Reputational Capital and Incentives in Organizations

The following passage, jarring in light of recent revelations, appears in the opening pages of Akerlof and Kranton's recently published book on Identity Economics:

On Wall Street, reputedly, the name of the game is making money. Charles Ellis' history of Goldman Sachs shows that, paradoxically, the partnership's success comes from subordinating that goal, at least in the short run. Rather, the company's financial success has stemmed from an ideal remarkably like that of the U.S. Air Force: "Service before Self." Employees believe, above all, that they are to serve the firm. As a managing director recently told us: "At Goldman we run to the fire." Goldman Sachs' Business Principles, fourteen of them, were composed in the 1970s by the firm's co-chairman, John Whitehead, who feared that the firm might lose its core values as it grew. The first Principle is "Our clients' interests always come first. Our experience shows that if we serve our clients well, our own success will follow." The principles also mandate dedication to teamwork, innovation, and strict adherence to rules and standards. The final principle is "Integrity and honesty are at the heart of our business. We expect our people to maintain high ethical standards in everything they do, both in their work for the firm and in their personal lives."

If the preservation of its reputation for serving the interests of its clients was a major organizational goal for Goldman, then something clearly went terribly wrong. Consider, for example, Chris Nicholson's report on the manner in which the bank managed to shed its holdings of mortgage backed securities shortly before they collapsed in value, allegedly serving itself "at the expense of its clients." Nicholson reproduces the following email from an employee at the European sales desk to the head of mortgage trading: 

Real bad feeling across European sales about some of the trades we did with clients. The damage this has done to our franchise is very significant. Aggregate loss of our clients on just these 5 trades along is 1bln+. In addition team feels that recognition (sales credits and otherwise) they received for getting this business done was not consistent at all with money it ended making/saving the firm.

Felix Salmon considers this email to be "particularly damning" for the following reasons:

Illiquid things like CDOs are sold as much as they’re bought, and Goldman’s highly-paid sales team was aggressively going out and selling instruments which were at one point on Goldman’s balance sheet and which wound up cratering in value.

The effects were twofold: firstly, the Goldman clients who got stuck with this nuclear waste when the music stopped were understandably none too impressed with Goldman. And secondly, Goldman managed to stick the losses on those instruments to its clients, rather than taking those losses itself, and as a result its profits were billions of dollars higher than they would otherwise have been.

Was the hit to Goldman’s franchise value a hit worth taking, given the billions of dollars it saved? Probably yes, until the SEC and Carl Levin came along.

But the possibility that the SEC and Mr. Levin would eventually come along was always there. This is a form of tail risk that is not unlike that taken by the folks at the AIG financial products division when they sold vast amounts of credit protection in the mistaken belief that they would never be faced with significant collateral calls. Raghuram Rajan, in a remarkably prescient 2005 paper, described this process as follows:

Consider the incentive to take on risk that is not in the [compensation] benchmark and is not observable to investors. A number of insurance companies and pension funds have entered the credit derivatives market to sell guarantees against a company defaulting. Essentially, these investment managers collect premia in ordinary times from people buying the guarantees. With very small probability, however, the company will default, forcing the guarantor to pay out a large amount. The investment managers are, thus, selling disaster insurance or, equivalently, taking on “peso” or tail risks, which produce a positive return most of the time as compensation for a rare very negative return. These strategies have the appearance of producing very high alphas (high returns for low risk), so managers have an incentive to load up on them. Every once in a while, however, they will blow up. Since true performance can be estimated only over a long period, far exceeding the horizon set by the average manager’s incentives, managers will take these risks if they can.

As in the case of tail risks arising from the sale of credit protection, damage to the firm's franchise value does not appear in standard compensation benchmarks. The problem in Goldman's case was not that such damage was "a hit worth taking" but rather that the incentives faced by its employees did not adequately reflect the value of the firm's reputation in the first place. To the extent that employee behavior is responsive to such incentives, the sacrifice of reputation for immediate profit will be made regardless of whether or not, in the broader scheme of things, the damage to franchise value exceeds the short term gains.

How, then, might a firm accomplish the subordination of short term goals to long term objectives in practice? There are two possibilities: one could hire individuals who are predisposed to behave in a principled manner even in the face of incentives not to do so, or one could design compensation schemes that adequately reward actions that preserve or enhance reputation. Economists, being fervent believers in the power of incentives, usually tend to favor the latter approach. But in this particular context, there are two possible problems with this. First, the contribution of any given transaction to the reputation of the firm is generally much more difficult to ascertain and quantify than any contribution to the firm's balance sheet. This makes it difficult to assign reward appropriately. Second, in order to serve as credible commitments to clients and customers, compensation schemes must be easily observable and not subject to renegotiation after the fact. This is seldom the case.

The alternative is to hire individuals who are predisposed to behave in a manner that meets organizational objectives: to place a premium not only on ability but also on character. But would this not create incentives for potential employees to simply misrepresent their values? As Groucho Marx famously said: "The secret of life is honesty and fair dealing... if you can fake that, you've got it made." 

Fortunately, the consistent misrepresentation of personality traits is often infeasible or prohibitively costly. There is an interesting line of research in economics, dating back to Schelling and continuing through Hirshleifer and Frank, that explores the commitment value of traits that are costly to fake. Hirshleifer went so far as to argue that the "absence of self-interest can pay off even measured in terms of material selfish gain, and... the loss of control that makes calculated behavior impossible can be more profitable than calculated optimization... we ought not to prejudge the question as to whether the observed limitations upon the human ability to pursue self-interested rationality are really no more than imperfections -- might not these seeming disabilities actually be functional?" 

One could take this a step further: not only might limitations on the unbridled pursuit of material self-interest be functional for individuals, they may also be functional for the organizations to which they belong. And in the long run, firms that manage to identify and promote such individuals will prosper at the expense of those who are unable or unwilling to do so.

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Update (5/2). At the end of the post I linked to above, Felix Salmon asks:

Let’s say you work at an investment bank and you’re in charge of a book which includes a $1 billion barrel of toxic nuclear waste. You know that barrel is going to zero sooner or later, and you manage to sell it to some European dupes just in time, for full face value, saving your bank from $1 billion in losses. How much of a bonus, if any, should you get on that deal, and where should the money come from? And should you feel bad about avoiding the losses and sticking them to your clients instead?

In a comment on that post, The Epicurean Dealmaker responds:

The answer depends. If you are a proprietary trading shop your job is to make money (and avoid losses) at all costs. In fact, you have a fiduciary duty to somebody (eg, limited partners or shareholders) to do so. You sell the crap and never look back. Caveat emptor rules.

If you are a traditional investment bank, you find out which morons allowed $1 billion of concentrated toxic risk to accumulate on your balance sheet and you fire their incompetent asses for cause (ie, no bonuses, no golden parachutes). Then you convene the Executive Committee to decide whether it is worth permanently damaging your franchise as a supposedly neutral market maker by offloading the waste before it blows up onto your clients, or whether you should eat the loss as punishment for failure...

This is why trying to run a large proprietary trading operation inside a traditional market-making investment bank introduces a fundamental, highly dangerous conflict of interest. At a small scale, this kind of stuff happens all the time, and should, in a traditional investment bank. However, it should never reach the scale that threatens the short- or long-term future of the bank.

This gets it about right in my opinion. See also the many excellent comments along these lines on Mark Thoma's page. Mark links to a related post by Richard Green, who in turn mentions pieces by James Surowiecki and Yves Smith that are both worth reading. Here is Yves' bottom line:

Legal issues aside, it isn’t merely the great unwashed public that is taking an increasingly dim view of Goldman. What is striking is the change in sentiment among professionals.

Recall Goldman’s reputation: that of being the best managed firm on the Street, and its boasting about its risk management as key to its superior profits... its once-vaunted risk management, which led observers to believe that Goldman was doing a better job of managing exposures, now increasingly looks like the firm was simply more systematic and aggressive than its peers in not just shifting risks onto customers but engaging in further profit-maximizing strategies that look downright predatory...

Goldman is increasingly beleagured. Its lobbyists are now pariahs. More private lawsuits are coming to the fore. There are rumors it is in settlement talks with the SEC. But the once-storied firm apparently turned its well oiled machine to ruthless profit-seeking. It is an open question how much damage the firm will sustain from the well-deserved backlash, and whether it can change its conduct. 

Indeed.

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Update (5/4). As usual, there are a number of excellent comments on Mark Thoma's page. Here's Roger Chittum:

Goldman and the other IBs are in a very different business now than they were in the 1970s. Formerly, their business was representing real-economy clients for generous fees in facilitating mergers, acquisitions, spin-offs, IPOs, bridge loans, restructurings, and other balance sheet transactions, in which they sometimes took participations. Their reputations were quite important to relationship building with the few firms that could afford their services and with the investors to whom they returned again and again. In fact, they used to regard proprietary trading as a business that was beneath them. Thus, Solomon Brothers, for example, which early on was very active in trading, especially in government securities, was not in the top tier reputationally.

In recent years, the businesses and cultures of the IBs have been transformed. Something like 75% of their profits now come from proprietary trading, and the top executives have come up through trading instead of the white shoe service businesses. They are essentially now hedge funds with advisory groups appendages. And they are dangerous and unapologetic predators.

It may be possible to have commercial banks and investment banks as formerly constituted have common ethical cultures that are concerned with the longer term and institutional reputations, but I don't see how that can happen that can happen in hedge funds and proprietary trading units. Each of the big IBs has a story of internal culture struggles as their businesses changed, and notice the recent reports of culture clash arising out of the dysfunctional forced marriage of BofA and Merrill.

