Here's a simple set of claims that may help give us insight into problems with what I have termed the "structure of incentives" in the banking industry. The same set of claims can be applied to other industries with potentially similar dynamics.

1) If any one of us were a banking officer or real estate agent, it would be in our interest to try to make as many loans as possible because we would get a commission on each loan. The same would be true for real-estate agents. And of course, the potential home buyer wants to be able to get the house. So all three players in a housing deal - as well as any others - would have an interest (an incentive) to sell as many houses as possible.

2) From the perspective of any of these individual players, it is rational to assume a) that prices of housing will keep going up at the average rate based on past experience. It is even more rational to assume based on past experience that they will not decline. This is relevant for the amount of risk that the banker and home buyer will be willing to assume in a home sale.

3) Once an entire industry makes it a principle of their business practice that a) housing prices will keep going up, or b) at least not go down, the reasonableness of any single set of players as defined in (2) continuing to hold the assumptions mentioned in (2) declines.

4) After a certain theoretically unknown point in a particular boom cycle, it becomes irrational for an industry to continue to function on the basis of the assumptions noted in (2). The same cannot be said for the CEO's and financial mangers as concrete individuals however. Their interests seem to diverge from the group in question, e.g. the employees and stock holders of the firm. It is clear from what has occured that the structure of financial incentives of the CEO's and managers with financial power are such that they have an incentive to create a boom and bust cycle, since they can make great wealth on the upside of the cycle. We have now all wittnessed this pattern a few times in the past two decades enough that all good citizens should be reflecting on this at some level.

5) Since everyone knows (4) at the start of a boom cycle, it is not rational for any industry as a whole to engage in business practices that are predicated on any statistical assumptions that deviate from long-term trends. This still does not tell us anything about the incentives of the concrete individuals who are the CEO's and managers of these industries.

Conclusion: The structure of incentives motivating the "average" CEO and others with financial power in banking and other industries is broken and must be reformed. It falls to others to come up with the means and ends of this necessary transformation. Otherwise, we risk transforming American capitalism into a means of preserving an oligarchy.

Some additional remarks: At the outset of the banking crises, Henry Paulson stated that we should not limit the pay on executives of the banks participating in the bailout. This was a tacit admission that the structure of financial incentives in play would not create incentives to do what is interest of the firm, but to do what is in the interest of the particular individual with the ability to make a great deal of wealth for himself by leaving the firm to go to another. The issue seems to be that the incentive structure is too short term, e.g. 1 quarter or maybe 2. Without knowing much about the particular facts, I would think we need to change the incentive structure so that a CEO cannot make a great deal of money in a short time period, but rather over a long period of time, e.g. 10 years.

Here's another question: Can a new incentive structure be born out of a free market system alone? If government madates were required, would they lead to the kinds of unintended consequences we have heard about resulting from the $1 million cap on business tax-deductible income? In any event, it does not seem possible for those who tout deregulation and the free-market to argue that freedom in the market place always or in principle serves society well. Here's another way to get at the same issue: Why is it not as things now stand in the interest of the firm's board of directors or whoever holds effective authority - the stock holders for example - to align the interests of the CEO's and others with financial power with the interests of the firm? Is the answer that they cannot make the necessary changes? Who has the real power here? How does the larger culture's radical individualism make taking this issue seriously more difficult?

If American business does not begin to show with viable long-term corporate practices that the structure of the financial incentives of managers and CEO's are such that the decisions of these individuals are consistently and not exceptionally in the interests of the firm - then we may have to begin to question whether a free-market model is serving an oligarchy rather than the larger society.   The real purpose of the laws and business practices is supposed to serve the well being of all citizens, not the financial well being of the "few" at the expense of "the many".   The primary purpose of the free-market is not to make it possible for single individuals to make great wealth, but to create incentives to best create and distribute wealth in an efficient way. This is the primary though not exclusive rationale for freedom in the market place. Freedom and dignity of the human person is the second reason for its existence. These rationales must remain in this order, however, to assue that the second rationale has any real meaning in the real legal and economic practices of society. Otherwise we are all talking sentimental nonsense, and acting bit players in the fairy tale "The Emperor's New Clothes", a fairy tale with a moral I have been thinking a lot about these last 8 years.

Terence Hoyt

New Orleans, October 5, 2008