Much has been written about the causes for the nasty economic downturn we are living through. The popular suspect is irresponsible sub prime lending leading to a real estate bubble, but some have blamed the Fed's past interest rate policies, while others have blamed deregulation or capitalism itself, still others place the blame on "Wall Street greed". The supposed causes are legion, but while all of these may have contributed to the downturn, none of these is the true underlying cause of the crisis. The ultimate cause is much more prosaic: misaligned incentives.
Incentives are the very foundation of capitalism. Capitalism is built on the assumption that when people act in their own self economic interest, a greater public good emerges from the chaos, and generally this is true. However it is only sustainable so long as people's own economic incentives are aligned with those of society as a whole. For example, getting an education improves my chances for economic success, while also allowing me to contribute more to society by paying more taxes and enabling me to use newly acquired skills to benefit myself and the company I work for. Society benefits from my actions because our incentives are aligned.
The trouble starts when my economic incentives are not aligned, or are even opposed to the public good. For example, I have an economic incentive to rob banks - if I do, I can get a lot of money for very little work. Of course, society will be greatly harmed by my actions, therefore our economic incentives are opposed. Government exists to resolve such economic conflict and to realign incentives - in the example I gave above, government legislates and enforces a penal code to ensure that if I decide to rob a bank, I get sent to jail. The threat of punishment realigns my interest with that of society at large - it is now no longer a winning proposition for me to turn into a masked bandit.
The example I gave above is an extreme one, but the take away is simple: as long as an individual's own economic incentives are aligned with society's interests, capitalism will generate prosperity. If economic incentives are out of whack things will turn sub-optimal, and if they are seriously misaligned, and given enough scale and time, really bad things will start to happen. Now let me show you how incentives are to blame for the current economic crisis:
Take mortgage bankers. In the past, mortgage bankers' interests were aligned with those of society as a whole: they made a loan decision and they would make or lose money based on the success of their mortgage. In recent years, however, these folks' had no economic incentives to ensure the stability of their loans - their incentives were to get as many loans as possible and sell them to a third party, perhaps to an investment bank. This meant that the banker had an economic incentive to accept loans even if he doubted their economic value. A completely different example: government regulators are poorly paid. However, there is never a shortage of folks who want to work for the SEC, the FCC, the IRS or any other three letter agency you can think of. Why? Because those folks know that their pay-day will arrive, it is simply delayed. While they are not highly compensated currently, they will be in extreme demand if they decide to go to work for the companies they once regulated or to become lobbyists. This means that while on the job as regulators, they have an incentive to cozy up to future employers rather than to ensure the economic interests of the public at large. Incentives are misaligned. In the case of bank regulators, could they have had an economic incentive to under regulate at the request of industry and at the expense of the public?
I could continue dishing out examples all day long, but let me get to the point. Incentives in our economy were and still are severely misaligned: industry groups, unions, individual workers and business owners have a built-in economic incentive to... not cheat, that would be too strong a word. They have an economic incentive to be persuaded that practices that might not seem too smart need to be allowed to continue... it pays to look the other way. misaligned economic incentives are the dynamite which makes the economic crisis go BOOM, regardless of what specific match or event lit the actual fuse.
Economic incentives are the key and the foundation for capitalism. Laws, regulations, work rules and, indeed, culture itself, should work together to ensure that economic incentives are aligned. Your success should be my success, and your failure should lead to mine. Shared incentives lead to mutual success, while misaligned ones encourage predatory or irresponsible behavior. Don't get me wrong, economic incentives could not stop the occasional Barney Madoff from initiating the odd ponzi scheme. However, if incentives are carefully controlled, the Madoffs of the world will not be able to bring economic calamity on the rest of us. Sure, it's easy to blame Wall-Street's greed for the problems we're in, but economically minded people understand that it is that very greed on which the capitalist system is built. Greed in itself is not a bad force, it is to be encouraged, it is part of human nature. Suppressing greed is simply impossible, but channeling it in ways that benefit society as a whole is the way to guarantee economic stability and long term prosperity.
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