Glass Steagall put the wall between commercial banking and investment banking. Perhaps commercial banking and fee-based investment banking in the 1970s style could thrive with a common culture, but proprietary trading needs to be hived off. There are irreconcilable differences there.

To which mrrunangun adds:

Another difference is that in Whitehead's time, GS was a partnership and the great bulk of the partners' wealth was their interest in the partnership. Any failure in the partnership had the potential of creating losses for all of the partners. The long-term success of the partnership was crucial to the long-term security of the partners.

In the public company that GS became, none of that discipline remained to restrain the people running the company from exploiting their position in order to maximize the short-term profits on which their claims to enormous annual pay packages were supposedly based. In contemporary practice, boards of directors are generally much more sympathetic to management than to shareholders. Boards put shareholders first only in small companies where the board is made up of the owners, who have a significant stake in the success of the enterprise, and perhaps their attorney and/or auditor. In medium to large company practice, the CEO generally recruits the board, probably always if the CEO serves as board chairman as well. Board members who are not inside directors rarely have a critical portion of their own wealth in the companies on whose boards they serve.

Then there's Bruce Wilder:

On the issue of "aligning incentives" for individuals, I can tell you what the right scheme looks like: it looks like a fixed salary, with modest "options" in the form of (mostly honorary in magnitude) raises and bonuses.

At the very top of a business enterprise, it makes sense to make top executives buy a substantial interest in the firm -- to essentially become "partners". The top executives don't have to own a large part of the firm, but their ownership interest has to be a large part of their personal wealth. And, it should not be a gift -- no free options; make them buy it, and make it hard to sell: a large part of their ownership interest should be tied up in trusts.

The top executives of large corporations really shouldn't be paid in "performance" contingent options. Shocking I know, but executive leadership has little to do with the piece-work of a sweat-shop or a cucumber field.

And, they shouldn't be paid in magnitudes that could make them independently wealthy in a single calendar year. 

Magnitude matters, and it can easily overwhelm any contingent "alignment" of incentives... If you promise to pay someone a vast amount, realizable in the short-term, contingent on some abstract score-keeping scheme, you are incentivizing (horrible word) them to corrupt the score-keeping. You are asking them to lie.

Rajiv Sethi comes around to this issue, via personal character and the difficulty most of the non-psychopaths among us have, in lying.

He might also consider that Goldman is a vast, hierarchical organization, embedded in a market-exchange network, all of which -- hierarchy and network -- consists entirely of generating and reporting numbers, as part of a complex scheme of compound control.
This system cannot function, if the participants have too much of an incentive to corrupt the reported numbers. If people at the top of the hierarchy, or the clients, or the counter-parties, or on-lookers in the same and related markets, get the "wrong" numbers, things go terribly wrong.

 Bruce also points to the following from Mike Konzal of Rortybomb:

To keep this in economic terms, this crisis has shown a wave of agency problems embedded inside financial institutions. The best phrase for why people were motivated to do the things they do is simple: IBGYBG–I’ll be gone, you’ll be gone.

The other obvious market failure is that in a ruthlessly competitive arena that is judged primarily on quantitative measures, any ability to juke your statistics forces others to participate in that as well. We see this in a variety of ways I can describe if people are interested, but if your competition is repo 105ing their balance sheet to make it look like they are getting better returns with less leverage, they are going to get better deals on customers and capital than you are going to get and put you out of business. So you better do that as well. The notion of Milton Friedman-ite self-regulation through reputation effects has been a complete failure.

This echoes Richard Serlin's comments below. And then there's this from an anonymous source:

My thought reading Sethi's post and also TED's latest was this:

Decades ago the investment banks stopped hiring the scions of wealthy families expecting a sinecure, and started looking for people who were smart and "hungry" (as Grisham has put it). They asked applicants "What would you do if you won the lottery?" And if you made it clear that you didn't really care about the money, you weren't the right person for them.

And as TED makes clear the people who make it to the top at the investment banks are the hungriest sharks. The people who aren't really hungry (and I think there are plenty of them), make enough and leave, or walk when they feel they're asked to do something that compromises their integrity. So there's a huge endogeneity problem here.

Finally, paine is skeptical of the idea that "we can create eisenhowerish org men and then blend em with fresh new corporate norms" on the grounds that competitive pressure transforms character. It's a fair point.

Trading Strategies and Market Efficiency

Here is David Merkel's tenth rule:

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become. This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack...

Momentum persists in the short run, so play it if you must, remembering that the market gets more volatile when many play momentum.

This is an important point with some very interesting implications for market efficiency and volatility clustering.

In a well functioning market, asset prices are supposed to reflect the best available information about anticipated earnings flows and the risk-sensitive rates at which these should be capitalized. But the only way in which such information can come to be reflected in prices is through the trading activity of those who are alert to changes in information. A market dominated by such "information traders" will tend to be stable in the sense that prices will reliably track changes in information about underlying asset values.

Such adjustments may be rapid but they are never instantaneous. This means that in a market that is functioning well, price movements (and other market data) can reveal some information about changes in underlying values to those who have not incurred the resource costs of acquiring the information directly. This, in turn, can make technical analysis profitable.

On the other hand, in a market dominated by technical analysis, changes in prices and other market data will be less reliable indicators of changes in information regarding underlying asset values. The possibility then arises of market instability, as individuals respond to price changes as if they were informative when in fact they arise from mutually amplifying responses to noise.

But if market stability depends on the composition of trading strategies, what determines this composition itself? A key determinant is past performance: strategies that have recently given rise to strong returns will come to represent a greater share of total trading volume both because wealth has been transferred to those executing such strategies, and because they will attract new funds. In stable markets with informative price movements, the incidence of technical analysis will grow. If it grows too much, the market will be destabilized and an asset price bubble could form. Information based strategies will initially suffer from this, but those with the confidence and liquidity to persist in using them will prosper eventually once the inevitable correction arrives.

In other words, one ought not to expect markets to be efficient or inefficient, but rather to experience periods of relative efficiency that are interrupted from time to time by severe disruptions. This is a phenomenon I described in a 1996 paper as endogenous regime switching:

Behavior conducive to stability... may be most profitable when the market is unstable, and behavior conducive to instability... may be rather lucrative in a stable market when it is costly to collect information about fundamentals. There is a sense in which the two groups of speculators enjoy a symbiotic relationship with each other: each group benefits from an increase in the numbers of the other.... As a result, one would expect heterogeneity of practices to persist in the long run, with the dominance of one set of practices giving way to that of the other. The implication for speculative markets is that periods of tranquility are likely to be punctuated from time to time by periods of excessive volatility.

This paper builds on work by Beja and Goldman and Carl Chiarella, who had earlier examined the price implications of heterogeneous trading strategies without allowing for endogenous changes in population composition. The model itself is simple and stylized, but I believe that the basic idea underlying it is sound. Destabilizing strategies will prosper and spread when they are sufficiently rare, giving rise at some point to market instability, and the eventual return of stabilizing strategies. Neither perfect efficiency nor drastic inefficiency can last indefinitely, as each regime gives rise to changes in behavior that serve to undermine its own existence.

Some Further Comments on the Leverage Cycle

In a previous post I discussed a paper by John Geanakoplos on the Leverage Cycle (due to appear in the NBER Macroeconomics Annual later this year). I presented this paper in the Columbia finance reading group last Thursday, and have posted my slides in case anyone is interested in taking a look.  

The paper is considerably more accessible to the general reader than most of the recent theoretical literature on the financial crisis. It avoids the standard theorem-and-proof format, and consists instead of a sequence of elaborate numerical examples that fit together like a jigsaw puzzle. It also contains a number of very interesting ideas and insights, many more than I was able to discuss in my earlier post. 

One of the key features of the Geanakoplos model is that the same set of physical assets can serve as collateral multiple times for loans of different maturities. For example, housing serves as collateral for long-term loans in the mortgage market, while the loans themselves (after securitization and tranching) can serve as collateral for short-term borrowing in the repo market. Geanakoplos shows that the extent of leverage in the long-term market will endogenously be such as to allow for a positive probability of default, and is interested in the effects of bad news in this market (interpreted as an increased likelihood of eventual default) on the market for short-term loans backed by financial rather than physical assets.

Among the main insights in the paper is the following: a decline in the expected terminal value of the physical assets will result in a far greater decline in the prices of the financial assets that they back. This happens for three reasons. Most obviously, there is a decline in fundamentals. But the effects of this are amplified because the initial prices (before bad news arrives) reflect the beliefs of the most optimistic market participants, who borrow from the pessimists in order to buy their asset holdings. In other words, the marginal buyer is (endogenously) very optimistic and this is reflected in the market price. The decline in fundamentals not only wipes out these highly leveraged optimists, but also substantially reduces equilibrium leverage in the market. As a result, the decline in the financial asset price is far greater than any market participant's expectations concerning the terminal value of the physical asset.

The careful reader will note that incomplete markets and maturity mismatch play a critical role in this argument. One of the most interesting aspects of the model is that both market incompleteness and maturity transformation arise endogenously, and the asset prices at various points in the tree of uncertainty are all correctly anticipated. The results are driven not by irrational exuberance or systematic biases, but by heterogeneous preferences and beliefs, and changes over time in equilibrium leverage. It's a precise, rigorous and carefully constructed interpretation of recent events, based on work that was done well before this crisis erupted.

In response to my earlier post on this paper, David at Deus Ex Macchiato agreed that the work is important, but added:

What astonishes me however is that this is in any way news to the economics community. Ever since Galbraith’s account of the importance of leverage in the ‘29 crash, haven’t we known that leverage determines asset prices, and that the bubble/crash cycle is characterised by slowly rising leverage and asset prices followed by a sudden reverse in both?

This is a good question. A lot of the less formal work in this area never made it into the canonical models taught to successive cohorts of graduate students in economics. Geanakoplos doesn't mention Galbraith explicitly, but he does mention Minsky and Tobin, who themselves were surely familiar with Galbraith's work on the crash. Implicit in David's question is the accusation that the training of professional economists has become too narrow, and on this point I believe that he is absolutely correct.

Claiming Ancestors

Here is Ta-Nehisi Coates on the subject of cultural ancestry, at the end of an expansive post on slavery, the Civil War, and Robert E. Lee:

Finally, there's the question of how we claim ancestors, a question that is more philosophical than biological. Africa, and African-America, means something to me because I claim it as such--but I claim much more. I claim Fitzgerald, whatever he thought of me, because I see myself in Gatsby. I claim Steinbeck because, whether he likes it or not, I am an Okie. I claim Blake because "London" feels like the hood to me.

And I claim them right alongside Lucille Clifton, James Baldwin and Ralph Wiley, who had it so right when he parried Saul Bellow. The dead, and the work they leave---the good and bad--is the work of humanity and thus says something of us all. And in that manner, I must be humble and claim some of Lee, Jackson, and Forrest. What might I have been in another skin, in another country, in another time?

It is not often that one encounters such willingness to recognize and lay claim to one's cultural ancestors in defiance of contemporary racial boundaries. But in America, of all places, the scope for such appropriation is enormous. Ralph Ellison explained the reasons for this with crystal clarity in a remarkable essay published forty years ago:

For one thing, the American nation is in a sense the product of the American language, a colloquial speech that began emerging long before the British colonials and Africans were transformed into Americans. It is a language that evolved from the king's English but, basing itself upon the realities of the American land and colonial institutions—or lack of institutions, began quite early as a vernacular revolt against the signs, symbols, manners and authority of the mother country. It is a language that began by merging the sounds of many tongues, brought together in the struggle of diverse regions. And whether it is admitted or not, much of the sound of that language is derived from the timbre of the African voice and the listening habits of the African ear...

Its flexibility, its musicality, its rhythms, freewheeling diction and metaphors... were absorbed by the creators of our great 19th century literature even when the majority of blacks were still enslaved. Mark Twain celebrated it in the prose of Huckleberry Finn; without the presence of blacks, the book could not have been written. No Huck and Jim, no American novel as we know it. For not only is the black man a co-creator of the language that Mark Twain raised to the level of literary eloquence, but Jim's condition as American and Huck's commitment to freedom are at the moral center of the novel.

In other words, had there been no blacks, certain creative tensions arising from the cross-purposes of whites and blacks would also not have existed. Not only would there have been no Faulkner; there would have been no Stephen Crane, who found certain basic themes of his writing in the Civil War. Thus, also, there would have been no Hemingway, who took Crane as a source and guide...

Without the presence of blacks, our political history would have been otherwise. No slave economy, no Civil War; no violent destruction of the Reconstruction; no K.K.K. and no Jim Crow system. And without the disenfranchisement of black Americans and the manipulation of racial fears and prejudices, the disproportionate impact of white Southern politicians upon our domestic and foreign policies would have been impossible. Indeed, it is almost impossible to conceive of what our political system would have become without the snarl of forces—cultural, racial, religious—that makes our nation what it is today.

I came across the essay thanks to Andrew Sullivan, who posted an excerpt on his blog last October. Sullivan independently discovered the truth of Ellison's claims through the fresh eyes of an immigrant to the United States:

It struck me almost at once, if only in the music I heard all around me - and then in so many other linguistic, cultural, rhetorical, spiritual ways: white Americans do not realize how black they are. Even their whiteness is partly scavenged from the fear of - and attraction to - its opposite... From the beginning, in its very marrow, this country was forged out of that racial and cultural interaction.

Rod Dreher, himself a product of the American South, came to the same realization while traveling overseas:

I'd spent several weeks traveling around Europe the summer before my junior year in college, and came to understand after being around all those fellow white people that deep down, we Americans have been deeply shaped by the black experience... for a white Southern boy like me to spend six weeks in the Heart of Whiteness was to feel my own Americanness to the marrow for the first time... and to surprise myself by recognizing that the main reason I was so different from these people who looked just like me was because I had been raised in a culture profoundly shaped by black Americans. 

Ta-Nehisi Coates is right to insist that the question of how we claim our ancestors is "more philosophical than biological." And it is entirely appropriate that he began his post with a quotation from Ralph Wiley, who answered Saul Bellow's famous taunt "Who is the Tolstoy of the Zulus?" with the brilliant and wise retort "Tolstoy is the Tolstoy of the Zulus -- unless you find a profit in fencing off universal properties of mankind into exclusive tribal ownership."

For me personally, it was liberating to see Coates claim Fitzgerald and Steinbeck and Blake alongside Clifton and Baldwin and Wiley. I too claim Baldwin, whose Notes of a Native Son I first read with choking emotion in a village in Sierra Leone at the age of twenty-one, and whose funeral service at the Cathedral of St. John the Divine I attended just a few weeks after first entering the United States as a graduate student. He is no less an ancestor of mine than Rushdie or Kureishi, and I am no less a descendant for not having his blood coursing through my veins.

The Astonishing Voice of Albert Hirschman

Albert Hirschman is 95 years old today.

Four decades ago, he published Exit, Voice and Loyalty, a slim volume that contains more insights per page than just about anything else I have read. I consider it to be among the finest books ever written by an economist. For reasons discussed below, it also has enormous contemporary relevance.

The subtitle of the book is "Responses to Decline in Firms, Organizations and States." Hirschman's concern is with "repairable lapses" in organizational performance: declines that could be corrected with the right balance of information, incentives and flexibility of response. This is not a subject to which economists had paid much attention, and he begins by asking why:

While moralists and political scientists have been much concerned with rescuing individuals from immoral behavior, societies from corruption, and governments from decay, economists have paid little attention to repairable lapses of economic actors. There are two reasons for this neglect. First, in economics one assumes either fully and undeviatingly rational behavior, or, at the very least, an unchanging level of rationality... In other words, economists have typically assumed that a firm that falls behind... does so "for a good reason"; the concept... of a... "repairable lapse" has been alien to their reasoning.

The second cause of the economist's unconcern about lapses is related to the first. In the traditional model of the competitive economy, recovery from any lapse is not really essential. As one firm loses out in the struggle, its market share is taken up and its factors are hired by others... in the upshot, total resources may well be better allocated. With this picture in mind, the economist can afford to watch lapses of any one of his patients... with far greater equanimity than either the moralist who is convinced of the intrinsic worth of every one of his patients (individuals) or the political scientist whose patient (the state) is unique and irreplaceable.

But is the neglect justified? Hirschman argues that it is not, because the vision of a "relentlessly taut economy" operating at or close to its productive potential is inapplicable to technologically modern societies capable of producing a substantial surplus relative to the needs of subsistence. The very existence of the surplus implies that considerable slack in the level of efficiency can be tolerated without disastrous consequences. As a result, firms and other organizations are "permanently and randomly subject to decline and decay, that is, to a gradual loss of rationality, efficiency, and surplus-producing energy no matter how well the institutional framework within which they function is designed."

It is critically important, therefore to consider the "countervailing forces" that can arrest and reverse such decline. Hirschman identifies two such forces: desertion and articulation, or exit and voice. Exit refers to the fact that the customers of a firm (or members of an organization) can simply leave and attach themselves to a competing firm or organization. Voice refers to the expression of discontent: the natural human tendency to complain, protest, and generally "kick up a fuss." Each of these mechanisms is interesting in its own right, but it is the interaction of the two (and their connection to loyalty) that gives rise to the most intriguing possibilities.

One of Hirschman's key insights is that exit will not serve as a reliable recuperation mechanism if it occurs too rapidly in the face of organizational decline:

For competition (exit) to work as a mechanism of recuperation from performance lapses, it is generally best for a firm to have a mixture of alert and inert customers. The alert customers provide the firm with a feedback mechanism which starts the effort at recuperation while the inert customers provide it with the time and dollar cushion needed for this effort to come to fruition.

In addition, rapid rates of exit can deprive an organization of precisely those customers (or members) who, had they remained, would be most inclined to utilize voice:

[Those] customers who care most about the quality of the product and who, therefore, are those who would be the most active, reliable, and creative agents of voice are for that very reason also those who are apparently likely to exit first in case of deterioration.

As a result, the "rapid exit of the highly quality conscious customers... paralyzes voice by depriving it of its principal agents."

While it is commonly believed that most organizations would prefer that their customers or members had no exit option at all (as in the case of a monopoly) Hirschman argues, instead, that monopolists would welcome a modest degree of competition in order to shed their most vociferous customers:

[There] are many... cases where competition does not restrain monopoly as it is supposed to, but comforts and bolsters it by unburdening it of its more troublesome customers. As a result, one can define an important and too little noticed type of monopoly-tyranny: a limited type, an oppression of the weak by the incompetent and an exploitation of the poor by the lazy which is the more durable and stifling as it is both unambitious and escapable.

This is why those holding power in dysfunctional states "have long encouraged their political enemies and potential critics to remove themselves from the scene through voluntary exile."

More generally, the performance of near-monopolistic service providers may be worse than that which would prevail if monopoly power were absolute. This has enormous and wide-ranging implications. The poor performance of a national railway system might persist indefinitely if the most demanding customers also have recourse to road transportation. Public schools might deliver worse learning outcomes if private or parochial options are available to the most quality conscious parents. A small decline in neighborhood quality could turn into a precipitous collapse if those most affected by it simply move elsewhere. And the ease with which common stock can be sold implies that the most vigilant shareholders will liquidate their holdings rather than attempt to improve the performance of management.

While most environments are such that either exit or voice is the dominant response to decline, there is one arena, that of political competition, in which both mechanisms are critical. In this setting, taking account of voice leads to sharply different predictions than theories based only on exit. Hirschman's critique of the Hotelling-Downs analysis of political competition (and the median voter theorem it implies) is devastating:

As soon as the Hotelling model had been thus refurbished by Downs, its power to explain reality was again cast into doubt by the undisciplined vagaries of history. The selection by the Republican party of Goldwater in 1964... testified to the extreme reluctance of at least one party to conform to the Hotelling-Downs scenario...

[It was not] Hotelling's original assumption of inelastic demand... that was wrong or unrealistic, but the inference that the "captive" consumer (or voter) who has "nowhere else to go" is the epitome of powerlessness. True, he cannot exit... but just because of that he... will be maximally motivated to bring all sorts of potential influence into play so as to keep... the party from doing things that are highly obnoxious to him... in a two-party system a party will not necessarily behave as the Hotelling-Downs vote-maximizer because "those who have nowhere else to go" are not powerless but influential.

With modern communication technologies able to transmit, coordinate and amplify voice to an unprecedented degree, these insights have more relevance than ever. 

As Hirschman's title suggests, the interplay between exit and voice depends critically on the presence or absence of loyalty:

When loyalty is present exit abruptly changes character: the applauded rational behavior of the alert consumer shifting to a better buy becomes disgraceful defection, desertion, and treason. 

By making exit less appealing, loyalty to an organization can therefore be functional; it can "neutralize within certain limits the tendency of the most quality conscious customers or members to be the first to exit." But since "the effectiveness of the voice mechanism is strengthened by the possibility of exit," too much loyalty will stifle voice. In particular, the active promotion of loyalty by an organization can be detrimental to its own long run functioning:

[Loyalty] promoting institutions and devices are not only uninterested in stimulating voice at the expense of exit: indeed they are often meant to repress voice alongside exit. While feedback through exit or voice is in the long-run interest of organization managers, their short run interest is to entrench themselves and to enhance their freedom to act as they wish, unmolested as far as possible by either desertions or complaints of members.

From this perspective, a key determinant of organizational performance is the price of exit (which may or may not arise from loyalty):

Such a price can range from loss of life-long associations to loss of life, with such intermediate penalties as excommunication, defamation, and deprivation of livelihood. Organizations able to extract these high penalties for exit are the most traditional human groups, such as the family, the tribe, the religious community, and the nation, as well as such more modern inventions as the gang and the totalitarian party... Since the high price of exit does away... with the threat of exit as an effective instrument of voice, these organizations... will often be able to repress both voice and exit. In the process, they will largely deprive themselves of both recuperation mechanisms.

And the absence of recuperation mechanisms can have catastrophic consequences, as the current predicament of the Roman Catholic Church vividly illustrates.

I could go on, but the point has been made. This is a book with dozens of sparking insights tied together by a coherent vision. The vision allows for a broad range of human motivation, encompassing (but not limited to) standard hypotheses regarding rational behavior. Economic actors in Hirschman's world shop for lower prices and higher quality, to be sure, but they also capable of making a nuisance of themselves, engaging in self-deception, and displaying fierce loyalty to organizations with which they are affiliated. This rich, complex conception of human behavior allows for a sweeping analysis that is as penetrating as it is ambitious.

My birthday wish for Albert Hirschman today is nothing less than that which he has long deserved: the Nobel Memorial Prize in Economics.

Norms as a Substitute for Laws

In a fascinating post on joke-theft in the world of stand-up comedy, Kal Raustiala and Chris Sprigman describe the manner in which social norms backed by informal sanctions can accomplish what copyright laws cannot:

Late one Saturday night in February 2007, a stand-up comic named Joe Rogan decided to take the law into his own hands... For weeks, Rogan had been furious over reports from fellow comedians that an even more famous stand-up, Carlos Mencia, had stolen a joke from one of Rogan’s friends... Rogan spotted Mencia in the audience, and he blew up. Slamming Mencia as “Carlos Menstealia,” Rogan accused his rival of joke thievery. Mencia rushed the stage to defend himself, and there began a long, loud, and profane confrontation...

