Joseph Stiglitz on the question of incentives:

In this piece, Stiglitz contrasts the career of Norman Borlaug to that of the nameless Wall Street bankers, and wonders whether some noble people are corrupted by the immense money to be made in finance. The question goes beyond this, as must be plain by now. The incentives themselves were corrupting, not only of the people, but they suborned criminal and near criminal unconsciousness of the public's welfare. You don't get rich by doing the right thing on Wall Street. Of course, many have clothed themselves in the invisible hand, a myth to which even Stiglitz gives too much credit.. It is less than a fig leaf. Here is Stiglitz.

Borlaug and the Bankers
Joseph E. Stiglitz
Project Syndicate
October 20, 2009

NEW YORK – The recent death of Norman Borlaug provides an opportune moment to reflect on basic values and on our economic system. Borlaug received the Nobel Peace Prize for his work in bringing about the “green revolution,” which saved hundreds of millions from hunger and changed the global economic landscape.

Before Borlaug, the world faced the threat of a Malthusian nightmare: growing populations in the developing world and insufficient food supplies. Consider the trauma a country like India might have suffered if its population of a half-billion had remained barely fed as it doubled. Before the green revolution, Nobel Prize-winning economist Gunnar Myrdal predicted a bleak future for an Asia mired in poverty. Instead, Asia has become an economic powerhouse.

Likewise, Africa’s welcome new determination to fight the war on hunger should serve as a living testament to Borlaug. The fact that the green revolution never came to the world’s poorest continent, where agricultural productivity is just one-third the level in Asia, suggests that there is ample room for improvement.

The green revolution may, of course, prove to be only a temporary respite. Soaring food prices before the global financial crisis provided a warning, as does the slowing rate of growth of agricultural productivity. India’s agriculture sector, for example, has fallen behind the rest of its dynamic economy, living on borrowed time, as levels of ground water, on which much of the country depends, fall precipitously.

But Borlaug’s death at 95 also is a reminder of how skewed our system of values has become. When Borlaug received news of the award, at four in the morning, he was already toiling in the Mexican fields, in his never-ending quest to improve agricultural productivity. He did it not for some huge financial compensation, but out of conviction and a passion for his work.

What a contrast between Borlaug and the Wall Street financial wizards that brought the world to the brink of ruin. They argued that they had to be richly compensated in order to be motivated. Without any other compass, the incentive structures they adopted did motivate them – not to introduce new products to improve ordinary people’ lives or to help them manage the risks they faced, but to put the global economy at risk by engaging in short-sighted and greedy behavior. Their innovations focused on circumventing accounting and financial regulations designed to ensure transparency, efficiency, and stability, and to prevent the exploitation of the less informed.

There is also a deeper point in this contrast: our societies tolerate inequalities because they are viewed to be socially useful; it is the price we pay for having incentives that motivate people to act in ways that promote societal well-being. Neoclassical economic theory, which has dominated in the West for a century, holds that each individual’s compensation reflects his marginal social contribution – what he adds to society. By doing well, it is argued, people do good.

But Borlaug and our bankers refute that theory. If neoclassical theory were correct, Borlaug would have been among the wealthiest men in the world, while our bankers would have been lining up at soup kitchens.

Of course, there is a grain of truth in neoclassical theory; if there weren’t, it probably wouldn’t have survived as long as it has (though bad ideas often survive in economics remarkably well). Nevertheless, the simplistic economics of the eighteenth and nineteenth centuries, when neoclassical theories arose, are wholly unsuited to twenty-first-century economies. In large corporations, it is often difficult to ascertain the contribution of any individual. Such corporations are rife with “agency” problems: while decision-makers (CEO’s) are supposed to act on behalf of their shareholders, they have enormous discretion to advance their own interests – and they often do.

Bank officers may have walked away with hundreds of millions of dollars, but everyone else in our society – shareholders, bondholders, taxpayers, homeowners, workers – suffered. Their investors are too often pension funds, which also face an agency problem, because their executives make decisions on behalf of others. In such a world, private and social interests often diverge, as we have seen so dramatically in this crisis.

Does anyone really believe that America’s bank officers suddenly became so much more productive, relative to everyone else in society, that they deserve the huge compensation increases they have received in recent years? Does anyone really believe that America’s CEO’s are that much more productive than those in other countries, where compensation is more modest?

Worse, in America stock options became a preferred form of compensation – often worth more than an executive’s base pay. Stock options reward executives generously even when shares rise because of a price bubble – and even when comparable firms’ shares are performing better. Not surprisingly, stock options create strong incentives for short-sighted and excessively risky behavior, as well as for “creative accounting,” which executives throughout the economy perfected with off-balance-sheet shenanigans.

The skewed incentives distorted our economy and our society. We confused means with ends. Our bloated financial sector grew to the point that in the United States it accounted for more than 40% of corporate profits.

But the worst effects were on our human capital, our most precious resource. Absurdly generous compensation in the financial sector induced some of our best minds to go into banking. Who knows how many Borlaugs there might have been among those enticed by the riches of Wall Street and the City of London? If we lost even one, our world was made immeasurably poorer.