11 March 2009

Reacting rationally to perverse incentives

The Icelandic financial crisis explained:
You have a dog, and I have a cat. We agree that they are each worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners, but Icelandic banks, with a billion dollars in new assets. “They created fake capital by trading assets amongst themselves at inflated values,” says a London hedge-fund manager. “This was how the banks and investment companies grew and grew. But they were lightweights in the international markets.” Wall Street on the Tundra, Michael Lewis
The result? In the same article, we learn that
When their three brand-new global-size banks collapsed, last October, Iceland’s 300,000 citizens found that they bore some kind of responsibility for $100 billion of banking losses—which works out to roughly $330,000 for every Icelandic man, woman, and child.
The details are no doubt more complex, but I would guess, that as in the rest of the financial world, the Icelanders were reacting rationally to the incentives on offer. Indeed, facing those incentives, the multitudes of traders, bankers and experts would have been mugs not to behave irresponsibly.

A Social Policy Bond regime might have avoided the entire calamity, at least from the viewpoint of ordinary people. Unlike with other financial assets, investors in Social Policy Bonds might well get rich, true, but their rewards would be inextricably linked to achievement of specified social and environmental goals. Achievement of such goals might be as complicated as the financial markets used to be, but the investors' goals, and those of the general public would be entirely congruent. If government backed Social Policy Bonds then social and environmental goals would be decoupled from the financial world's volatility. There would still be huge gyrations in fortunes, but not at the expense of taxpayers.

No comments: