Incentives Without Disincentives

by Krishna on April 9, 2009

Nassim Nicholas Taleb, of “The Black Swan” fame, writes:

Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks. Odds are he would cut every corner on safety to show “profits” while claiming to be “conservative”. Bonuses do not accommodate the hidden risks of blow-ups. It is the asymmetry of the bonus system that got us here. No incentives without disincentives: capitalism is about rewards and punishments, not just rewards.

But even if you have disincentives, the incentives can distort everything. As I wrote sometime back about the reward-and-punishment methodology of management, the fundamental problem is that you are creating static rules for dynamic people. Each incentive and disincentive create many unwanted side effects. So you have to keep changing the carrots and sticks all the time to deal with these side effects making people confused. The real villains of the game always know how to get what they want.

I also find it difficult to imagine the right disincentive. Remember we are not talking about breaking the law, but for “cutting corners” like the CDOs which were perfectly legal. Would a person have to give back the incentives they earned over a period of years if the financial instrument crashed one September day? If such a contract was time-limited, it would be a perverse disincentive that would exacerbate a crash. If it was not, I cannot imagine someone signing a contract to give up their earnings several years after they have quit a firm. This is just an example, but shows the pitfalls of designing an actual reward-punishment system.

Also, since each firm can create its own incentive system, there will be rush of employees towards those companies which have the best incentives and the least disincentives. With better employees (because of the bigger pool from which it can hire), a firm can be more successful, thus encouraging the others to drop the disincentives. In general, this is the trend in every competitive industry: Employers have to offer a better deal to employees or they die.

So what is the solution? I hinted that you need passionate people and you need to find a way to keep them excited and motivated through company growth and good management practices. But you also need rules to ensure quality and prevent risks. In a competitive industry like the financial markets or medicine, you need regulation enforced by the government. Otherwise, one unscrupulous firm can start short-changing established practices and create a trend that could cause the whole industry to fall apart.

Comments on this entry are closed.

Previous post:

Next post: