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 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 Unfortunately, that’s probably not politically feasible.

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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