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.
An employer I once had sent me to school to take some management courses and I remember one class in particular that addressed motivation. It turns out that the greatest motivator wasn’t money, benefits, or any of the typical things you would assume.
It was, in fact, the nature of the job itself.
When people felt they were doing something important and that they had a stake in the success of the company, that alone motivated them.
I took such a course myself…and i thought it hogwash…as at the SAME time, I was taking a business theory course, a human psychology course AND both a macro and micro economics course.
I was a full time student AND majoring in business theory and economics.
The ideas in the one class contradicted those of the other courses.
I think the courses that suggest that ASSUME that the proper economic incentives ( a LIVING WAGE) are being paid and thus ASSUME that since the IMMEDIATE needs of working are MET that pay isn’t the only motivator. I also suggest those same courses are working for the benefit of the corporate hieracrchy and not the individual…because those same gurus often argue that those at top positions ( executive management) MUST be paid in the millions in order to ‘attract the best and brightest’.
I suggest there is a disconnect somewhere and those in HR are being fed a line of bull in an effort to make those at the bottom stay in their place.
very good article. Stiglitz is da bomb…sadly obama will not hear the correct economic advice from the likes of stiglitz or krugman, instead obama’s man crush on reagan will intensify his infatuation with reaganomics.
THAT is my biggest complaint with Obama…his economic team.
There are so many great macroeconomic minds out there…Stiglitz, Galbraith, Krugman…among others…yet those he chose were not in their league in terms of academic accolades or prominence in their field. WHY?
THAT has bothered me…is it because it doesn’t want better advisement or is it because he CAN’T (for other reasons) chose better advisers?
Stiglitz, was fired from the World bank for attempting to tell the truth about some of the problems inherent in our world wide economic policies.
Krugman is considered a ‘leftist’ and has been heavily criticized by those on the far right, including some VERY powerful elite people.
Jamie Galbraith has received the same beating in the press and in public opinion…even though he is the son of John Galbraith…who was widely esteemed.
It seems that some REALLY good economists who have a REAL understanding of macro economic principles are being derided in favor of some who’s ideas are less than honest…WHY?
Who and what is behind this? Something doesn’t pass the smell test…AND while I understand economics is NOT an exact science…because after all it is a SOCIAL science, that as the name implies is not just science, but also encompasses motivational theory, human behavior and social behavior….those who have a more liberal viewpoint on economic policy have been ignored…even though their views and theories have just as much merit as those who are more ‘conservative’ yet aren’t receiving the positions or airplay in ANY forum or administration…why is that?
Something is amiss.
Excellent economic description of incentives. I want to talk a little about the psychology behind what motivates people in business.
Incentives for workers is quite different than incentive for management, especially management in big business.
Incentives for workers usually include being able to buy essential needs for their families, providing healthcare security and having a reasonably comfortable retirement income etc…
Incentives for too many who are money and power hungry are closer to the motives of sociopaths. They can never have enough to fill what is the emptiness inside themselves, with love or any positive human emotion so they seek power and control over society which in this case is their victim. The “risks” they are taking are just part of the psychopathy because as ultimate narcissists they have the illusion they can control any situation.
We have built an economic system that rewards all those qualities that suit the 1 in 10 sociopaths around us the best and then we expect free markets to benefit everyone. As a society government needs to find a way to protect us from these people not keep on rewarding their destructive behavior through unfettered capitalism.
I have to put a disclaimer that of course not all people who make it rich are sociopaths, maybe even most are not sociopaths, many people get rich from their unique talents, hard work and innovative ideas but make no mistake sociopaths they have a distinct advantage.
I do agree with you. I read a piece recently that laid out the situation just as you described.
Did you see it?
If you hadn’t, here is the link.
I’m sure you’ve seen the movie “The Corporation” but see it if you haven’t.
The concept of corporate psychopathy is nothing new. Noam Chomsky has been talking about it for a long time. I think with the advent of popularity of profiling serial killers and such it’s just become more mainstream.
No, I haven’t seen it…
It’s funny but I thought about that myself when I was in the corporate world…I’ve worked for a few in my day and YES they were full fledged sociopaths.
It was hell.
Greenspan was like Captain Renault in “Casablanca”, shocked, SHOCKED to learn that there was gambling taking place on Wall Street!
Oh, he was shocked, all right…just befuddled…what a world…what a world! 🙂
Very thoughtful and well put.
The capacity of a system is the capacity of the bottleneck. It is true that wrong incentives appear to be the cause of much of that what had gone wrong but I am afraid that upon eliminating this “bottleneck” we would find another, and then another,… There is more wrong with our system than skewed incentives.
