Stiglitz and Deming on Perverse Incentives

In Freefall, Stiglitz argues that the crash of the financial system was caused by a "systemic" problem, which means something more specific than a likely or common problem. It means the structure of the system has a tendency to do things (like fail) other than its original function such as providing banking services. Stiglitz elaborates that the business models of the banks and other financial institutions had incentives that caused actors in the system to increase the likelihood that it would fail in this way.

One major problem was that many executives had an incentive to maximize the stock prices because they get paid in stock options. Also, bonus pay depends on the income generated, and in the financial sector, income is generated most easily with fees. However, when the company has losses, executives get paid "retention bonuses," which should actually mitigate the incentive to ruthlessly maximize the share prices. Stiglitz wants to discredit the argument that bonuses give incentives to executives to work harder, but also argues that, to the extent that they work harder, the executives work harder only to maximize the stock price and the profits. Deming claims that any measure of performance will always have this problem since people will always find ways to fudge the numbers in their favor. He strongly cautions against using quantitative metrics to measure performance because maximizing one number (short-term profit) may end up minimizing another number (long-term profit) somewhere else in the system. Another way it comes up that I have experienced at my company is that saving time for one group may end up taking up more of another group's time so there is a need to think of the whole system when setting the agenda for everybody.

Stiglitz then goes on to describe the problems with corporate governance, where management typically appoints most of the board, and the board sets the executive pay.

Organizational Economy

In Freefall, Stiglitz mentions the research of Herbert Simon arguing that there is no reason for profit enterprises should be any more efficient than non-profit or government organizations given neo-classical assumptions. This is because most people are employees no matter what the organization is, and so there is no difference in motivation. Furthermore, in public companies, the owners are the shareholders, who are very removed from management.