Sunday, November 23, 2008

Greenspan's mistake

It seems to me, after reading Applebaum and Nakashima's excellent article in the Washington Post on the failure of regulation that allowed the disaster of the subprime mortgage market, that the main mistake that was made and that led to the current crisis was to assume that companies act according to their own interests, as Greenspan famously admitted recently.

The problems lie in that executives' interests are not necessarily synonymous with the ones of the company; their salaries and promotions are tied almost exclusively to short term metrics, mostly profit. The problem is the divergence between executives massive incentives to increase short term profits and the almost total lack of punishment for long term problems; which creates a personal moral hazard and to the distorted behavior of firms. The "irrational" behavior at the firm level is explained by rational behavior at the individual level. A step in the good direction would be to diminish rewards for short term profits and increase incentives to promote the long term interests of the company. I don't have all the answers, but increasing by law the power of shareholders would be a good start.

Additionally, a healthy skepticism about firms ability to act according to their self-interests would lead to an increased respect for the benefits of regulation, as Spanish and us Canadians can attest.

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