ANTICORRP 2nd Meeting Berlin, 18-21 October 2012

1. Information asymmetry in politics and the ideal-types of corruptionZoltán Szántó – István János TóthCorruption Research Center, Corvinus University of Budapest ANTICORRP 2nd Meeting Berlin, 18-21 October 2012

2. Introduction • The presentation (based on a manuscript with the same title)argues in favour of employing in political science the concept of information asymmetry – its mechanisms among the players of the political market may have negative effects on the operation of a democratic political system (as information asymmetry among economic actorshas on the efficiency of market competition). • The presentation sheds new light on the phenomenon of adverse political selection, and goes on to deal in detail with the appearance of moral hazard and principal/agent relations in politics – and four idealtypical corruption transactions are explicated in terms of principal/agent/client model. • The presentation touches also on the appearance in politics of mechanisms – signalling and screening – that economists suggest for reducing information asymmetry.

3. The distorting effects of information asymmetry on market competition (1) • Literature on information economics discusses the two basic scenarios of information asymmetry in their own merit: • 1. adverse selection stands for the consequences of hidden and false information („hidden information”), • 2. moral hazard stands for the – previously unrecognized – hidden motivation that develops after selection („hidden action”) • Adverse selection takes place when one of the parties (for example, a car buyer, an employer or a voter) is unable to recognize an important characteristic (for example, well-preparedness, actual intention or level of integrity) of the other party (for instance, a used car seller, an employee, or a political candidate) (Akerlof 1970): • As a result, the former may fall victim to the misleading behaviour of the latter - the mechanism of adverse selection kicks in - morally correct used car sellers, trustworthy employees and good politicians become increasingly harder to find.

4. The distorting effects of information asymmetry on market competition (2) • Moral hazard develops when players who are difficult to observe and monitor are motivated by a number of factors to behave in the opposite way than we have previously expected – e.g.: insurance companies have observed the common phenomenon, whereby people’s behaviour significantly changes after signing the insurance agreement: • On the one hand, they are less cautious (they are less careful when handling matches after they have taken out fire insurance or drive less cautiously with collision insurance in their pocket, etc.), • On the other hand, when the damage does occur, they are inclined to exaggerate its extent (in case of household fire, a faded rug suddenly becomes a Persian carpet, or, in a collision situation, the value of the damaged car skyrockets). • These two scenarios are referred to as • ex ante and • ex post moral hazard.

5. The distorting effects of information asymmetry on market competition (3) • Principal-agent relationships constitute a unique scenario of moral hazard: one party (agent) acts in the interest of the other (principal) - agents are usually better informed of their own abilities, intentions and actions, since these can never be known or monitored to the fullest extent by the principal. • Thus, it becomes possible for agents to exhibit behaviour that goes against the interest of the principal – e.g.: the employee after signing the employment contract– with his or her own interests in view – will exhibit a tendency for slacking off, as the employer, for the most part, is not able to closely observe and monitor his/her work habits.

6. Protection against adverse selection and moral hazard on the market (1) • In order to diminish information asymmetry, it is in the interest of the sellers of high-quality used cars to indicate (signalling) the actual quality of their merchandise, and perhaps also offer a warranty - while this may be an expensive option, this is the only way to increase their chances of selling the car at a good price - signallingonly works if those involved spend less on it than the profit from the price margin. • The theory of signalling in the labour market was first introduced by Spence [1973]:he studied whether, and to what extent, information asymmetry could be decreased between employers and applicants during the hiring process if applicants present documentation attesting to their qualifications (e.g. transcripts, recommendation letters) in order to authentically signal abilities, competence and intentions that the employer is not aware of.

7. Protection against adverse selection and moral hazard on the market (2) • In order to avoid adverse selection, according to economists, buyers can use a different approach: they can vet sellers (screening) by making an offer that forces them to show their true colours. • For instance, by offering a very low price for the merchandise, they can vet out crooked dealers and pay a higher price to the dealer who sells better quality cars. • Stiglitz [1977] was the first to use the concept of screening in connection with his analysis of the competition distorting effects of information asymmetry in the insurance market: he modelled a market where insurance companies didn’t have sufficient information regarding the actual hazard level of their clients, so they tried to reduce hazard by screening their potential clientele.

