Agency Problems

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Agency Problems

Agency Problems

Background and Theory

From a policy perspective, if the width and depth of this principal-agent problem in the management of a state debt is large, then debt restrictions may be warranted. On the contrary, if there is no evidence of a pervasive principal-agent problem, it may be in the best interests of state governments to limit these restrictions and provide greater flexibility to their debt managers. The analyses of debt management decision-making offered in this study provide a direct test of agency theory. That is, agency theory will be supported in understanding public financial management behavior if such principal-agent problems exist. On the other hand, alternative public management theories to agency theory (which will not be tested) may offer a better theoretical explanation for public financial management behavior; in the event large agency problems do not exist, and persist in the management of a state debt given the decision-making context under study, which is highly conducive for agency problems to exist.


The municipal bond issuance process is a web of principal, and agent relationships whereby some groups are both principals and agents while other groups may only be an agent or a principal. Simonsen and Hill (1998, 72) illustrate this web of principal-agent relationships. That focuses on the principal-agent relationships relevant to this study of bond refinancing decision-making and the goals and interests of the participants in this process (i.e., the public, elected official, and state financial manager). In general, the public favors efficiency in government finance activities and does not prefer debt management decisions that produce short-term benefits at long-term costs as current taxpayers do not want themselves or, the future taxpaying public (which may include their children, and grandchildren) to be burdened by short-term reckless debt management decisions made by the prior generation's elected officials and debt managers.

Thus, the public's goal is the long-term cost efficient management of a state debt. However, the bond issuance process is quite technical, and decisions by elected officials working through their debt managers often not transparent, and depending on a state's debt disclosure requirements may not easily be known or understood by the public. Thus, there is a strong information asymmetry between the principal (the public) and its agents (elected officials and financial managers) as it relates to the nuances of bond refinancing decision making.

The elected official, who ultimately oversees the state's bond practices (usually the governor or state treasurer), is the agent to the public and principal to the state's financial managers (in the case of bond refinancing the financial managers) is the state budget director or debt manager). The interests of the elected official are short term and primarily consist of electoral self preservation. Re-election is achieved by keeping taxes low (i.e., maintaining or decreasing tax rates) and raising or maintaining government service levels, both of which can be facilitated by certain debt refinancing practices.

Re-election is further achieved by maximizing campaign contributions, which can be partially achieved directly or indirectly by providing bond refinancing contracts to certain financial market ...
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