From the Archives: Burning Down the House

Watch out! You might get what you’re after—-Talking Heads, Burning Down the House

I was in a bookstore over the weekend where I saw no fewer than six books suggesting that capitalism and our economic system had failed. The prescription in most cases was more government and more income redistribution. They system might be broken, but with the way our business and economic incentives are currently structured, I suspect the prescription of more government intervention will not help at all. The underlying incentives need to be fixed.

Adam Smith’s “invisible hand” is a useful economic concept. For a moment, let’s strip away all of the idealogy surrounding the invisible hand and get down to the base assumption: people act in their own self-interest.

Market theorists contend that with everyone acting in their own self-interest that markets run economies much better than bureaucrats. This is stupid. Bureaucrats contend that markets favor some groups and disadvantage others, so they should be able to step in and fix things. This is equally stupid.

The only thing the invisible hand guarantees is that people will act in their own self-interest. That makes the ultimate outcome mainly a matter of creating the proper incentives. If you have dumb incentives, the invisible hand will run the economy like a moron. If you have smart incentives, the invisible hand will run the economy like a genius.

Let’s look at a couple of examples. Let’s say that you have a private investment partnership, like Goldman Sachs or Smith, Barney, Harris, Upham used to be. On the one hand, the partners are incentivized to maximize their earnings through trading and underwriting. On the other hand, since the capital in the partnership is their own money, they are also incentivized not to blow up the firm. This prevents all manner of lousy underwriting deals and insures that trading leverage is managed carefully. The result is a company that tries to make as much money as possible without destroying the firm. This is the invisible hand at work with proper incentives. Everyone is working in their own self-interest, but those interests are balanced.

Now, think for a moment about a modern institution we will call Megabank. It is public, not private. Acting in their own self-interest, the traders and investment bankers are still incentivized to maximize their own compensation. However, the money the trading desk is using does not belong to the traders–it is other people’s money (OPM). What are the odds that they will overleverage in an attempt to make a huge bonus? Likewise, what incentive does an investment banker have to underwrite only good deals? (In fact, the bad deals usually come with bigger fees—bring it on.) Plenty of employees will act responsibly, of course, but moral hazard has been introduced. With everyone acting in their own self-interest, the invisible hand has this firm headed for the emergency room.

Think about AIG’s incentives: if they are allowed to underwrite insurance (credit default swaps) that is incredibly profitable because no reserves are required, is it likely they will underwrite a little or a lot? Think about a homebuyer’s incentive: tell the truth and stay in your apartment, lie a little (or a lot) and move into a nice house. Think about a sub-prime lender’s incentive: if they are allowed to offload all of the bad loans through securitization, are they likely to underwrite a little or a lot? Are they likely to care about the ultimate credit quality or default rates? With these sorts of incentives in place, what did policy makers think was going to happen? Now, what would happen if instead they had to eat their own cooking and retain a significant portion of the sub-prime loans on their balance sheet? Might that change their behavior? What if, instead of doing same-day exercise and sale of their stock options, executives had to exercise and hold the company stock for three years after their affiliation with the company ended? Would their stewardship change in any way?

The problem with the invisible hand is not that it doesn’t work—the problem is that it works incredibly well. This puts an enormous burden on policy makers to think carefully about how incentives are structured–and about what the ultimate consequences might be. Congress appears to have a very limited understanding of either the invisible hand or the consequences of incentives. It’s safe to say that most parents, who have to deal with kids and behavioral incentives all the time, are doing a better job, since most of their children live and become productive members of society.

I don’t know whether you think this is a brilliant piece of political economy or something so obvious that a fifth-grader could figure it out. But we, as a society, have apparently not figured it out. If we decide we want vast national savings, lots of capital formation and innovation, and a clean environment—all of that is probably achievable with properly thought out incentives. There are always trade-offs, and incentives usually have to include a lot of carrots and a few sticks. The invisible hand can’t give us everything, but with thoughtful incentives, we can do a lot better than we are doing now. We don’t have to let the invisible hand sucker punch us.

—-this article originally appeared 8/3/2009.  There are still a lot of books suggesting that capitalism has lost its way and, unfortunately, still very little coherent thinking about incentives going on.  It doesn’t have to be this hard.

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