“People will play the way you pay them”

By Reuters Staff
October 27, 2008

Arthur Kimball

This might be old news to readers of this blog, but still a nice way of putting it.

In this article, the Times does a good job summarizing the observations of three deans of high finance, Stephen Friedman, Marty Lipton and Joseph Rice III. These guys know what they are talking about. The comment regarding compensation should buoy those who have argued that tying pay to long term performance (perhaps something like a ten year running average) is really the only responsible way to run a company.

I think that one of the modern economy’s biggest problems is the dearth of self-aware principals in the system. Everyone seems to be an agent who profits on the up-side and moves on when things go bad.

To put it all very simply: principals are owners and agents work for them. Principals have to pay up on losses when a venture fails, but get all that is left over once all liabilities are paid. The buck stops with principals. Agents are only needed because principals can’t be everywhere at once. It’s a division of labor thing.

But, with modern portfolio diversification theory and the modern corporation, all decision makers became agents. After all, it’s not worth it for shareholders – who the law technically regards as principals – investing in index or mutual funds to monitor what goes on in an individual corporation. The fallout is that management thinks like an agent and takes big risks. Sometimes those risks go “boom.”

The fact that guys like Lipton think the super banks are here to stay scares me. The government should break these places up ASAP because of the systemic risks they pose.

Moreover, I’d be interested to know who has thought about the consequences of the big Wall Street houses going public in the 1980s and 1990s (Morgan Stanley, Goldman Sachs, etc…). If these places had still been partnerships, without limited liability for the owners, would things be different today?

I hope Obama and McCain are both thinking about this kind of thing. But, I doubt it.

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