Friday, July 25, 2008

It's All a Matter of Incentives

“Economics is, at root, the study of incentives…” (Steven D. Levitt and Stephen J. Dubner, “Freakonomics”, p. 20.) The modern economy is a “thicket of information about jobs and real estate and banking and investment.” (p. 13) And, we respond to that information, respond to the incentives built into that information “from the outset of life.” (p. 20) “There are three basic flavors of incentive: economic, social, and moral. Very often a single incentive scheme will include all three varieties.” (p. 21) In many cases, incentives lead us to cheating and lying. (In the latter case see “Nobel-winning economist who put a premium on truth.”

The reason I am bringing up the issue of incentives today is to put into perspective some of the behavior we have observed in the economy in recent years and the results of such behavior. My major point is the obvious statement that everyone is looking for an edge. That is, people have goals and objectives to achieve, whether or not these are explicitly understood or not. As a consequence, people will respond to the incentives they observe that will move them ahead in their quest to achieve these goals and objectives.

Many of these goals and objectives are couched in relative terms. That is, the result we are looking for is not one of ‘absolute’ performance, but of ‘relative’ performance. We learn very early in life that in games like baseball, it is not important that we score 10 runs in a game, but at least one more run than our competition. In golf, we don’t need to shoot a score of 10 under par…all we need to do is shoot a score that is at least one stoke less than our opponents. And, we see that this objective holds in many other areas of life as well.

And, stating our objectives in relative terms lead us to ‘copy cat’ types of behavior. If another person, or another firm, has found a way to relative success, others will copy that way in order to duplicate that success, or, hopefully, perform at even a higher level. People that move to ‘the new way’ faster than others tend to achieve more success than those that move at a later date, although this is not altogether the case. But, this is the essence of dynamic markets. When there are opportunities for people to achieve returns that are in excess of costs, new participants will be drawn into the market if the costs of entering the market are relatively minor. In the case of financial markets the costs of entry are usually not excessive relative to the potential returns.

Another important factor is that once favorable market situations arise participants and potential participants often develop the attitude that a “new” world has arrived and that this “new” world represents the future. When this attitude develops, the perspective between the long run and the short run disappears. Thus, concern over conventional standards and conservative practices also disappears because the “new” world demands new standards and practices.

Retrospectively, we can look back at various situations over the past 30 years or so and see many examples of how people and organizations responded to market incentives in an effort to get an edge over their competition. Of course, the movement in the area of derivative securities is a prime example of this competitive behavior. The subprime mortgage market is the premier current example of this kind of behavior. There were many incentives hanging around the development of this market. There were the social and political incentives to develop this market to allow more and more Americans to achieve the ‘dream’ of owning their own home. There were the incentives for financial institutions to acquire these mortgages, package them into securities and sell them to others, thereby earning fees rather than making profits on interest rate spreads. There were the incentives for the brokers to initiate these loans to generate fees for themselves. There were incentives for funds to hold these securities because of the yields they earned and the fact that they could leverage up their portfolios to add basis points to returns. And, there were incentives for individuals and families to go ‘out-on-a-limb’ to get their own home.

Incentives work…for better or worse. Where does one put the blame? When does one go ‘over-the-edge’? The important thing to remember is that it always is a matter of trade-offs. Levitt and Dubner ask the question: “Who cheats?” And, they answer…”just about anyone, if the stakes are right. You might say to yourself, I don’t cheat, regardless of the stakes. And then you might remember the time you cheated on, say, a board game.” (p. 24) Then they go on: “For every clever person who goes to the trouble of creating an incentive scheme, there is an army of people, clever and otherwise, who will inevitably spend even more time trying to beat it…Cheating is a primordial economic act: getting more for less.” (p. 25)

Thus, certain types of behavior, as they succeed are copied. This is the way markets work. If exceptional returns are being earned, others will be drawn to duplicate the behavior that succeeds. The “new” behavior becomes a social phenomenon. David Brooks, in the New York Times, has recently discussed this “social” behavior. (“The Culture of Debt”, Everyone jumps on the bandwagon.

However, the additional competition tends to drive out the exceptional returns and promotes even more excessive actions to perform. Again, this is the way markets work. For example, in the 1970s and 1980s there was a move to buyout companies, break them up and sell the various parts. Valuation was such that the individual parts were not being valued at their ‘stand alone’ value and consequently this strategy could succeed and generate a lot of wealth. However, as time passed, the valuations of companies came to incorporate these ‘stand alone’ values and hence people that got into this game at a later date did not achieve the rewards that those who got in earlier received. By the start of the 1990s buyouts were actually losing money in the effort to duplicate what had gone on before.

If a movement continues on for a lengthy enough period of time it becomes more and more difficult for the person operating in a more conservative way to stick to their principles. For example, a friend of mine ran a mutual fund during the 1990s; he had a fair amount of Nobel-prize money in his funds; his funds performed very well for most of the decade; and his funds stayed out of ‘tech’ stocks since he felt that their performance tended to be speculative in nature. However, toward the end of the decade his funds began to lag other funds that were more heavily invested in “technology”. As a consequence, investors began to move money out of his funds. Finally, feeling that he could not stay away from the ‘dot-coms’ he finally began to move into that area of the market. Nine months after he began this move, his performance was recorded in the main article on the front page of the Wall Street Journal. He had moved just before the crash in dot-coms began. The fund recovered, but if he had stayed with his initial principles for just a while longer, he probably would have made the lead article in the Wall Street Journal heralding his adherence to the fundamentals. (For a happier outcome see “PNC’s caution gives it last laugh over rivals”:

The bottom line to this is that this type of behavior is not going to go away. Legislation is not going to change human behavior. “Incentives are the cornerstone of modern life.” (p.13) Congress can try and put a halt to speculation, they can attempt to halt higher leverage, they can move to prevent ‘cannibalistic’ lending behavior. Yet, if the incentives exist, individuals will find a way to get around regulators and legislators. I am not trying to justify this behavior…just accept the reality of it. The only thing I believe that can help the situation is to create greater openness and transparency in transactions and reporting. This will not change behavior but it will provide more information so that we can more fully understand what is going on in the
markets and the positions that people are taking.

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