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






Previous articleWriting Responsibly for Other Universes
Next articleGod’s Blog – 2-19-2011
For the last 21 years, I worked in international trade as a licensed customs broker, international freight forwarder and international trade consultant. I ended up in that business after having studied Journalism and communication in college. (Strange how that worked) Over the last 3 years I have been trying to change my life and my career, so I left my job, returned to school and am on the last leg of completing my Bachelor's of Science in Business Administration and Economics, and am planning on going on for my masters in International Business. It might seem odd that I decided to formally study the business I was in for 21 years...but there is a reason for that... I hope to teach and write on the subject in the future. I'm a mother of 2 young adults and have many hobbies; reading, researching, writing, blogging, decorating, are my current favorites.

42
Leave a Comment

Please Login to comment
11 Comment threads
31 Thread replies
0 Followers
 
Most reacted comment
Hottest comment thread
13 Comment authors
teamplayerphreadMightywoofKQuarkwhatsthatsound Recent comment authors
  Subscribe  
newest oldest most voted
Notify of
teamplayer
Member
teamplayer

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.

Report this comment

phread
Member
phread

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.

Report this comment

KQµårk 死神
Member

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.

Report this comment

whatsthatsound
Member

Greenspan was like Captain Renault in “Casablanca”, shocked, SHOCKED to learn that there was gambling taking place on Wall Street!

Report this comment

Sposton
Member

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.

Report this comment

2ndClassCitizenPundit
Member

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).

http://positivesharing.com/2006/12/why-motivation-by-pizza-doesnt-work/

You may like the points about diminishing returns.

Report this comment

ParadisePlacebo74
Member
ParadisePlacebo74

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.

Report this comment

UpstateSC
Member
UpstateSC

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.

Report this comment

KB723
Guest
KB723

Abby, You are Amazing! :mrgreen:

Report this comment

PocketWatch
Member

“…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.

Report this comment

2ndClassCitizenPundit
Member

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.

http://positivesharing.com/2006/12/why-motivation-by-pizza-doesnt-work/

Report this comment

PocketWatch
Member

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.

Report this comment

2ndClassCitizenPundit
Member

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%.

Report this comment

UpstateSC
Member
UpstateSC

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.

Report this comment

jkkFL
Guest

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?

Report this comment