The incentives are all wrong

Hello everyone!

I promised that I would do a blog based on Nate’s excellent comment from last week. Nate had made the point that the problem with all of the government stimulus is that there were no rewards for people who have managed their finances responsibly and continued to do the right thing financially. And I believe that he is entirely correct in this view.

The problem with all of this is the cold, hard fact that economic incentives do work. If you incentivize someone with money then it is very important to make sure that you are rewarding the proper behaviors, otherwise you end up with big problems. For example, in the stock brokerage industry the brokers are all compensated based on high transaction volumes, either in terms of number of transactions, or in terms of high dollar amounts. So what aspect of a stock broker’s job do you think they focus in on? Making you money? Of course not. They understandably focus on high transactions, volume and dollar amount. Whether you make any money or not is irrelevant; if you elect to stop being their customer then they will simply plumb the depths of the other 300 million Americans in hopes of landing another “sucker.” Another example of economic incentives working is that my wife Dawn and I started providing monetary remuneration to my step-daughter in exchange for good grades. I figured that paying her a small sum of money for good grades would pay us back in the long-run as she was more apt to get financial aid. To the surprise of my in-laws and wife, the incentive plan worked and Kate’s grades have steadily improved despite a more active social life. I can also attest that they worked during the course of my career, too. And I don’t consider myself to be super interested in money.

So what happens when the people who have made the very worst decisions in our economy receive absolutely all of the bailout money? These folks include mortgage lenders who lent money to poor credit risks; investment banks who bundled and sold mortgage-backed securities of poor credit risks; insurance companies that insured the MBS poor credit risks; and poor credit risk families that took on a lot of debt. You guessed it, they are incentivized to continually make bad economic decisions. If you make the cost of failure low then people will continually push to the edge the financial chances they take. Think about it…if your gambling losses in Las Vegas were subsidized by your fellow financially responsible tax payers and thus there was no consequence to risky behavior, how much of your fortune would you bet? And wouldn’t you gamble on the games that were most risky and consequently had the highest payouts? It takes a strongly ethical person to say that they would not gamble any of their money. Heck, I think if I knew that I couldn’t lose, I would bet everything in hopes that if I won I could, yes, be wealthier, but give more money to the causes I care most about. Hmmm, sounds kind of like big companies in need of bailout funds giving money to their favorite cause: supportive politicians. This is not cynicism, this is what is happening.

So what’s in it for the responsible people? Absolutely nothing positive. But negatively, it’s the taxes on your earnings that are being used to ultimately pay for all of this subsidization of these bad choices. This is ass-backwards. As I have said before, capitalism only works if there is a fear of loss commensurate with risks taken. If you take that away then money is allocated inefficiently and the whole system ultimately collapses. Hmmm, that sounds kind of familiar doesn’t it? Especially when we are talking about trillions of dollars and high percentages of the accumulated wealth in the economy. Yikes!

What can be done? At this point, almost nothing. However, as a part of all of this bailout there could be a national discussion about the fact that this is absolutely, irrefutably a one-time freebie and that in the future there will be no bailout for dumb ass choices. Yeah, good luck on that one. Why do I say that? Because the politicians are the one’s that get to make these choices and guess what their incentive is? You guessed it, to placate big donor constituents. Hmmm, sounds like an argument for term limits and a cap on political donations. Hmmm. Unfortunately, we currently are embroiled in an ethical crisis that is a vicious circle of poor incentives. And hopefully some of these issues begin to be addressed, lest our country literally suffers from moral and financial bankruptcy – the two go hand in hand.

Thanks Nate for your excellent post!

Jason