Pay More Attention to "What" and "How"

Carrots and sticks are no substitute for good character.

Posted Jan 09, 2009

[This post was written in collaboration with my colleague, political scientists Kenneth E. Sharpe]

When the acute phase of the current financial crisis has abated, what steps will we take to make sure it doesn't happen again? Policy makers are already talking about better regulation and smarter incentives-sticks and carrots-that are aimed at changing how bankers and brokers do their work. Understandably so. But some caution is in order. The financial industry has found clever ways to dodge all sorts of regulations in the past. And the "perverse" incentives that generated the most egregious recent behavior in the financial world were hailed only a few short years ago as the "smart" alternative to what had gone before. Something more is needed. Instead of simply worrying about engineering the "how," with rules and incentives, we would do well to pay attention to the "what."

If, thirty years ago, you casually asked a banker you'd just met at a cocktail party "what do you do?," a common answer might have been "I make loans so people can buy or improve houses, or expand their businesses, or start new ones" or "I help people save for retirement." If you'd asked a few months ago, the answer to the "what" question might more likely have been: "I make money. By any means possible. Let me tell you about this great scheme of slicing and dicing risky loans into marketable securities." You might once have asked a steel manufacturer "what do you do," and been told "I manufacture girders that provide the infrastructure for office towers." Now, if you could find a steel maker, he'd tell you "I make money. I just made a great deal, closing my steel plant in Indiana and buying shares in a Korean steel company." A pharmaceutical executive who might once have said, "I make drugs that prevent and cure disease and ease suffering" might now say "I make money. Let me tell you about this great line of ‘copycat' drugs we've developed to protect us from patent expiration." A newspaper-publishing conglomerate CEO who might once have said "I contribute to democracy by keeping citizens well enough informed that they can be intelligent participants in the political process" might now say "I make money. I've just finished trimming down our news division, and channeled the savings into our ‘first-person-shooter' game division."

When the "what" involves aims that are appropriate to banking, steel making, drug making, publishing, or anything else, the "how" is more likely to take care of itself. But when the "what" is only about making money, the "how" becomes "by any means possible." As long as we focus on the how, we have only two flawed tools at our disposal. We can try to turn the greed that we just take for granted as "human nature" to our advantage by using incentives to leverage behavior in a better direction-for example, tying CEO pay to long term performance so that they will at least be greedy about the right things. Or we can try to overwhelm greed with fear (Thomas Hobbes' advice to us in The Leviathan), by reaching for the stick of regulation and punishment.

Sure, we need to regulate financial industries better, and we need to eliminate perverse incentives. But what is left out of this mix of carrots and sticks is character: the commitment and knowledge to aim at the right thing. A critical purpose of banking is to serve others. And far from being a sacrifice, dedication to such service will probably make bankers much more satisfied with their own lives too. Carrots and sticks don't teach character; they substitute for it. Worse, over-reliance on carrots and sticks can have the perverse effect of eroding the motivation to do our work well.

Decades of research in behavioral psychology has shown that rewards and punishments can be very effective in changing behavior. But, at the same time, they create an addiction to rewards and punishments. Behavior that might once have occurred for other reasons (for example, because it's the right thing to do) will now only occur when the reward or punishment dispenser is watching. Even if the rules and incentives for bankers could be designed exactly right-which is highly dubious-how can we trust that bankers won't find a way game the system, discovering shadows that the regulators' flashlights don't illuminate? The banking system, as we've painfully seen, only works when there is trust, and when the system depends entirely on regulation and incentives, "trust" becomes an empty word. The problem with the slogan "trust but verify" is that ever increasing attention to verification gives the lie to the notion that there is any trust.

If people were reminded that there is a point to what they do, in addition to making money, regulation would be ever so much easier, incentives would be less important, and "how" would be not be as much of a problem. If people could be reminded that what they do has, and is meant to have, a significant effect on the lives of others-that virtually every form of work has an essential moral component-then making money, by any means possible, might stop being the only thing that guides people's conduct. Encouraging this kind of character will not be achieved with ethics courses. Proper attention to appropriate "whats" will only happen if it becomes a norm that suffuses the daily practices of our business leaders and the organizations they run.

primary aim of all these money-making and profit-driven corporations has to be a dedication and service to others. Built into decision making algorithms, risk models, business plans, and spread sheets must be this question: how can we do well by doing good, by serving our customers, clients, patients, and students as they are meant to be served. Better regulation and smarter incentives will perhaps protect us from really bad bankers (and drug makers, steel makers, and newspaper publishers), but it will never get us good ones.