Optimal Prevention? Dynamic Moral Hazard in Political Principal-Agent Problems

• In Event: Agency and Accountability

Abstract

How do governments prevent disaster? Whether it be 9/11 or the 2008 nancial crisis, governments task permanent bureaucratic agencies like the CIA, the SEC and the NIH with preventing such national disasters. Given these crises are not perfectly preventable, what is the optimal prevention policy should a failure occur if the objective is to induce bureaucratic agencies to maximize prevention, i.e., minimize the probability a disaster occurs in the rst place? In this paper, we develop a novel dynamic principal-agent model in which a government can choose a policy to alter the incentives of the agency in the wake of a prevention failure. We show that the optimal prevention policy is not politically feasible: the optimal prevention policy would be to punish the agency in the event of a failure, however, the government's equilibrium policy after a crisis has occurred is to increase the incentive of the agency to prevent the next crisis. This creates a dynamic moral hazard problem which in turn increases the probability a crisis occurs in the first place. This paper contributes to the literature in bureaucratic politics, principal- agent problems and law and politics.

Authors

• Tiberiu C. Dragu, New York University

• William P Godel, New York University