The wonder of the private sector, of course, is that incentives magically align themselves in a way that makes everyone better off. Right? Well, not exactly. From top to bottom, corporate America is a cesspool of competing and misaligned incentives. Have you ever seen some variation of the sign near the cash register at a fast-food restaurant that says, “Your meal is free if you don’t get a receipt. Please see a manager”? Does Burger King have a passionate interest in providing a receipt so that your family bookkeeping will be complete? Of course not. Burger King does not want its employees stealing. And the only way employees can steal without getting caught is by performing transactions without recording them on the cash register—selling you a burger and fries without issuing a receipt and then pocketing the cash. This is what economists call a principal-agent problem. The principal (Burger King) employs an agent (the cashier) who has an incentive to do a lot of things that are not necessarily in the best interest of the firm. Burger King can either spend a lot of time and money monitoring its employees for theft, or it can provide an incentive for you to do it for them. That little sign by the cash register is an ingenious management tool.
Principal-agent problems are as much a problem at the top of corporate America as they are at the bottom, in large part because the agents who run America’s large corporations (CEOs and other top executives) are not necessarily the principals who own those companies (the shareholders). I own shares in Starbucks, but I don’t even know the CEO’s name. How can I be sure that he (she?) is acting in my best interest? Indeed, there is ample evidence to suggest that corporate managers are no different from Burger King cashiers—they have some incentives that are not always in the best interest of the firm. They may steal from the cash register figuratively by showering themselves with private jets and country club memberships. Or they may make strategic decisions from which they benefit but shareholders do not. For example, a shocking two-thirds of all corporate mergers do not add value to the merged firms and a third of them leave shareholders worse off. Why would very smart CEOs engage so often in behavior that seems to make little financial sense?
One partial answer, economists have argued, is that CEOs benefit from mergers even when shareholders are left with losses. A CEO draws a lot of attention to himself by engineering a complex corporate transaction. He is left running a bigger company, which is almost always more prestigious, even if the new entity is less profitable than the merged companies were when they were on their own. Big companies have big offices, big salaries, and big airplanes. On the other hand, some mergers and takeovers make perfect strategic sense. As an uninformed shareholder with a large financial stake in the company, how do I tell the difference? If I don’t even know the name of the CEO of Starbucks, how can I be sure that she (he?) is not spending the bulk of her day chasing attractive secretaries around her office? Hell, this is harder than being a manager at Burger King.
For a time, clever economists believed that stock options were the answer. They were supposed to be the CEO equivalent of the sign near the cash register asking if you received your receipt. Most American CEOs and other important executives receive a large share of their compensation in the form of stock options. These options enable the recipient to purchase the company’s stock in the future at some predetermined price, say $10. If the company is highly profitable and the stock does well, climbing to say $57, then those stock options are very valuable. (It is good to be able to buy something for $10 when it is selling on the open market for $57.) On the other hand, if the company’s stock falls to $7, the options are worthless. There is no point in buying something for $10 when you can buy it on the open market for $3 less. The point of this compensation scheme is to align the incentives of the CEO with the interests of the shareholders. If the share price goes up, the CEO gets rich—but the shareholders do well, too.
It turns out that wily CEOs can find ways to abuse the options game (just as cashiers can find new ways to steal from the register). Before the first edition of this book came out, I asked Paul Volcker, former chairman of the Federal Reserve, to give it a read since he had been a professor of mine. Volcker read the book. He liked the book. But he said that I should not have written admiringly about stock options as a tool for aligning the interests of shareholders and management because they are “an instrument of the devil.”
Paul Volcker was right. I was wrong. The potential problem with options is that executives can do things to goose the firm’s stock in the short run that are bad or disastrous for the company in the long run—after the CEO has sold tens of thousands of options for an astronomical profit. Michael Jensen, a Harvard Business School professor who has spent his career on issues related to management incentives, is even harsher than Paul Volcker. He describes options as “managerial heroin,” because they create an incentive for managers to seek short-term highs while doing enormous long-term damage.10 Studies have found that companies with large options grants are more likely to engage in accounting fraud and more likely to default on their debt.11
Meanwhile, CEOs (with or without options) have their own monitoring headaches. Investment banks like Lehman Brothers and Bear Stearns were literally destroyed by employees who took huge risks at the firm’s expense. This is a crucial link in the chain of causality for the financial crisis; Wall Street is where a bad problem became disastrous. Banks across the country could afford to feed the real estate bubble with reckless loans because they could quickly bundle these loans together, or “securitize” them, and sell them off to investors. (A bank takes your mortgage, bundles it together with my mortgage and lots of others, and then sells the package off to some party willing to pay cash now in exchange for a future stream of income—our monthly mortgage payments.) This is not inherently a bad thing when done responsibly; the bank gets its capital back right away, which can then be used to make new loans. However, if you take the word “responsibly” out of that sentence, it does become a bad thing.
