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Broken Incentives: “People See What They're Incentivized to See. If You Pay Someone Not to See the Truth, They Won’t See the Truth.”
Upton Sinclair said:
It is difficult to get a man to understand something, when his salary depends upon his not understanding it.
Bestselling financial writer Michael Lewis is now saying the same thing. In an interview with 60 Minutes, Lewis said:
Wall
Street is able to delude itself because it's paid to delude itself.
That's one of the lessons of this story. People see what they're
incentivized to see. If you pay someone not to see the truth, they
won't see the truth.
As Lewis makes clear, the broken
incentive system causes the heads of the Wall Street giants to act in
ways which are not only destructive to the economy as a whole and to
American jobs, but to the long-term health of their own companies.
If
the broken incentive system were fixed, Wall Street big shots could
suddenly be able to "see" the destructive effects of fraudulent and
risky behavior. That Unfortunately, that's probably not politically feasible.
would take politicians getting out of bed with Wall Street for a couple
of minutes, which is unlikely, given how warm and cozy it is
Of
course, executive compensation should be linked to performance, in the
sense of creating sustainable wealth for shareholders and the economy
as a whole. But if the companies and politicians are too spineless to
do that, at least ill-gotten gains could be taken away after the fact
when executives are found to have committed fraud or driven their
companies into the ground. For example, as I wrote last April:
[William
K. Black - the senior regulator during the S&L crisis, and an
Associate Professor of Economics and Law at the University of Missouri
] provided the historical background to the PCA [The Prompt Corrective Action Law (PCA)] in a little-noticed essay last month:...
PCA also recognized that failing bankers had perverse incentives to
"live large" and cause larger losses to the FDIC and taxpayers. PCA's
answer was to mandate that the regulators stop these abuses by, for
example, strictly limiting executive compensation and forbidding
payments on subordinated debt.
As I wrote last June:
Because
the current incentive for high-level corporate people is to commit
fraud. Even if they are caught and go to jail, they'll be rich when
they get out.
Hitting the crooks in the wallet is the only thing
which will motivate people not to rip off their shareholders, the
taxpayers and the American treasury.
As Paul Volcker says, the incentive systems at financial firms are broken.
Hitting wrongdoers with big fines will help fix them.
***
And Nobel prize-winning economist George Akerlof co-wrote a paper in 1993 describing the reasons for financial meltdowns:
Financial
crises in the 1980s, like the Texas real estate bust, had been the
result of private investors taking advantage of the government. The
investors had borrowed huge amounts of money, made big profits when
times were good and then left the government holding the bag for their
eventual (and predictable) losses.
In a word, the investors
looted. Someone trying to make an honest profit, Professors Akerlof and
Romer [co-author and himself a leading expert on economic growth] said,
would have operated in a completely different manner. The investors
displayed a “total disregard for even the most basic principles of
lending,” failing to verify standard information about their borrowers
or, in some cases, even to ask for that information.
The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”
If enough people ... are hit with [large] fines for fraud, future losses will not be somebody else's problems, but their own.
That
would make the game of financial fraud a lot less profitable, and so
undermine much of the motivation of corporate big-wigs to commit fraud.
And - given that Black says
that massive fraud is what caused the economic crisis - that in turn
would save the taxpayers from having to fund many billions in bailouts
. . .
The incentives should - of course - be on the front
end, so that Wall Street folks are dissuaded from committing fraud in
the first place.
At the very least, they should be at the back
end, so that any profits made by fraud are recouped and put back in the
government coffers.
Of course, some people simply cannot help themselves.
That's one reason I like James Kwak's novel approach:
As Kwak writes:
Why
not say that all bank compensation above a baseline amount - say,
$150,000 in annual salary - has to be paid in toxic assets off the
bank’s balance sheet? Instead of getting a check for $10,000, the
employee would get $10,000 in toxic assets, at their current book
value. . . . That would get the assets off the bank’s balance sheet,
and into the hands of the people responsible for putting them there -
at the value that they insist they are worth . . . think about the
incentives: talented people will flow to the companies that are valuing
their assets the most realistically (since inflated valuations
translate directly into lower compensation), which will give companies
the incentive to be realistic in their valuations.Of course, there's an argument that the executives' base salary should
be paid in toxic assets as well. Since these fatcats don't seem to be
motivated to run their companies well so as to save the economy and the
people, maybe having their own salaries on the line will motivate them.
