This is both an explanation of, and a condemnation of, Alan Greenspan's failed "worldview". I think it will be instructive to assess exactly how he was wrong, and how he got to be more and more wrong as time went on. Especially since we haven't shown many signs of actually addressing the things he was wrong about.
Our economic system is now chock-full of perverse incentives, and if we don't understand those incentives, and work actively to correct them, our economic system will continue to falter.
Perverse Incentive:
A perverse incentive is an incentive that has an unintended and undesirable effect, that is against the interest of the incentive makers. Perverse incentives by definition produce negative unintended consequences.
Plus, I really, really like the term "perverse incentives", and think everyone should get more conversant with the concept. Follow me below the fold for the three major perversities afflicting our system, and let's discuss how we can create positive incentives instead!
We all remember Alan Greenspan's almost-confessional before the House Committee on Oversight and Government Reform. The most telling exchange was this:
Waxman: “Do you feel that your ideology pushed you to make decisions that you wish you had not made?”
Greenspan: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.”
I think you can get into Greenspan's head by remembering how business used to run, back in the 1950s, or the 1960s, or whenever he stopped being receptive to new ideas, and forged ahead with his paradigm solidified.
Here are the three major areas I've identified (if you've got more - please add them in the comments!)
Deregulation has gotten a lot of attention, and it's certainly part of the problem, particularly that which allowed multiple lines of financial business to cozy up under one roof, compounded by that which allowed companies to bundle of financial instruments and sell them (much like a pig in a poke) off to other companies. By allowing banks to become brokerages, and brokerages to become insurance companies, we wind up with companies who are investing people's money into products they themselves created, or into which they have no visibility.
The old positive incentives for these companies were minimized. Banks used to attract investors by creating returns, which they got by making good loans. Brokerages used to earn their fees by assisting investors with buying and selling stocks and bonds. And insurance companies used to sell insurance, which made them a low-risk investment, since their very business was caution.
Cheap Money. Cheap money leads to borrowing, rather than saving. That can be good in the short run, if people have been saving, and the economy needs stimulus. But over the long term, it makes most traditional investing unattractive, leading to riskier and riskier behavior by investors, who are looking for some kind of return. Long-term cheap money created the merger & acquisition frenzy, and the leveraged buy-outs that gutted companies. There is definitely something deeply wrong about people being able to put a company into debt to buy itself.
Greenspan somehow came to see everything from just one side. He saw the economic stimulus and the frenzy of activity, but didn't see the risks building up from folks chasing diminishing returns.
Compensation. This is the big one for me, since it is one of the biggest drivers of the behavior of the individual people who make up any business enterprise. The last 40 years have seen a gradual destruction of everything that promoted long-term thinking and company loyalty, from the boardroom down to the front desk.
Back in Alan Greenspan's younger days, a manager at a company was often promoted from within, and while commanding a larger and larger salary as he (always "he" back then) rose up the ranks, he also had a pension to think about. A pension that would only be paid if the company remained in business after he left. And with less mobility between companies, if your own company wasn't healthy, it could be devastating to your career - who would hire someone who helped sink a company? (Ah, the good old days)
As most folks are now only too aware, the best path to the highest-paid jobs is now a hop-scotch, since companies now routinely dismiss the value of their own employees and seek out the "best talent", which is somehow always a person who has worked somewhere else. And pensions have turned into forced investment, mostly of your own money, which you take with you when you go. Even the stock grants, options and matching funds usually "mature" over a window of less than 5 years.
When all the individuals involved in a business venture are looking around for their next job, either because they're managers who think the next place will give them a bigger wad of cash, or they're a front-line worker who knows they'll never get a raise, and their current bosses think of them as interchangeable parts . . . well, lets say you may not have the best interests of the shareholders firmly in mind (nor that of the customers, which compounds the problem).
“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,” [Greenspan] told the House Committee on Oversight and Government Reform.
The "self-interest" of a lending institution can only be a force if it is mirrored by the self-interests of the individuals who make the decisions at that lending instution. It is a mistake to think of an "institution" as having any will or identity of its own. It only takes one person really, to come in and loot a company.
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Obviously, there are a few fixes that can go into effect soon, and depend on political will and the government: re-regulation of the financial sector, and more prudent monetary policy which might balance the need for stimulus with the need to encourage prudence. But what about corporate culture and compensation? Many new companies are more fluid, nimble enterprises, which can't provide life-time employment, though I'd say that there is still a place for that type of model at, for example, a bank. So, how do we reform compensation to properly align the motivation of the employees and management with the interests of shareholders, and to the benefit of customers?
My first suggestion is that the top and bottom of the income scale need to get closer, and quickly. Shareholders need to understand that the money that goes to the executives is coming right out of their dividends/retained earnings. Compensation committees need to get a lot less incestuous. And any "deferred compensation" should be wholly dependent on the long-term continued health of the company. Also, why are we rewarding failure? Both signing bonuses and parachutes should be strongly discouraged, since they encourage managers to jump from one company to another as quickly as humanly possible.
Any other thoughts? I'm interested to hear anyone's opinion on how tax policy could be adjusted to promote good corporate and managerial behavior. . .