Wall Street's Misaligned Incentives

To The Editors, Wall Street Journal:

Jonathan Macey (“’Say on Pay’ and Other Bad Ideas”) argues that “new federal regulations on compensation attempt to obtain by bureaucratic fiat results that the markets and ordinary democratic processes rejected.” I would argue that Wall Street’s “market driven” compensation practices, which all too frequently misalign incentives, are one of the core problems behind the meltdown.

Markets only work when participants’ financial incentives motivate them to “do the right thing.” In today’s complex markets (unlike Adam Smith’s simpler times) it is extremely difficult to design appropriate financial incentives – just ask any board member who sits on a compensation committee. All too often the financial incentives focus participants on short-term results, to the detriment of the long term, since we imperfect humans understand the short term much better. It is an expensive expedient.

Participants in our financial markets are largely motivated by quarterly and annual transaction performance, even when 30-year mortgages, permanent acquisitions or company-risking derivatives are the transactions in question. This is gross market failure, and we are all paying the consequences. While I’m not sanguine about Washington doing a better job, it is Wall Street’s failure to get it right that has stirred the beast into action.

Sovereign Funds for Vultures

In the search for solutions to the financial system crisis, economists have not spent enough time exploring options for adapting to failures. Classical economic theory posits that homo economicus – the mathematically perfect man walking around free markets – doesn’t make mistakes. How could he? He knows all – perfect information is necessary for perfect markets. Studies of market imperfections abound, but mistakes and failures still aren’t considered part of the normal modus operandi of markets.

Back in the real world, mistakes and failures happen all the time. Remember New Coke? People’s Express? OS/2? Companies large and small, consumers large and small make mistakes on a daily basis. Cascading mistakes lead to failures of companies and industries, and are part of the normal landscape of business as far-from-perfect homo sapiens try, try again to make money.

Just as humans are “predictably irrational” (the title of behavioral economist Dan Areily’s recent book), businesses fail predictably enough that there are “vulture industries” that can feed regularly on the carnage. Bankruptcy lawyers, overstock merchandise retailers, wholesale liquidators, vulture investors, pawn brokers – the list is long of companies and individuals who have gained expertise in profitably following in the wake of others’ mistakes and failures. In the U.S., about 35,000 businesses and over 1 million individuals filed bankruptcy each year during the 21st century.

While vultures and their human equivalents are distasteful to some, they perform an important role in the (financial) ecosystem – recycling waste efficiently. Just as rotting cadavers are more of a threat than picked-over bones, “zombie banks” (Japan’s lost decade), debtor prisons, fallow factories, empty warehouses are all worse alternatives than enabling financial vultures to work their recycling magic.

Financial crises like the one we’re in create enormous piles of economic detritus that need to be cleaned up. Government bureaucrats (with the exception of FDIC-type bank liquidators) tend not to have the skills, experience, inclination or cojones necessary to be efficient recyclers of damaged goods. The same is true of traditional bank senior executives, for whom impaired assets are an embarrassment rather than an opportunity.

If we want to clean up the mess, we need to turbocharge the vultures who know what they’re doing. So I’d like to propose that TARP funds be used to invest across the vulture investor industry. Armed with $300 billion and a chance to earn 20% of the profits (the rest going to US taxpayers), vulture investors could go on a buying spree and do what is needed to wrest productive assets from toxic sludge. Undoubtedly other investors would join in alongside taxpayer money and trigger a spree, knowing that the government is determined to let weak institutions go to their deserved place in the dustbin of history. Yes, it wouldn’t be pretty for a while, but a year or two of “recycling” is preferable to a decade drifting downward with the stench of death still around us.