January 01, 2009

Follow the money

The start of a new year is a good time to learn from the past. Easier to say than do, though. Stanford b-school professor Jeffrey Pfeffer offers some good thoughts in his blog on why this is so.

He zeroes in on poorly designed incentive systems as a key culprit.

"While pundits expound endlessly on how the current financial mess arose, the answers are, in virtually every case, quite simple. People did what they were paid to do—make (bad) loans, take excessive risks, package and resell worthless paper, leverage up the balance sheet, and so forth. Unless we get better at the seemingly simple task of predicting what reward systems are actually going to do, and unless we get smarter about designing rewards that don’t produce destructive behavior, the current bad news will just get recycled in the future. That’s because we don’t seem to learn anything from experience.

There are many, many instances of financial incentives driving behavior that then causes organizations major problems. This fact raises the question of why no one ever seems to learn anything—which explains why the current situation with home mortgages looks remarkably like the case of making bad loans to countries that couldn’t repay them about 25 years ago and a little like the savings and loan mess of the late 1980s."

The good news is that having identified the problem - incentives that don’t take account of consequences – we have the know-how to reshape them into something more functional. The issue remaining, though, is do we feel enough pain from the economic mess we are in to have the will?

I’m optimistic.

Happy New Year!


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