A good example of the importance of incentives

Well, make this a bad example if you must. It is an example of bad incentives that produce bad outcomes. I am referring to the article by Bebchuk, Cohen, and Spamann in the Project Syndicate web site, in which the authors discuss the compensation of the executives of Lehman Brothers.

The article discusses a report by a court-appointed examiner on the finances of Lehman Brothers prior to the bankruptcy of the company. The report shows that while the shareholders of Lehman Brothers lost plenty of money in the bankruptcy, the executives managed to stay in the black, because of the structure of their performance-compensation pay contracts.

The authors point out that the ability of executives to make lots of money by pursuing highly risky strategies and their ability to avoid losses when their risky strategies lead to financial disaster are very bad news for the shareholders. This is the point I want to emphasize here. The shareholders, the owners of the company, gave bad incentives to their managers, and once a fiscal panic came about, the owners lost big.

But they were not the only ones to lose. The risky actions of executives such as those at Lehman (and they were not the only ones to be overly aggressive in taking risks) magnified the financial panic, once it had started, which resulted in the major recession we are still enduring. All of us lost.

Bebchuk, Cohen, and Spamann conclude that executive compensation schemes should be changed to give executives better incentives. This is certainly correct but it does not go far enough. Since the bad incentives created by such pay structures affect everybody, it is really a general reform of the mechanisms for performance pay throughout the economy that is indicated. Mechanism design theorists have the tools to suggest possible solutions. These tools are not a panacea, but they would certainly result in a safer financial system if applied carefully.

The biggest problem is probably political. As the Democratic administration moves to consider financial reform, after getting health reform passed, the Republicans are likely to resist meaningful reform. This is a basic issue with all mechanism design. Indeed, mechanism design theory starts with the assumption that a plan on how the system should be made to work has been agreed upon by society and the remaining problem is only technical: how to give people the right incentives so that the plan is achieved. This, and the reliance of mechanism design theory on classical game theory with its hyper-rational model of players, are the two biggest hurdles in coming up with mechanisms that deliver optimal incentives.

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