Mark Thoma at Economist’s View, citing Frank Rich, has a nice post up elaborating on a point I sometimes try to make, namely, the interests of executives and their corporations do not always coincide. Key quotes…..
“ “Individual and group interests are almost always in conflict when rewards to individuals depend on relative performance.” In these situations, which occur frequently in economic and social relationships, the assumption in neoclassical economic models that the maximization of self-interest is consistent with the maximization of social interest does not hold, and failure to recognize this has ” undermined regulatory efforts … causing considerable harm to us all”:…..
The central theme of Darwin’s narrative was that competition favors traits and behavior according to how they affect the success of individuals, not species or other groups. As in Smith’s account, traits that enhance individual fitness sometimes promote group interests. For example, a mutation for keener eyesight in hawks benefits not only any individual hawk that bears it, but also makes hawks more likely to prosper as a species.
In other cases, however, traits that help individuals are harmful to larger groups. For instance, a mutation for larger antlers served the reproductive interests of an individual male elk, because it helped him prevail in battles … for access to mates. But as this mutation spread, it started an arms race that made life more hazardous for male elk over all. The antlers of male elk can now span five feet or more. And despite their utility in battle, they often become a fatal handicap when predators pursue males into dense woods.”
There are still many people who deny that compensation played any role in the recent banking fiasco. I have contended that it has played a significant role. This has looked like tournament theory writ large. A couple of good years with huge bonuses, and one could be set for life. I do not contend that this was the only factor, but an under-appreciated one.
Michael Lewis at Vanity Fair (remember the Iceland piece?) has been kind enough to give me Exhibit A in my case in his article on AIG and Joseph Cassano. Key quotes.
“How and why their miracle became a catastrophe, A.I.G. F.P.’s traders say, is a complicated story, but it begins simply: with a change in the way decisions were made, brought about by a change in its leadership. At the end of 2001 its second C.E.O., Tom Savage, retired, and his former deputy, Joe Cassano, was elevated. Savage is a trained mathematician who understood the models used by A.I.G. traders to price the risk they were running—and thus ensure that they were fairly paid for it. He enjoyed debates about both the models and the merits of A.I.G. F.P.’s various trades. Cassano knew a lot less math and had much less interest in debate.
It’s impossible to deliver the full flavor of a man’s character without talking to him, and relying instead upon a bunch of people who remain afraid of seeing their names in print. That Joe Cassano is the son of a police officer and was a political-science major at Brooklyn College seems, in retrospect, far less relevant than that he’d spent most of his career, both at Drexel and A.I.G. F.P., in the back office, doing operations. Across A.I.G. F.P. the view of the boss was remarkably consistent: a guy with a crude feel for financial risk but a real talent for bullying people who doubted him. “A.I.G. F.P. became a dictatorship,” says one London trader. “Joe would bully people around. He’d humiliate them and then try to make it up to them by giving them huge amounts of money.”
Please read the whole article, there is much to learn in it. Cassano was clearly not prepared to handle his responsibility. He handled it with bluster and total control. Not unusual for someone out of their depth. While Lewis makes a strong case that there were personality issues at play, I have to think that the $280 million Cassano made in 6 years, at a job he did not quite understand, had to be a major motivator also.
As a bonus, when you read this please note that AIG essentially stopped writing CDS’s not long after dropping from AAA to AA by the credit-rating agencies. From that point on, about 2006, the big Wall Street firms took on the risks themselves. Even after a meeting with Cassano and his proposed replacement, Gene Park a real mathematician who understood that the system was poised to crash, told them that any drop in housing prices could cause a systemic collapse. The official response of the big firms was that housing prices across the U.S. could not all fall. It had never happened and never would. Unofficially, some conceded the system was ripe for a fall.
In the end, Mr. Cassano was just another cog, but a big one. He followed the incentives that best rewarded him, exactly what free marketers should expect. However, his incentives ran counter to those of AIG and all of the rest of us. The more one reads, the more apparent it becomes that many insiders knew things were heading for a crash, but the money was just too good to make it stop.
