Politicians don’t know how incentives work

Jamie Whyte
THE chancellor George Osborne and business secretary Vince Cable believe that Britain’s economic problems are partly to be blamed on poorly designed incentive schemes. They believe that senior businessmen are “rewarded for failure”.

If this were true, it would indeed be a problem. But the idea is preposterous. Why would the owners of a company (or their agents) design a pay scheme that rewards employees for failing? Of course, executives do often receive high pay when their company is performing poorly. But this is not evidence of a badly designed incentive scheme that encourages failure. It is evidence of a well designed incentive scheme, aimed at solving a problem that government ministers do not seem to recognise.

The principal challenge of corporate governance is to align the managers’ interests with the owners’. An obvious way to achieve this is to make managers owners too, by paying their bonuses in company shares. Yet this is an imperfect solution because it fails to give managers the same risk appetites as other shareholders.

Few of a company’s shareholders are investors in that company alone; most hold a diversified portfolio of stocks. Provided these stocks are not perfectly correlated, the volatility of the portfolio’s value is lower than the average of each stock’s volatility. When held in such a portfolio, the optimal volatility of each individual stock is higher than it would be if held on its own.

The risks of company managers, by contrast, are concentrated in the firm they work for. Not only are they partly paid in its shares, which they must normally hold for a considerable period, but, if the company fails, they lose their incomes. A company’s managers are therefore more risk averse than its owners.

This fact helps to explain the high salaries, bonuses in bad years, golden parachutes and other elements of “fat cat” compensation that outrage the popular press and politicians. They are designed to relieve corporate executives of their natural caution and bring their risk appetites up to the same level as other shareholders. If you want people to take risks, you might offer to pay them pretty well even if they fail.

The serious incentives problem in Britain lies not with business executives but with politicians. They can make absurd, anti-enterprise speeches and pass legislation harmful to business without incurring any costs themselves. On the contrary, provided their rhetoric and policies appeal to the prejudices of sufficiently many voters, politicians can profit simply by harming unpopular groups.

Unlike business people, who profit by applying ideas that turn out to be correct, politicians profit from ideas that are popular, even when they are false. They live in a world of pure opinion, with little reason to concern themselves with reality.

Powerful people whose incentives encourage such intellectual irresponsibility are dangerous. The urgent task of constitutional reform in Britain should be to create legal limits on what these highly motivated charlatans are allowed to meddle with.

Jamie Whyte is a management consultant and author of Crimes Against Logic (McGraw Hill, 2004).