Incentives and penalties: Getting counter-intuition and paradox out of the equation

A central feature of most economic theories is that economic actors are rational beings who react in an anticipated manner to changes in economic stimuli such as prices, wages and interest rates.

Thus, an excess demand for a particular good will, in a market with no barriers to entry, result in an increased price that will restore the balance between demand and supply by a combination of reduced demand and increased supply of that good.

Where exceptional profits are being made new suppliers will enter a market, reducing its profitability.  Skills in short supply will initially attract high wages, but this in turn will encourage more people to acquire similar skills, eventually reducing their high price.

It follows that appropriately structuring incentives and rewards are an important feature of ensuring successful economic performance.  In responding to such incentives rational economic agents produce desired outcomes.

Long ago employers realized that the most appropriate incentive for, say sales staff of furniture or used-cars, was to link individual remuneration to the volume of sales generated.

In what is termed the “agency problem” economists argued that publicly owned firms run by professional managers would underperform relative to those with owner-managers.

This is because salaried executives will avoid making business decisions which complicate their task of managing firms – such as ambitious expansions funded by debt – even if such decisions are clearly in the interests of the firms’ owners (the shareholders).

To better align the interests of managers and shareholders, firms increasingly introduced performance-based bonuses.  Bonuses were tied to a firm’s profits and became an important part of executives’ remuneration so that they would more strongly influence their behaviour.

Ultimately, managers were given shares or share options in the company for which they worked, so that a growing part of their earnings was directly linked to the rise in the share price.

In this way it was believed the interest of executives would be more closely aligned to those of the shareholders, reflected in a higher share price.

Karl Marx argued that the alienation of labour from the production process under capitalism would ensure that all such attempts to incentivize labour would be fruitless.

Only in a utopian communist state wherethe enslaving subordination of the individual to the division of labour” has vanished would labour “become not only a means of life but life’s prime want”.

In such a society individuals would automatically want to work for the good of others.  Each would willingly and automatically produce “according to their ability” and each would receive “according to their needs”.

In the real world, experience shows us that inappropriately designed incentives and penalties – or equally the absence of incentives and penalties – produce results that are often the opposite of what was intended.

It is now widely accepted that inappropriate incentives played a critical role in the risky decisions that recently resulted in the collapse of global financial institutions that plunged the developed world into recession.

Mortgage originators in the US housing market were rewarded for the amount of new business they brought to the banks, not on the ability of the home buyers to actually repay the mortgages.

The banks issuing the mortgages passed them on to Federal-supported agencies such as Fannie-Mae and Freddie-Mac, as well as to pension funds and other buyers of collaterised mortgage instruments.

As a result, none of the parties involved in issuing the risky mortgages appeared to bear any risk should the sub-prime borrowers default.  So mortgages were granted to individuals who were unable to repay them.

The credit rating agencies were paid only for the bonds which they rated and therefore had a powerful incentive to increase the amount of collaterised sub-prime bonds which they rated positively.

Finally, bank executives, witnessing a sharp increase in the contribution to their profits from an area of business that was previously almost unknown, had a strong incentive to encourage further such growth as they were rewarded by bonuses linked to short-term profits and short-term increases in share prices, regardless of the risk.

As a result, executives literally “bet the bank” and when the US housing market collapsed in 2008 many of the leading players in the banking industry were plunged into insolvency and were either forcibly merged into their larger rivals or had to be bailed out by increasingly irate taxpayers.

“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” confessed former Chairman of the Federal Reserve Bank Alan Greenspan in testimony to Congress in October 2008.

The absence of any incentives or penalties can equally produce adverse consequences.  A principal reason for poor public service delivery in South Africa is the absence of incentives to encourage success in the public sector, as well as a lack of penalties to deter underperformance.

Poorly performing public servants are paid the same as their underperforming colleagues and powerful trade unions prevent disciplinary action from being taken against even serial underperformers.

Inadequate systems often make difficult the apportionment of praise or blame to individuals.  The practice of political deployment to key offices involved in service delivery further hinders disciplinary action for non-performance.

If government is as serious as it claims to be in remedying the problem of poor service delivery, the lack of incentives and penalties must urgently be addressed.

Tinkering with the structure of service delivery will not succeed until the individuals employed to provide those services are motivated through rewards and penalties to ensure they deliver what they are paid to do.  This will require tackling vested interests.  But until this is done underperformance will remain endemic.

Likewise, as banking regulators globally seek to ensure that the sub-prime financial crisis cannot be repeated, they too must be willing to tackle established interests.

High-earners in the financial services industry are unwilling to give up their positions of privilege.  But it is critical that incentives that led to high-risk lending behaviour be replaced by rewards based solely upon long-term sustainable performance.

Much of the attention has focused on the enormous bonuses paid to top executives and there is outrage that such practices should continue even after taxpayers have been forced to pay billions of dollars to rescue firms which would otherwise have been destroyed.

Such a focus is understandable, but of greater importance than the actual size of bonuses is that executives’ remuneration should be aligned to long-term sustainable performance.

Importantly, bonuses should be reversible if the profits on which they were based prove to have been unsustainable beyond the short-term.

Thus bonuses should be granted in the form of shares not cash, and be awarded on the basis of multi-year performance rather than short-term windfalls.

The shares should be held in a trust so that awards can be reduced or cancelled if the profits on which they were granted prove to be short-lived.

Ensuring such a link between remuneration and long-term performance is the responsibility of active shareholders in whose interest it is to ensure that such linkages exist in practice.

Shareholders – who are mostly pension fund mangers – must also look at their own behaviour.  Fund managers’ focus on quarterly portfolio performance encourages behaviour based on short-profitability in the companies in which they invest.

The importance of getting incentives right in both the public and private sectors is summed up in the words of Charlie Munger, Warren Buffett’s partner at Berkshire Hathaway.  Munger noted in a speech to the Harvard Law School in 1995 that “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.  And never a year passes but I get some surprise that pushes my limit a little farther.”   It is the role of government and shareholders to limit the extent of future surprises.


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