exposure to risk. In addition to the current work analyzing incentives to manage risk, future work in the project will look more closely at regulatory and policy responses to encourage risk management.