But if you believe that is too harsh, at least demand that their
bonuses be paid in this way.... Apparently, Credit Suisse is already doing this.
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Broken incentives: Chapter 1 of new book, Pension Ponzi, Routledge Press.
That's a great idea, to pay the bankers a fee based on the continued performance of the financial asset they built. If they originate, close, package, and sell/securitize crap then it'll come back to them. In what other business is the proprietor / service provider able to walk away with wads of cash with absolutely no responsibility for what was sold, even when it is comparable to a pile of dog shit dressed up like a wedding cake. Fuck'em let them eat what they cook.
I think compensation in toxic assets is one of the most hilarious things ever.It would crash the system when their true value was declared!
Not everone can be bought. There are always other places to work. While my significant experience is restricted to engineering work, I have seen a number of people who couldn't be bought.
I was also once replaced in function because I didn't go along with a program that was going to hurt the company.
You have to be right but it just doesn't work in the long run to go along with a scam.
"It appears to me that with the Huge Bonuses that the Bankers are litterally taking all of the profits out of the Banks"
Why is this your problem? Are you a shareholder? Then vote to replace the board. Or sell your stock.
My only complaint is having my money taken away involuntarily to bail out failed companies I have no interest in. I think if failed companies collapse, so much the better. Let them be liquidated and let their factors of production go to more efficient uses.
Have you ever voted a proxy?
You can't defeat a board member. You can only vote to withhold your vote for him. They still get "yes" votes, and absolutely no "NO" votes. Result, they stay in their seats.
You have to realize this is a very small community that sits on the boards of corporations.
Lending your money out recklessly to unverified borrowers is stupid, but it's certainly not "fraud". Lending out money that you don't have ("fractional reserve banking") is in fact bailment fraud.
Apparently, when your economy is built on a foundation of fraud, all kinds of contortions are required to keep it from collapsing, including calling innocent things "fraud".
>"Why not say that all bank compensation above a baseline amount - say, $150,000 in annual salary - has to be paid in toxic assets off the bank’s balance sheet?"
But this will create a perverse incentive. Per Ludwig Von Mises's Human Action,
"It is possible to reward the manager by paying for his services in proportion to the contribution of his section to the profit earned by the entrepreneur. But this is of no avail. As has been pointed out, the manager is under any circumstances interested in the success of that part of the business which is entrusted to his care. But the manager cannot be made answerable for the losses incurred. These losses are suffered by the owners of the capital employed. They cannot be shifted to the manager... It is precisely when he is rewarded by a share of the profits that he becomes foolhardy because he does not share in the losses too"
Instead of trusting the free market, let's be harebrained and layer on more and more band-aid interventions to prop things up.
It appears to me that with the Huge Bonuses that the Bankers are litterally taking all of the profits out of the Banks and in doing so hurt the Companies Balance sheet. Gutting their Companies of any solvency. So, if in fact a Company fails they have already taken all of the Assets of that Company.
What ever is left on a picked over Carcus is left for the Shareholders, Bondholders. And in the end the US Citizens.
So you watched 60 Minutes last night too? Fucking great!!!!!!
GW,
The system is corrupted and co-opted beyond repair or redemption. When everyone stands to win or loose by what happens on Wall Street, nothing will change on Wall Street.
I remember watching a video lecture by Catherine Austin Fitts a few years back in which the above "we're all in this together" mentality was graphically illustrated. While the lecture was filmed well before the 2008 bailouts, she was talking to an audience that very clearly recognized the problems with Wall Street and Main Street.
At one point, after receiving a near unnainmous show of hands of people who wished to see real and significant reform of both Wall Street and Congress, she then asked the question a bit differently. How many people would still like to see the same reform if it meant a significant reduction in the value of their investments, be it IRA, 401(k)'s, brokerage accounts, real estate etc. Only a few hands went up in an audience of 50 or more.
We are all conflicted and biased and will settle for nothing less than owning our cake and eating it too. The powers that be fully understand this dynamic and it's used over and over again to beat us silly and rob us blind.