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Incentives get at the heart of the current economic crisis.  In an interview yesterday for the WSJ, Roubini said

“I believe that people react to incentives, that incentives matter, and that prices reflect the way things should be allocated. But I also believe that market economies sometimes have market failures, and when these occur, there’s a role for prudential — not excessive — regulation of the financial system. The two things that Greenspan got totally wrong were his beliefs that, one, markets self-regulate, and two, that there’s no market failure.”

via Nouriel Roubini Says Nationalizing the Banks Is the Market-Friendly Solution –

Roubini makes the point that incentives matter.  And indeed, incentives get at the heart of the current fiasco, and there may lie the long term solution as well.  Paradoxically, the short term fixes that might be needed to claw our way out of the crisis might end up creating all kinds of perverse incentives (i.e., the problem of moral hazard that occurs by rewarding destructive behavior through bailouts).  But for the moment, let’s step back though and think through a few of the perverse incentives that helped cause this problem.

Executives at large financial firms (and indeed, at many companies in general) are largely compensated through stock options.  The goal of stock options is well intentioned — they’re meant to align the incentives of the executives with the interests of the company.  If the company does well, then the executives profit, which seems like a good thing.  But as they say, the road to Hell is paved with good intentions.  The reason that some scheme needs to be setup to align incentives is because of what’s known as the principal-agent problem.  In this context, the company (which is essentially the collection of shareholders) is the principal, which hires the executives, who are the agents, to run the firm.  The executives want to act in their own self-interest, so we need a scheme to align their self interests with those of the company.  Stock options seem like a good way to do that.  Unfortunately, any incentive scheme is imperfect, and it is generally not possible to perfectly align the interests of the agent with that of the principal.  What are the imperfections of stock options?  Well there are many, and they’re not exactly secret; for instance:

  • The agent is incented to increase short term performance of the company to drive up  the stock price,  just long enough for him to sell his shares.  Since options generally vest within 4 years, the long term health of the company is irrelevant to the agent.
  • The agent is incented to be risk seeking because of the asymmetry of his exposure to the company’s performance — if the company does well, the agent gets lucratively rewarded; but if the company does poorly, the agent doesn’t suffer losses (assuming our starting condition is when the strike price of his option is the market value of the share).

Just these two fairly obvious flaws in the incentive schemes for Wall street executives goes a long way towards explaining the current financial crisis.  The execs at Fannie Mae, Freddie Mac, AIG, Countrywide, … ad naseum were all acting in their self interests by taking on undue risk, and profiting heavily.  But the principals (namely the companies themselves) suffered.  And how can you really blame the executives, when they were doing exactly what the company was incenting them to do?  (By the way, railing at the current Wall Street execs is somewhat pointless; the people behind this mess cashed out long ago.)

As a side note, consider the fact that stock options are heavily used in the tech industry as well.  It’s interesting that the largest and most prominent of the tech companies don’t suffer the same kinds of problems.  Isn’t it curious though that at highly successful companies like Microsoft, Amazon, and Google, the “principal” is to a large extent the founder(s) of the respective companies?  In other words, if Jeff Bezos is running the show at Amazon, he does care about the long term health of the company, since not only is he the founder, he’s by far still the largest stakeholder.

It seems clear that companies should develop incentive schemes that reward executives and employees for long-term rather than short term performance.  In some sense, pre-IPO companies are like that, in that it could be several years before an employee’s shares are even tradable.

Game theory provides a framework for understanding incentives and how people react to them.  Several other key aspects of the current crisis can be understood in that context, which I’ll post about later.  But bailouts, restructuring, and masses of regulation won’t really fix the problem until we think about better ways to improve the incentive structures at the key points of our economy.

Ask the expert – Nouriel Roubini on prospects for 2009

An excerpt from a fascinating Q&A with Nouriel Roubini:

Is the solution to just keep re-inflating bubble after bubble to recapitalize our consumer driven economy or is it time for a huge systemic paradigm shift away from consumerism? What type of shift would you envision and would it destroy the economy as we currently know it?
Robert Singer, Oregon, USA

NR: For the last 30 years the US has been growing fast only during periods of asset bubbles that eventually burst with significant economic and financial costs.

The 1980s real estate bubble went bust in the late part of that decade leading to a severe banking crisis for the Savings and Loan banks, a credit crunch and a severe recession in 1990-91; next the 1990s tech/internet bubble went bust in 2000 leading to the 2001 recession; massive monetary and credit easing – as well as lax supervision/regulation of mortgages and credit – led to another housing and credit bubble that has now gone bust creating a severe financial crisis and recession.

The current monetary easing may lead to another bubble but we are somehow running out of bubbles to create.

Housing, credit, equities, commodities, hedge funds, private equity bubbles: they have all gone bust now. We need to create an economic system that is less prone to bubbles and more likely to lead to sustainable stable growth.

For the last few years the US has overinvested in the most unproductive form of capital – residential housing stock that increase utility but not labor productivity – and not enough into physical capital that increases the productivity of labor.

Also we overinvested in the financial sector, a corollary of the housing boom: when the S&P500 market capitalization of financial firms was 25 per cent of the market and when over a third of the profits or earnings of S&P500 constituents came from financial companies, that was an excess of finance.

And having a country where there are more financial engineers than computer engineers or mechanical engineers means a misallocation of human capital as well.

So we need to create a growth model relying less on housing/real estate, less on finance and less on having the brightest minds of the country going into financial services rather than into the production and innovation of new and improved goods and services.

via / Markets / Ask the expert – Nouriel Roubini on prospects for 2009.

The above discussion by Roubini gets at the heart of what is often not given enough importance in the discussion on the government’s role in helping fix the economy.  Propping up bubbles is akin to a kid on a candy binge — a euphoric sugar rush followed by a crash.  Talking heads often assert that falling housing prices are at the epicenter of the current crisis, and then proceed to say the only way to fix the economy is to prop up housing prices.  The most insightful statement Roubini makes above is that

For the last few years the US has overinvested in the most unproductive form of capital – residential housing stock that increase utility but not labor productivity – and not enough into physical capital that increases the productivity of labor.

More investment should go to sectors of the economy that increase productivity, so that in future the economy can produce more of what we all want.  The economic growth of this past decade was largely an illusion — rising home prices led people to believe they had more wealth, causing them to spend more.  But excessive growth in housing adds nothing to the productive capacity of the economy.

Adding to the Long Tail

I figured I should make my own contribution to the “Long Tail” of information by having a blog.  My favorite niches include computer science, economics, politics, and sociology.