8. The consequences of information asymmetry in politics (1) • Using the concepts of adverse selection and moral hazard to explain political phenomena presupposes a game of incomplete information • between political candidates running for election (agents) and • representative voters (principals). • In theprocess of electing agents, the principals would like to support politicians who are competent, serve public interest, as well as follow the law and social norms - the challenge mayinspire a lot of candidates to run in the elections - there will be some among them who are less suitable, even ill-intentioned, which can easily put the mechanism of adverse selection into operation - good political candidates could be elected instead of bad political candidates only if well-preparedness, suitability and virtues were easy to observe and monitor.

9. The consequences of information asymmetry in politics (2) • This situation constitutes a typical case ofinformation asymmetry: the voters can never be perfectly informed about the real abilities and intentions of the political candidates - there will always be some degree of uncertainty with reference to the characteristics of the political candidates. • Every candidate will advocate their own excellence and integrity during the campaign - the uncertainty experienced by voters continues to grow - ill-intentioned candidates - aside from the fact that they deceptively paint a false picture of themselves - will not shy away from spreading misinformation about the others - honest candidates do not employ this weapon – at least for now – because they have faith in the voters’ well-informedness and sober thinking - these processeswillresult in the honest candidates being forced out of the race (or a portion of them breaking under the pressure and joining the game of dirty politics).

10. The consequences of information asymmetry in politics (3) • Moral hazard becomes an issue in politics when, following elections, a portion of the candidates assume power and take political control. • While exercising power, politicians are increasingly exposed to temptation - one of the greatest temptations is for politicians • to use their position in service of their own ambitions instead of the promises they made during the campaign and to use their status and influence to their own personal advantage, or to serve the interests of friends, family, or business partners, while gradually forgetting about public interests. • If rent-seeking and corruption that originate from moral hazardbecome a political problem, they can soon be expected to closely connect with three important factors of the system of representation: • the degree of power, • the amount of extra profit, and • the length of time spent in office.

11. Representative democracy as a chain of principal/agent relations – hidden information and hidden action in politics (1) • In the representative system, a unique chain of power delegation develops - power is delegated • 1. by voters (as principals) to the elected representatives (as agents), • 2. by the elected representatives (as principals) to the prime minister (as agents), • 3. by the prime minister and his or her cabinet (as principal) to the members of government (as agents), • 4. by the members of government (as principals) to state officials, civil servants and their offices (as agents). • From the perspective of modern political economy these relations can also be interpreted in the contexts of the principal-agent model.

12. Representative democracy as a chain of principal/agent relations – hidden information and hidden action in politics (2) • The delegation of power in all its forms inherently contains the risk that agents will not reliably follow the interests of the principal - if the agent’s preferences and incentives are not in (complete) harmony with the principal’s interests, the delegation of power will result in an agency problemat every point of interaction in the abovementioned chain. • In a hidden information scenario, the principal is not fully aware of the abilities and preferences of the agent, and – as we have previously seen – this can lead to the development of adverse selection.

13. Representative democracy as a chain of principal/agent relations – hidden information and hidden action in politics (3) • In case of hidden actionthe principals are not able to precisely observe the behavior of the agents, and this leads – as we have pointed out before – to the proliferation of moral hazard. • The preferences and opportunities of the selected agent can be directly opposite of the interests of the principal - in such a situation, there is considerable chance that • representatives will go against the interests of citizens, • the prime minister and his or her cabinet will go against the interest of the representatives, • with a similar dynamic down the line between the members of government on one side and the prime minister and his or her cabinet on the other, • between state officials and civil servants on one side and members of government on the other.

14. Signalling and screening mechanisms in the world of politics (1) • Can well-prepared and honest candidates send out signals that can help voters avoid the harmful consequences of adverse selection? • Will these voters be able to screen these candidates – compelling them to show their true colours? • Perhaps it is those social norms, conventions and commitments that can play such a role in politics, which signal mutuality, solidarity and a cooperative attitude to voters in a manner that prevents dishonest candidates from employing them • Taking trust-building steps, a safeguarding of honesty and a deliberate commitment to legal (even constitutional) restrictions can also improve the situation.

15. Signalling and screening mechanisms in the world of politics (2) • Voters – albeit to a limited degree – do have screening methods at their disposal: • the collection of proposal coupons (which were not originally intended for screening purposes, but can nevertheless be used as such) or • the pre-elections held during US presidential elections, for instance. • If we succeeded in vetting out at least a portion of the bad political candidates already at this stage, the situation can improve – although plenty of room still remains for manipulation even in these scenarios.

