A lot of people, reading the reporting on the current financial
\ndisaster, have been writing me to ask what people mean when they talk
\nabout incentives. The traders, the bankers, the fund managers, and all
\nof the other folks involved in this giant cluster-fuck aren’t
\nstupid. So naturaly, the question keeps coming up, why would they go
\nalong with it? And the answer that we keep hearing is something along
\nthe lines of “perverse incentives”.<\/p>\n
The basic idea is that the way that the people in the industry got paid, <\/p>\n The easy way to understand this is to just walk through a simple Imagine that you’re a fund manager at an investment bank, and Your coworkers are all investing in mortgage-backed You could invest in the MBSs. Then, if the MBSs do well, you’ve You could invest in something else. The problem is, there are very You could split things. But if things go well for the MBSs, that So – if the MBSs follow the 80% pat and do well, and you didn’t Well, if that happens, everyone is screwed. Your firm is so deeply Look at it as a game table:<\/p>\n Given your incentives, what’s the smartest thing to do? Invest Of course, to make matters worse, you can fill in that bottom A lot of people, reading the reporting on the current financial disaster, have been writing me to ask what people mean when they talk about incentives. The traders, the bankers, the fund managers, and all of the other folks involved in this giant cluster-fuck aren’t stupid. So naturaly, the question keeps coming up, why would […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"jetpack_post_was_ever_published":false,"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_publicize_message":"","jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":false,"jetpack_social_options":{"image_generator_settings":{"template":"highway","default_image_id":0,"font":"","enabled":false},"version":2}},"categories":[71],"tags":[],"class_list":["post-752","post","type-post","status-publish","format-standard","hentry","category-bad-economics"],"jetpack_publicize_connections":[],"jetpack_featured_media_url":"","jetpack_shortlink":"https:\/\/wp.me\/p4lzZS-c8","jetpack_sharing_enabled":true,"jetpack_likes_enabled":true,"_links":{"self":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts\/752","targetHints":{"allow":["GET"]}}],"collection":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/comments?post=752"}],"version-history":[{"count":0,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/posts\/752\/revisions"}],"wp:attachment":[{"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/media?parent=752"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/categories?post=752"},{"taxonomy":"post_tag","embeddable":true,"href":"http:\/\/www.goodmath.org\/blog\/wp-json\/wp\/v2\/tags?post=752"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}
\nit was actually in their interest do do things that they knew<\/em> would
\neventually cause a disaster. How could that work?<\/p>\n
\nscenario, looking at it from a game-theoretic approach.<\/p>\n
\nyou’ve got one million dollars to invest. You want to invest in a way
\nthat maximizes your bonus at the end of the year. Your bonus is
\ngoing to be computed based on your performance relative to your
\ncoworkers.<\/p>\n
\nsecurities. They’re bringing in 20% a year, but you know<\/em> that
\neventually they’re going to collapse; for the purposes of simplicity,
\nassume that there’s a 20% chance each year that they’ll fail. What
\nshould you do?<\/p>\n
\nperformed just as well as your coworkers. If they fail, then
\nall<\/em> of you fail; you’re no worse off than they are.<\/p>\n
\nfew other investments that are earning 20% like the MBSs. So if you
\nput your money into something else, odds are, you’re going to be
\nbringing in less<\/em> than you coworkers. So your bonus is going
\nto suck.<\/p>\n
\ndoesn’t help. By dividing your investment between the MBSs and
\nsomething else, you’ll be closer to what you coworkers are making,
\nbut still less. And so you bonus is gonig to suck.<\/p>\n
\ninvest in them, you’re screwed. But what if the MBSs follow the 20%
\npath, and they crash?<\/p>\n
\ninvested in them that if they crash, there’s not going to be bonus
\nmoney for anyone. So even if you didn’t invest in them, if they crash,
\nyou’re going to be screwed.<\/p>\n\n
\n <\/th>\n Invest in MBS<\/th>\n Invest in something
\nelse<\/th>\n<\/tr>\n\n MBSs do well<\/th>\n Hurrah! Big bonus<\/td>\n You’re
\nscrewed<\/td>\n<\/tr>\n\n MBSs crash<\/th>\n Firm bankrupt: you’re screwed<\/td>\n Firm bankrupt: you’re screwed<\/td>\n<\/tr>\n<\/table>\n
\nin the MBSs, even though you know that they’re going to crash.<\/p>\n
\nrow a bit differently. Based on how things are going now, the table
\nshould look like the following:<\/p>\n\n
\n <\/th>\n Invest in MBS<\/th>\n Invest in something
\nelse<\/th>\n<\/tr>\n\n MBSs do well<\/th>\n Hurrah! Big bonus<\/td>\n You’re
\nscrewed<\/td>\n<\/tr>\n\n MBSs crash<\/th>\n Gov’t Bailout: big bonus!<\/td>\n You’re screwed<\/td>\n<\/tr>\n<\/table>\n","protected":false},"excerpt":{"rendered":"