If you take a look at the links from Professor Stiglitz, you will see that he builds quite a case for how incentives and the wrong incentives are really at the root cause of much of our ills…they aren’t the only cause of course, but they are a major consideration, of this ALL economists agree.
Incentives matter and are at the root of motivational theory. Proper incentives are key.
Incentives can be good or bad, dependent on how they are offered and for what they are offered. Consequences must accompany them as well.
I respect Professor Stiglitz and his opinion but I find him pretty conventional (not willing to be overly critical). Perhaps he looks radical when compared to Wall Street agents around Obama. 😉
My point is not that skewed incentives were not a problem but that even with the best incentives our financial sector is no longer capable of serving this country.
The main function of our financial sector is the efficient allocation of capital. Better incentives would help but even with perfect incentives we would soon enough encounter the next “bottleneck”.
Our corporations are guided with best ROI for their shareholders. What do we do when the best ROI is to be found in China and India and not in this country? Those perfect incentives would still choose the wrong investments viewed from the standpoint of society.
The single most important factor for our troubles is the fact that our economic elites interests have diverged from the interests of the rest of us. Even perfect incentives will not solve this problem.
As a student of economics, I can assure you INCENTIVES have ALWAYS been a part of economic theory, free market theory and business theory.
If you look back at the work of Adam Smith, you will see he talks about it too…sometimes though the words used are not the same and I think that adds to the confusion. I think the word Incentives has been co-opted to mean different things than what it should be.
As professor Stiglitz said ALL economists agree that incentives matter. Perhaps the mistake being made, by me and others is using the ‘term’ incentives to discuss the concept of what MOTIVATES people to action. That is what the term incentives actually means, but I think most people assume it means something else…such as compensation packages, which don’t get me wrong is a part of it.
I agree with you that our system of economics and allocating resources is an utter mess! But as Stiglitz theorizes, it’s because the incentives or MOTIVATIONS are wrong…which in turn causes the whole system to be a mess.
So what you are suggesting DOES go back to motivational incentives. INCENTIVES don’t just mean compensation or parties or whatever…incentives are the REASON why people do things….call it motivations if you will.
The desire to simply focus on return on investment, is a form of motivation based on incentives. THAT is what he is talking about when he says that our system has lost its focus as the incentive structure is what is a mess, which causes people to do things to attain those incentives which are NOT positive for the economy as a whole.
Look at what you yourself just wrote…you are talking about incentives when you discuss ROI…the motivation for the investment is the economic return (the incentive).
I think maybe some are misinterpreting the message here.
Let’s look at Maslow’s hierarchy of needs, as well as other business theorist such as Victor V’room, Henri Fayol, Max Weber and others who have studied motivational business theory since the beginning of the 20th century.
They all make valid cases as to what motivation causes to effect. Maslow suggests that unless basic NEEDS are met, such as food, shelter, clothing…no other need with be focused upon. So the motivation or the incentive to work, is based on need for self survival…food and shelter.
I can go on at length on the theories of the others but it would get boring and redundant.
Incentives are the basis behind motivational theory concepts and in turn are the basis behind Economic theory as well.
What motivates or incentivizes people to work towards an outcome? THAT is what is being referred to when talking about incentives in this context.
I hope I helped clarify my point! 🙂
While I agree that MOTIVATIONS of the elite and the masses are different. Their motivation and thus the incentives attached are NOT about money anymore, it’s about POWER, absolute power.
HE who has all the gold, makes all the rules. Their motivation or incentives are not monetary in nature…whereas for the masses, who still need the basics for survival…money or enough money to provide for a basic life and to THRIVE is the most motivating factor!
I do understand what economic incentives are and their importance. I don’t disagree either with you or Stiglitz. All I am saying is there is more wrong with our economy than incentives. This would become readily apparent once we’d solve the problem of incentives, which we are unlikely to solve any time soon anyway.
I’m sorry Sboston…I’m very passionate about this subject and I don’t disagree the problem is BIGGER than just incentives…but this to me is a ‘chicken or egg’ debate.
I do agree, we aren’t anywhere near solving any of our REAL problems anytime in the near future. 🙂
I’ve recently watched a series of videos of Joseph Stiglitz in a lecture at The University of Queensland titled “Who Sank The Global Economy?” which I highly recommend to all.
At the end of part 5 and continuing to part 6 an ecological economist Richard Sanders poses an excellent question which professor Stiglitz basically ignores in his response. I’ve found that quite puzzling. 😉
I SO wish I can watch the series…but the speakers on my computer are shot!
I bet it is interesting to watch.
so what is the question he asks????
On the subject of incentives, “The Chief Happiness Officer”, who consults with companies on improving employee morale and satisfaction, as well as improving customer service, has tried for years to stop companies from using pizza as an incentive for their “production level” employees (in other words, the ones that do the work of the company – like the people who answer the phones at a call center or the people who build the speedometers at assembly lines).
You may like the points about diminishing returns.
That was good article..thanks.
I suggest it is even simpler than what he suggest…pay them appropriately for the work they do as part of the success of the organization, provide long term economic incentives (such as profit sharing, paid yearly) and stock options. AND here is the big one…treat employees like HUMAN beings and with respect. Take their suggestions for improvement SERIOUSLY. Don’t treat employees like children, train them appropriately and communicate with them like adults.
And for goodness sake, HIRE appropriately those who will fit in with the culture of the company, don’t just use generic flavors of the day hiring techniques and silly background checks and credit checks that don’t prove shit!
All the other psychological mumbo jumbo is really unneccessary if you treat people well and go by the golden rule. “Treat others as you wish to be treated”
Don’t manipulate them, don’t blow smoke up their ass and don’t underpay and oh provide adequate vacation time and health benefits as well as retirement.
So simple really
Another excellent article!
I think the most depressing version of the perverse incentive concept can be applied to the American voter. They put politicians into office that will do just about anything they can to help those entities that will cause the most harm, just so that voter can say that they expressed an opinion of what they’re against. It’s like voting for the bully that beats up on everyone, including you — just because you both root for the same team. It’s just unreal.
I think the current governor of Florida is a perfect example of this: “I’m disabled and on dialysis, and I rely on the continued availability and solvency of Medicaid to survive, but I’m going to vote for the man who won the Republican primary — even though he oversaw the largest Medicaid fraud in history — just because I’m also a Republican.” It’s just not rational.
p.s. Somebody let me know if I’m mixing my analogies up.
Your analogy is apt, and it isn’t rational to vote for someone just because they root for the same team. The reason so many vote GOP is because they are “pro-life” and the GOP claims to be so too.
What they both really are is ant-abortion, but it puts them on the same team, and it puts God (so they think) on their team. Some wonder how people can consistently vote against their own self-interest. They can if they think that they will be blessed by doing so, and anti-abortion voters fall into that category. Abortion is wrong (although not mentioned in the Bible) and against God. If a nation is against God, he will curse the nation, but if it is with God, he will bless it. Therefore, in their minds, voting GOP is voting for God, because they are “pro-life” (although they have never even tried to overturn Roe v. Wade) and if abortion is once again outlawed, God will bless this country.
According to that “logic”, they are voting in their own self-interest.
Abby, You are Amazing!
Ah shucks…thanks KB!
“…it is appropriate that they should garner for themselves some fraction of the resulting increases in productivity.”
For those following my business series, keep this statement in mind!
THIS is the entire basis for a rational and effective employee incentive plan. There are financial reasons why it works, and the major reason it works for employees is that there are psychological reasons that cause positive feedback chains within employee groups.
That dynamic will be explained once I get there, but remember this quote. It is the core rationale for constructing a business model that allows an owner to get to that dream we talked about all the way back at the beginning in the first installment.
PW…I was going to write more about incentives structures and packages…but since you let me in how that was going to be your next topic, I figured I would leave it to you..and I would just concentrate on the bigger picture! 🙂
Abby… It’s not the NEXT topic, but I’ll be getting there. I have to build into it. Without the financial understanding behind it, it makes no sense otherwise, and actually sounds a little crazy.
Sorry PW…I misunderstood! 🙂
Just remember, an incentive program should not be the reason for the employee to do a better job, it should also make the employee feel great about doing a great job.
2nd – absolutely. Employees need to feel invested in their work, and in control of what they are doing. Responsibility and accountability are very important. “Manna from heaven” once in a while gets nowhere, IMO.
One place I worked gave away gift cards to Target, Walmart, and Best Buy as incentives for sales.
They did not tell us they were doing this beforehand. We found out when the first of them were handed out.
We were somewhat pleased. Some of us put work into achieving those cards, when we found out the criteria (about half a week after the first ones were handed out).
A month later, enthusiasm tapered off as the taxes on those cards were deducted from our paychecks. We were less than impressed when we found out those $25 and $50 cards were being taxed at 33%.
They also need to be paid appropriately for the job their doing and their contribution to the company’s success. THAT needs to be addressed FIRST before the other items come into play.
While they need to be feel in control and have a vested interest in their actual work, they also need to have the proper economic interest.
I always say if you are only willing to pay someone $10 an hour with 3% raises every year, don’t be surprised if that is ALL they give you in return, even IF you provide all the other bells and whistles. At the end of the day, that person still has to pay to have a roof over their head and food on the table and THAT is the main reason they are working.
If they all won the lottery tomorrow…80% would call in rich the next day, regardless of how many of the other things were provided.
You know what always cracks me up about these how to motivate employees seminars and books, courses, etc…is they always try to PRETEND like actual financial compensation isn’t that much of a factor in how employees perform…I say that is all bullshit.
MOST people do not work because they love working…they work for money and for financial reasons. To pretend otherwise is ludicrous. ONCE the financial aspect is properly secured THAN the other things come into play…but if you aren’t paying your employees enough, where they are worried about how to keep a roof over their head and food on the table, they really aren’t going to care too much about the other stuff.
Especially because on the TOP end of the company pyramid, they claim just the opposite, that money matters….well guess what geniuses, it matters at ALL levels, not just the top and offer proper incentives in terms of compensation packages is necessary at all levels of the pyramid.
This is a great article Abby! I just had to comment on your money always matters – of course it does! There are very few areas in life where it doesn’t ….. not all of us grow up wanting to be a starving artist or a religious taking a vow of poverty. Most of us want a job we can enjoy and be proud of and that pays a living wage that also allows for some of the perks of life.
A personal anecdote: I worked for a bank, in head office. They introduced a bonus scheme that really made sense – each individual branch had to meet a target but in order to get a bonus all the branches in the region had to meet their targets and in order for the regions to get their bonuses the bank had to meet it’s target. Great way to foster co-operation and it worked ……. but – an ‘effin’ big BUT – what they didn’t tell us ants doing the work was that the bonuses would only go down to managemebnt level – we got diddly squat. Oh, hang on, our own manager felt a bit guilty about this so he brought in a box of doughnuts as a reward for all our hard work. If you guessed that morale hit an all-time low you wouldn’t be wrong. The amount of the bonus or even not getting a bonus didn’t matter – it was the being hoodwinked that mattered.
I eventually became management myself and attended a lot of management courses and two things I always kept in my head (although, as with most truisms, they don’t always apply)
– Pay peanuts, get monkeys
– If you have a problem employee go look in the mirror, the problem’s staring you in the face
I love your last paragraph…BRAVO!
THAT Is so true!
I can imagine how demoralizing that was, and unfortunately those at the top probably didn’t get why morale sank. The way that many companies treat their rank and file employees is often disgraceful…with donuts and pizza parties…its condescending. PEOPLE work for money…the is the most important motivator AFTER that comes the other stuff.
I we look at Maslow and his theory of the hierarchy of needs, which I personally believe has much merit, if you don’t have the basics met, the other stuff doesn’t matter.
I love Maslow’s hierarchy and for a while, in the Golden Age of the 70’s, corporations actually managed to believe themselves in getting their employees beyond the first three levels – and then came greed is good and now most working folks fight to even keep on the first 3 levels.
…. and I don’t talk out of class envy – hubby and I had very good jobs (hubby still does) and earn/earned way above average folks. But we were lucky – we were in the right place at the right time and we worked hard. We believe that we could only excel because of all the hard-earned benefits that our parents and grand-parents fought for – a good education, health care that kept us healthy didn’t bankrupt us, an economy that worked for ALL people, and a work environment that was conducive to using your brain and that, for the most part, respected us and recognised our contribution to the bottom line …… and we don’t think taxes are high enough on us let alone those who are mega-millionaires – but that’s a rant for another day 😆
Woof, your last comment and you and your hubbies experiences says a lot!
More so than all the analytical babble!
Externalities, being in the right place at the right time (ergo luck) and a host of other factors ALL play a part in how things turn out.
Your example is a perfect illustration of that…and fortunately WE get it.. but why don’t so many others not understand how all these factors COMBINE to make success happen and not just one factor or the other?
Well thought out and well written article Abby. There is no doubt that things are really out of whack in this country. I’m still trying to figure out why those who broke our economy not only still have a job, but got record bonuses these past few years as well.
Completely out of balance. I wish I could figure out how to change it…so that is why I’m writing about it, because perhaps if more people think about it and understand it, they will hopefully start saying no…and organizing for changes in the systems and with the powers that be…and I’m not just talking politics.
We need to start making demands with our pocket books and with our feet…complaining can be a good thing, if done right!
Abbyrose- another stellar performance! 🙂
The government is supposedly founded on checks and balances- we already know that’s screwed.
Incentives are supposed to be based on performance- that is screwed as well.
Parties are to be representative of their constituants- that’s a joke.
Corporations should be politically restrained- gone.
Wars should be fought for national defense- again- gone.
So much rebuilding needs to be done; is it even possible?
I don’t if the powers that be are going to be receptive to rebuilding. I think we have to start thinking in the terms of “Walk like an Egyptian” to really get their attention.