16. The ideal-types of corruption in terms of principal-agent-client model Following the argumentation „information asymmety → moral hazard → principal/agent relationship → corruption” four idealtypical corruption transactions can be explicated: • bribery and extortion are described as two different types of agent-client relationship, • embezzlement and fraud as two different types of principal-agent relationship too.

17. The principal-agent-client graph: the basic model (1) • Principal-agent-client triad (Lambsdorff 2007: 18-19) • The agent (ex.: an official who issues construction permits) is entrusted with power by the principal (ex.: local government) • The principal • (i) delegates certain tasks to the agent, • (ii) determines the formal rules according to which the tasks are to be performed, and • (iii) offers remuneration to the agent for completing the tasks • The agent, in return, • (iv) remains loyal to the principal, which means s/he performs the tasks in accordance with the rules that have been laid out, • (vi) expectably respond to the client’s needs within the specified framework, • (v) for example, an application for a construction permit

18. The principal-agent-client graph: the basic model (2)

19. The principal-agent-client graph: the basic model (3) • Corruption takes place when one of these players (in most cases the agent) breaks the rules out of self-interest, thereby hurting the interest of the other players (in most cases the interest of the principal and/or the client). • Based on the information asymmetry between the actors, four idealtypes of corruption can be distinguished in the principal-agent-client model (Lambsdorff 2007: 18-19). • Within these four pure types, two subtypes of corruption relationships, between the principal and the agent on the one hand, and between the agent and the client on the other.

20. Briberygraph (1)

21. Briberygraph (2) The client acts as a briber, and makes a payment (bribes) to the agent (the bribee) In return the client obtains an advantage (such as a service or a license) (s)he is not entitled to obtain (for example a tax rebate or a public contract)

22. Extortiongraph (1)

23. Extortiongraph (2) The agent (as an extorter) uses her/his power to extract money (or other benefit) from the client (the extortee) The client (the extortee) may have to pay for a service, although (s)he is legally entitled to obtain it without such a payment The agent (the extortee) uses coercion, violence, or threats to obtain this payment

24. Embezzlementgraph (1)

25. Embezzlementgraph (2) Theft of public resources by the agent (the embezzler) The disloyal agent (the embezzler) steals from the principal (the embezzlee)

26. Fraudgraph (1)

27. Fraudgraph (2) The agent is commomly better informed about details of her/his daily tasks and her/his efforts devoted to their fulfillment. (S)he can benefit from informational advantages. The agent can also actively conceal information from the principal (swindle, trickery, manipulation of information, facts etc.) .

28. Conclusion (1) In modern political economy, it is those political institutions that provide the incentive for an adequately functioning political system, which can limit moral hazard, corruption and rent-seeking, as well as support transparency and the accountability of elected politicians and civil servants Political institutions, however, can only offer a partial explanation for the differences in the quality of government between various countries, and between different from one time period to the next. According to another approach – which can be thought of as compatible with the previous stance – the quality of policymaking depends on the competence and decency of the political class.

29. Conclusion (2) It seems that theoretical and empirical research that, in explaining the performance of a political system, focuses on the players – their characteristics, motivations, and the mechanisms of their election – is gaining ground. There are increasing empirical research findings in support of the hypothesis, according to which, political leaders, in addition to the political institutional system and political culture, also play an important role in the formulation of competent politics and, through that, the socioeconomic performance of the given country .

30. Thank you for your attention! www.crc.uni-corvinus.hu Recent publications of the members of the Corruption Research Center at Corvinus University of Budapest: Local Government Corruption in Hungary. In.: Bruno Dallago - Chiara Guglielmetti (eds.): Local Economies and Global Competetiveness. Palgrave MacMillan, UK. 2011. pp. 134-153. Business Sector. In.: Petra Burai - Péter Hack (eds.): Corruption Risks in Hungary 2011 National Integrity Study. Transparency International, Berlin, Germany, 2011. pp. 232-247. The social and institutional structure of corruption: some typical network configurations ofcorruption transactions in Hungary. In.:Balazs Vedres – Marco Scotti (eds.): Networks in SocialPolicy Problems. CambridgeUniversity Press, 2012. pp. 171-193.