IT IS TIME TO TREAT WALL STREET LIKE MAIN STREET / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( HIGHLY RECOMMENDED READING )

It is time to treat Wall Street like Main Street

By George Akerlof and Rachel Kranton

Published: February 24 2010 20:27

Thirty years ago, when we were still using typewriters and fewer than 25 per cent of households invested in the stock market, economists conjectured that employees would work harder and make better decisions under a “pay-for-performance” system. This theory became popular in boardrooms – especially since it was an influential argument for increasing the pay of the chief executive and top officers. Bonuses tied to performance became standard practice in US companies and on Wall Street in particular.

But economics has not stood still, and we now know there are at least four reasons why bonuses and pay-for-performance are a risky business. First, it can be hard to see whether employees make the right decisions; superiors do not hold the same information, and the results of decisions play out years later. Second, performance pay will attract exactly those who are willing to take on more risk. People interested in high but steady income will choose other careers. Third, to get their pay, employees may manipulate the system, against the interests of those who set up the incentives: like teachers who are threatened with losing their jobs and teach to the test. Finally, and most perniciously, performance pay can crowd out intrinsic rewards, as when children, having received gold stars for drawing pictures, later draw less than before in their own time. Why draw without getting paid?

But if monetary incentives do not work, what does? Identity economics – a new way of thinking about motivation – gives an answer. In organisations that work well, employees identify with their work and their organisations. People want to do a good job because they think they should and because it is the right thing to do. In organisations that function effectively, the goals of the workers and of the organisation are aligned. There is little conflict of interest and little need for performance pay.

Identity economics also tells us why the public, in America and elsewhere, are so angry about the bonuses on Wall Street. Most of us just get up in the morning and do our jobs – jobs that for the most part are neither glamorous nor well paid. We take pride in jobs well done, and we celebrate people such as Sully Sullenberger who, after ditching his plane in the Hudson River, checked the cabin twice for remaining passengers before being the last to evacuate. As he explained: “I was just doing my job.” (A month later, his pay was cut by 40 per cent and his pension was terminated.) The New York City firefighters on September 11 and the troops who stormed Omaha Beach just did their jobs. Most people’s work is not as dramatic and involves less risk, but these are role models we admire. Why then, we ask, do traders and bankers need outsize bonuses and performance pay to get them to do their jobs?

High salaries attract and keep talented, hard-working people, with specialised skills. But fair compensation should not be confused with outsize bonuses. In identity economics, performance pay demonstrates bad faith. It tells employees they are not trusted to do the right thing. Rather, incentives have to be right. (In any case, there is no magic formula for bonuses and stock options. Without a crystal ball, incentives will never be right.)

Identity economics gives us a new way to think about work and rewards. The incentive should not be to manipulate the system, but to live up to responsibilities: to pilot the plane; to storm the beach; to run to the fire. In the financial world, it is called fiduciary duty. It is an obligation to serve the client and the larger good of an organisation.

Current US law misses a fundamental point. Misconduct and decisions that benefit a company but not the clients are not seen as violations of this simple principle, but rather as failure to meet a dizzying maze of procedures and codes. For example, under the Sarbanes-Oxley Act, chief executives must attest that their organisations have followed extremely detailed accounting procedures. Such laws guarantee a robust market for accountants and for lawyers. But procedures, like bonus schemes, can be manipulated. And procedures, like bonus schemes, are impossible to get exactly right.

Acting in your own interest and not in the interest of clients is a failure to carry out the duties of office, to fulfil one’s fiduciary duty. While principles and responsibility sound lofty and idealistic, they can be taught, followed, institutionalised and enshrined in law. We see it every day in fire stations, on factory floors, in surgery rooms and schools. It is time to treat Wall Street like Main Street. Otherwise, it is just more risky business.

George Akerlof is Koshland professor of economics at University of California, Berkeley and 2001 Nobel Laureate in Economics. Rachel Kranton is professor of economics at Duke University. They are authors of the recently published book ‘Identity Economics’


Copyright The Financial Times Limited 2010.