Balancing Incentives…

Balance…it is a pivotal aspect in most areas of life and is  an integral part of most philosophical, economic, and political concepts. TOO much of anything, even a good thing, is not necessarily a positive in the long run.

Some people learn this lesson as children, when they have overindulged in a favorite treat and ended up with a belly ache.

Some people pick up on this concept while playing  on a teeter totter at the playground.

Some people are taught this idea by their parents.

Some people never quite learn this concept and think that if one of something is good, ten is better and 100 is even better still.

For those with addiction issues or who are suffering from obsessive disorders, this concept is difficult for them to truly grasp.  However for MOST people, the idea is not unfamiliar.   In almost everything in life balance is key.

A perfect example of this idea can be summed up with research which shows a single glass of wine a day may have positive health effects.  HOWEVER, drinking a bottle a wine a day is damaging to one’s health.

This concept applies to economics as well.

In introductory economics we learn about equilibrium within the supply/demand curve.  When supply and demand function intersect equilibrium is achieved.  At this point, the allocation of goods being supplied is the exact amount being demanded, thus everyone (buyers/sellers/nations) is satisfied economically.

Equilibrium also applies to incentives.

Incentives are what motivates people to do things.  Incentives can be good or bad.  They can provide positive or negative outcomes.

Good incentives that motivate people to do the right thing or to work at their most productive benefit not only the individual, but society in general.

Perverse incentives, on the other hand, can have unintended consequences and may lead to adverse outcomes at many levels.  Perverse incentives can cause damage to an individual’s well being, a company’s long term well being, a nation’s long term well being,etc.

The right balance of incentives both in the work place and within the macro economy, is essential to fostering a prosperous economy and positive society for everyone.

When incentives are completely out of whack, both in business world and the political ones, things start deteriorating.

Nobel prize winning, Professor Joseph Stiglitz, of Columbia University who teaches at the Columbia School of Business, the Graduate School of Arts and Sciences and the School of International and Public affairs(1), has written many books, columns and provided testimony about this subject and how these perverse or in his words skewed incentives led to our current economic crises.

In his testimony before the House Committee on Financial Services, in January of last year, Dr. Stiglitz explained to the committee how these skewed incentives were at the heart of the financial crisis which led to the  bailout of wall street.

Here’s an excerpt from that testimony:

“Underlying all of these failures is a simple point, which seems to have been forgotten: financial markets are a means to an end, not an end in themselves. If they allocate capital and manage risk well, then the economy prospers, and it is appropriate that they should garner for themselves some fraction of the resulting increases in productivity. But it is clear that pay was not connected with social returns—or even long-run profitability of the sector. For many financial institutions, losses after the crisis were greater than the cumulative profits in the four years preceding the crisis; from a longer-term perspective, profits were negative. Yet the executives walked off with ample rewards, sometimes in the millions. Most galling for many Americans was the fact that even when profits were negative, many financial institutions proposed paying large bonuses.

We should remember this is not the first time that our banks have been bailed out, saved from bearing the consequences of their bad lending. While this is only the second major bailout in twenty years in the US, past responses to financial crises abroad – in Mexico, Brazil, Russia, Indonesia, Thailand, Argentina, and many others – were really bailouts of American and European banks, at the expense of taxpayers in these countries, engineered through the bankers’ allies at the IMF and the US Treasury. In each of these instances, the banks had made bad lending decisions, lending beyond the ability or willingness of borrowers to repay.

Market economies work to produce growth and efficiency, but only when private rewards and social returns are aligned. Unfortunately, in the financial sector, both individual and institutional incentives were misaligned. The consequences of the failures of the financial system were not borne just by those in the sector but by homeowners, retirees, workers, and taxpayers, and not just in this country but also around the world.

The “externalities,” as economists refer to these impacts on others, were massive. There were huge private profits in the short run, in the years before the crisis, offset by the even larger losses during the crisis. But the banks and the bankers reaped the benefits of the former without paying proportionately for the costs of the latter. Alan Greenspan, in his famous mea culpa, explained his misguided confidence in self-regulation—he had assumed that bankers would do a better job in managing risk, in doing what was in their own interests. Even this diagnosis was flawed: he was right about the failure to manage risk, but it was not so obvious that what they did was not in their own interests. But all of this misses the real reason for regulation. If I gamble in Las Vegas and lose, only I (and my family) suffer. But in America’s casino capitalism, when the banks gambled and lost, the entire nation paid the price. We need regulation because of these externalities.(2)

And is another excerpt from that same testimony, where he talks about executive compensation:

“The one thing that economists agree upon is that incentives matter, and even a casual look at the conventional incentive structures—with payment focused on short-run performance and managers not bearing the full downside consequences of their mistakes—suggested that they would lead to short-sighted behavior and excessive risk taking. And so they did.

Leverage ratios in excess of 30 to 1 meant that even a 4% decline in asset prices would wipe out an institution’s net worth, and with even smaller declines a bank would fail to meet basic standards of capital adequacy. To put this in perspective: average housing prices have fallen from their peak by nearly 30%. , and again, I regret that it appears that little if anything is likely to be done about these institutions. Too much attention has been focused on how to deal with the consequences of a failure of these institutions; what is required is prevention: preventing financial institutions from becoming too big to fail or too intertwined to fail.

In some ways, the “apparent” incentive structures were worse than this, because compensation typically increased with stock prices, which provided incentives for management to provide distorted information that would result in higher stock prices. The banks excelled at this, moving risks off balance sheet, with consequences that I have already described.

Markets can only work well when there is good information, and the banks’ incentive structures encouraged the provision of distorted and misleading information.

Moreover, management was rewarded for higher returns, whether those returns were produced merely by increasing risk (higher beta, in the parlance of finance) or by truly outperforming the market (higher alpha). Anyone can do the former; the latter is almost impossible. Again, no wonder that all the financial wizards took the easier route—and it was this excessive risk taking that helped bring capitalism to the brink.

These problems in incentive pay have long been recognized. Unless appropriate care is paid to the quality of what is produced, those who are paid on the basis of the quantity produced will put more effort into quantity than quality. And that is what happened in finance; with fees based, for instance, on the amount of mortgages written, there was little attention paid to the quality of the mortgages—and not surprisingly, quality deteriorated markedly, especially with securitization.(2)

Perverse incentives coupled with lack of accountability or consequence usually have very bad results for the whole, while only benefiting the few.

Which is what we saw and are still seeing in the financial sector, on Wall Street and at many business organizations, as well as within the political arena as well.

Understanding the role of incentives and understanding their affect on behavior and how they can cause unintended consequences is crucial to understanding human behavior which effects our economy and our system of governance and politics.

Policy issues and business trends cannot be really debated without really understanding what the motivating factors are behind decisions.  In addition understanding how  incentives which are out of balance, such as what we have seen of compensation packages of executives and salespeople, as well as perks offered to Politicians and  tax policy  that rewards risky behavior at the behest of responsible behavior, can wreak havoc on the system as a whole and bring down everyone.

Sources:

1) http://www2.gsb.columbia.edu/faculty/jstiglitz/bio.cfm

2)http://www.house.gov/apps/list/hearing/financialsvcs_dem/stiglitz.pdf

http://www.marketobservation.com/blogs/index.php/2009/10/10/joseph-stiglitz-about-skewed-incentives?blog=10