Simon Johnson, former chief economist for the International Monetary Fund, wrote an excellent postmortem of the financial crisis for The Atlantic in 2009. He notes, “Major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew.”12
Each transaction carries some embedded risk. The problem is that the bankers making huge commissions on the buying and selling of what would later become known as “toxic assets” do not bear the full risk of those products; their firms do. Heads they win, tails the firm loses. In the case of Lehman Brothers, that’s a pretty accurate description of what happened. Yes, the Lehman employees lost their jobs, but those most responsible for the collapse of the firm don’t have to give back the huge bonuses they made in the good years.
One other culpable party deserves mention, and again misaligned incentives was a key problem. The credit rating agencies—Standard & Poor’s, Moody’s, and others—are supposed to be the independent authorities that evaluate the risk of these newfangled products. Many of the “toxic assets” now at the heart of the financial meltdown were given stellar credit ratings. Part of this was pure incompetence. It didn’t help, however, that the credit rating agencies are paid by the firms selling the bonds or securities being rated. That’s a little like a used car salesman paying an appraiser to stand around the lot and provide helpful advice to customers. “Hey Bob, why don’t you come over here and tell the customer whether he is getting a good deal or not.” How useful do you think that would be?
These corporate incentive problems remain unresolved as far as I can tell, both for senior executives in public companies and for other employees taking risks with their firm’s capital. There is a fundament
al tension that is tough to resolve. On the one hand, firms need to reward innovation, risk, insight, hard work, and so on. These are good things for the firm, and employees who do them well should be paid handsomely—even astronomically in some cases. On the other hand, the employees doing fancy things (like designing new financial products) will always have more information about what they are really up to than their superiors will; and their superiors will have more information than the shareholders. The challenge is to reward good outcomes without creating incentives for employees to game the system in ways that damage the company in the long run.
One need not be a corporate titan to deal with principal-agent problems. There are plenty of situations in which we must hire someone whose incentives are similar but not identical to our own—and the distinction between “similar” and “identical” can make all the difference. Take real estate agents, a particular breed of scoundrel who purport to have your best interest at stake but may not, regardless of whether you are buying or selling a property. Let’s look at the buy side first. The agent graciously shows you lots of houses and eventually you find one that is just right. So far, so good. Now it is time to bargain with the seller over the purchase price, often with your agent as your chief adviser. Yet your real estate agent will be paid a percentage of the eventual purchase price. The more you are willing to pay, the more your agent makes and the less time the whole process will take.
There are problems on the sell side, too, though they are more subtle. The better price you get for your house, the more money your agent will make. That is a good thing. But the incentives are still not perfectly aligned. Suppose you are selling a house in the $300,000 range. Your agent can list the house for $280,000 and sell it in about twenty minutes. Or she could list it for $320,000 and wait for a buyer who really loves the place. The benefit to you of pricing the house high is huge: $40,000. Your real estate agent may see things differently. Listing high would mean many weeks of showing the house, holding open houses, and baking cookies to make the place smell good. Lots of work, in other words. Assuming a 3 percent commission, your agent can make $8,400 for doing virtually nothing or $9,600 for doing many weeks of work. Which would you choose? On the buy side or the sell side, your agent’s most powerful incentive is to get a deal done, whether it is at a price favorable to you or not.
Economics teaches us how to get the incentives right. As Gordon Gekko told us in the movie Wall Street, greed is good, so make sure that you have it working on your side. Yet Mr. Gekko was not entirely correct. Greed can be bad—even for people who are entirely selfish. Indeed, some of the most interesting problems in economics involve situations in which rational individuals acting in their own best interest do things that make themselves worse off. Yet their behavior is entirely logical.
The classic example is the prisoner’s dilemma, a somewhat contrived but highly powerful model of human behavior. The basic idea is that two men have been arrested on suspicion of murder. They are immediately separated so that they can be interrogated without communicating with one another. The case against them is not terribly strong, and the police are looking for a confession. Indeed, the authorities are willing to offer a deal if one of the men rats out the other as the trigger man.
If neither man confesses, the police will charge them both with illegal possession of a weapon, which carries a five-year jail sentence. If both of them confess, then each will receive a twenty-five-year murder sentence. If one man rats out the other, then the snitch will receive a light three-year sentence as an accomplice and his partner will get life in prison. What happens?
The men are best off collectively if they keep their mouths shut. But that’s not what they do. Each of them starts thinking. Prisoner A figures that if his partner keeps his mouth shut, then he can get the light three-year sentence by ratting him out. Then it dawns on him: His partner is almost certainly thinking the same thing—in which case he had better confess to avoid having the whole crime pinned on himself. Indeed, his best strategy is to confess regardless of what his partner does: It either gets him the three-year sentence (if his partner stays quiet) or saves him from getting life in prison (if his partner talks).
Of course, Prisoner B has the same incentives. They both confess, and they both get twenty-five years in prison when they might have served only five. Yet neither prisoner has done anything irrational.
