Sunday, July 7, 2013

Misaligned Incentives

Notice how the Donkey isn't even interested anymore.

I remembered a Businessweek article I read in 2009 this morning. Thankfully, the Internet stores and remembers everything (I hope I don't get to regret that thought), so I was able to find it and read it again.

The article is titled: "Misaligned Incentives and the Economic Crisis".

Misaligned incentives, the article explains, produce unacceptable risks.

I remember that specific line in the article, mostly because it was kind of a "Duh" moment for me. It makes complete sense, to think, that misaligned incentives in the financial world, produce unacceptable risks. What doesn't make sense is how to get rid of these management flaws.

When the finance game becomes perverse through juicy tempting carrots and weak and battered sticks, the players become entranced through no collective fault of their own. Their managers rationalize these reward/punishment structures, because they seem to work, and also because they blindly rely on institution-wide practices. The institution's inner workings and widely accepted managerial policies lead to collectivization and a pernicious groupthink phenomenon. All this becomes maintanable because the juicy carrot is always within reach, and is rarely sacrificed.

Much later, when people start to scratch their heads and figure out how they lost so much money, it all becomes "so obvious".

The caricature of a greedy money-grubbing, salivating wolf that surrounds the sub-prime mortgage lenders and real estate agents of 2008 has been well absorbed by the public. Greed is good, but too much greed got us in this mess. That's the popular line of thinking that most likely holds up with laypeople.

I would have liked to have been a fly on a couple of walls right after the 2008 crisis. Witnessing passionate intellectual vindication, from experts and non-experts, with Main Street demonizing Wall Street and vice versa, and with high-profile Economists and business oriented Ph.D.'s making sense of what minutes before they would have been unable to foresee or, in some cases, would have correctly predicted, yet had failed to convince the people that mattered.

Those conversations were most likely ripe with the standard projections that come from expressing personal opinions: (i) some were doing their job, (ii) others were living the American Dream, and (iii) all were innocent bystanders, victims of the nefariousness that comes with systemic risk and the market's neverending appetite for growth and future profit.

Once the dust settled, the investigation began. The never ending one-word question (Why?) came forth, and the search for truth began.

The culprits were found and the government responded in a couple of ways.

And misaligned incentives are proving hard to correct - aligned incentives come with their own bag of tricks. But the jury's still out on how to exactly prevent "unacceptable risks", mostly because there is no such thing. Not when risk means business and lack of risk means lack of growth.

To be continued...

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