The amazing thing about this model is that it offers great insight into real-world situations in which unfettered self-interest leads to poor outcomes. It is particularly applicable to the way in which renewable natural resources, such as fisheries, are exploited when many individuals are drawing from a common resource. For example, if Atlantic swordfish are harvested wisely, such as by limiting the number of fish caught each season, then the swordfish population will remain stable or even grow, providing a living for fishermen indefinitely. But no one “owns” the world’s swordfish stocks, making it difficult to police who catches what. As a result, independent fishing boats start to act a lot like our prisoners under interrogation. They can either limit their catch in the name of conservation, or they can take as many fish as possible. What happens?
Exactly what the prisoner’s dilemma predicts: The fishermen do not trust each other well enough to coordinate an outcome that would make them all better off. Rhode Island fisherman John Sorlien told the New York Times in a story on dwindling fish stocks, “Right now, my only incentive is to go out and kill as many fish as I can. I have no incentive to conserve the fishery, because any fish I leave is just going to be picked up by the next guy.”13 So the world’s stocks of tuna, cod, swordfish, and lobster are fished away. Meanwhile, politicians often make the situation worse by bailing out struggling fishermen with assorted subsidies. This merely keeps boats in the water when some fishermen might otherwise quit.
Sometimes individuals need to be saved from themselves. One nice example of this is the lobstering community of Port Lincoln on Australia’s southern coast. In the 1960s, the community set a limit on the number of traps that could be set and then sold licenses for those traps. Since then, any newcomer could enter the business only by buying a license from another lobsterman. This limit on the overall catch has allowed the lobster population to thrive. Ironically, Port Lincoln lobstermen catch more than their American colleagues while working less. Meanwhile, a license purchased in 1984 for $2,000 now fetches about $35,000. As Aussie lobsterman Daryl Spencer told the Times, “Why hurt the fishery? It’s my retirement fund. No one’s going to pay me $35,000 a pot if there are no lobsters left. If I rape and pillage the fishery now, in ten years my licenses won’t be worth anything.” Mr. Spencer is not smarter or more altruistic than his fishing colleagues around the world; he just has different incentives. Oddly, some environmental groups oppose these kinds of licensed quotas because they “privatize” a public resource. They also fear that the licenses will be bought up by large corporations, driving small fishermen out of business.
So far, the evidence strongly suggests that creating private property rights—giving individual fishermen the right to a certain catch, including the option of selling that right—is the most effective tool in the face of collapsing commercial fisheries. A 2008 study of the world’s commercial fisheries published in Science found that individual transferable quotas can stop or even reverse the collapse of fishing stocks. Fisheries managed with transferable quotas were half as likely to collapse as fisheries that use traditional methods.14
Two other points regarding incentives are worth noting. First, a market economy inspires hard work and progress not just because it rewards winners, but because it crushes losers. The 1990s were a great time to be involved in the Internet. They were bad years to be in the electric typewriter business. Implicit in Adam Smith’s invisible hand is the idea of “creative destruction,” a term coined by the Austrian economist Joseph Schumpeter. Markets do not suffer fools gladly. Take Wal-Mart, a remarkably efficient retailer that often leaves carnage in its wake. America
ns flock to Wal-Mart because the store offers an amazing range of products cheaper than they can be purchased anywhere else. This is a good thing. Being able to buy goods cheaper is essentially the same thing as having more income. At the same time, Wal-Mart is the ultimate nightmare for Al’s Glass and Hardware in Pekin, Illinois—and for mom-and-pop shops everywhere else. The pattern is well established: Wal-Mart opens a giant store just outside of town; several years later, the small shops on Main Street are closed and boarded up.
Capitalism can be a brutal, cruel process. We look back and speak admiringly of technological breakthroughs like the steam engine, the spinning wheel, and the telephone. But those advances made it a bad time to be, respectively, a blacksmith, a seamstress, or a telegraph operator. Creative destruction is not just something that might happen in a market economy. It is something that must happen. At the beginning of the twentieth century, half of all Americans worked in farming or ranching.15 Now that figure is about one in a hundred and still falling. (Iowa is still losing roughly fifteen hundred farmers a year.) Note that two important things have not happened: (1) We have not starved to death; and (2) we do not have a 49 percent unemployment rate. Instead, American farmers have become so productive that we need far fewer of them to feed ourselves. The individuals who would have been farming ninety years ago are now fixing our cars, designing computer games, playing professional football, etc. Just imagine our collective loss of utility if Steve Jobs, Steven Spielberg, and Oprah Winfrey were corn farmers.
Creative destruction is a tremendous positive force in the long run. The bad news is that people don’t pay their bills in the long run. The folks at the mortgage company can be real sticklers about getting that check every month. When a plant closes or an industry is wiped out by competition, it can be years or even an entire generation before the affected workers and communities recover. Anyone who has ever driven through New England has seen the abandoned or underutilized mills that are monuments to the days when America still manufactured things like textiles and shoes. Or one can drive through Gary, Indiana, where miles of rusting steel plants are a reminder that the city was not always most famous for having more murders per capita than any other city in the United States.
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