Rogan’s decision to confront Mencia is an example of what stand-up comedians do all the time. Comedians have rules of their own about joke-stealing. And they impose their own punishments on thieves... Why do comedians do this? In part, because they live in a world where intellectual property law – in particular, copyright – does not help them much when a rival comedian steals a joke... lawsuits are simply too expensive and uncertain to work as an effective response... Today’s comics are intent on enforcing ownership rights. Yet they do so via social norms – informal but nonetheless powerful rules enforced by comedians on their peers... Comedians maintain a small list of commandments that every comic must follow – or risk being ostracized, boycotted, and sometimes worse. These norms track copyright law at times... More often than not, however, the norms deviate from copyright: for example, copyright protects expression but not ideas, but comedians’ norms protect expression as well as ideas...

Importantly, comedians’ norms... include informal but powerful punishments. These start with simple badmouthing and ostracism. If that doesn’t work, punishments may escalate to a refusal to work with the offending comedian – which can keep the accused joke-thief off of comedy club rosters. Occasionally, punishments turn violent. None of these sanctions depend on the law – indeed, when comedians resort to threatening or beating up joke thieves, that’s against the law. That said, although both the rules and the punishments are informal, they are effective. Within the community of comedians, it hurts to be accused of stealing a joke. In some cases, repeat accusations may destroy a showbiz career.

Raustiala and Sprigman recognize that the prevalence of such phenomena undermines one of the standard arguments for copyright protection:

What does this all mean? The story of stand-up tells us that... the law is not always necessary to foster creativity. Using informal group norms and sanctions, comedians are able to control joke-stealing. Without the intervention of copyright law, comedians are able to assert ownership of jokes, regulate their use and transfer, impose sanctions on joke-thieves, and maintain substantial incentives to invest in new material.

This presents a challenge to the conventional economic rationale for intellectual property rights. Absent legal protection, the usual theory goes, there will be too few creative works produced — authors and inventors would be unlikely to recoup their cost of creation, so they won’t bother creating in the first place. As we have described, there is no effective legal protection against joke theft. Yet thousands of stand-ups keep cranking out new material night after night. In the absence of law, we find anti-theft norms providing comedians with a substantial incentive to innovate. Which leads to an important and fascinating question: Where else might creativity norms effectively stand in for legal rules?

In fact, one could ask an even broader question: in which other areas of economic and social life might norms (backed by decentralized sanctions) operate as effective substitutes for legal institutions?

This question lies at the heart of the lifelong work of Elinor Ostrom, co-recipient of the 2009 Nobel Memorial Prize in Economics, whose contributions I discussed in in a couple of earlier posts. Using an eclectic mix of methodological approaches, including case studies, laboratory experiments, and game theoretic models, Ostrom managed to overturn conventional wisdom regarding the "tragedy of the commons." She demonstrated the possibility of self-governance when a well-defined group of users with collective rights to an economically valuable resource were at liberty to develop their own rules, and to ostracize, expel, or otherwise sanction each other for violations. 

While Ostrom's focus was on natural resources such as forests, fisheries, and pastures, her basic insights have more general relevance. For instance, institutions of self-governance are critically important in the case of urban communities that lie largely outside the reach of the formal legal system in the United States. There are parts of the country where residents do not have recourse to the courts to adjudicate contractual and other disputes. Given the very high costs of violence as an enforcement mechanism, norms backed by limited community sanctions can therefore play a crucial role.

Sudhir Venkatesh provides a number of vivid examples of this phenomenon in Off the Books, his first-hand account of a Chicago community that functions with limited direct reliance on the police, courts, banks or government agencies. In order to do so, it must draw upon on its own informal substitutes for formal institutions. There is extensive use of barter and in-kind payments for wages and debt settlement, reciprocal lending agreements for insurance, and informal mechanisms for the resolution of disputes and the assignment of property rights. As in the local commons studied by Ostrom, norms sustained by the threat of sanctions allow a broad range of mutually beneficial transactions to occur without formal contracts backed by the power of the state.

The kinds of norms and enforcement mechanisms identified by Ruastiala and Sprigman (and Ostrom and Venkatesh) are pervasive. Many more examples may be found in an extraordinary volume edited by Daniel Bromley. Included among these is a study of sea tenure in Bahia by Cordell and McKean in which the authors describe a system of ethical codes "far more binding on individual conscience than government regulations could ever be." Such codes also crop up in James Acheson's work on the lobster gangs of Maine, E. Somanathan's account of forest resource management in Central Himalaya, and literally hundreds of other studies, enough to fill a two volume bibliography and more.

Norms not only accomplish the goals of laws, they can often do so more efficiently. The erosion of norms (or the prohibition of the sanctions that stabilize them) can therefore be costly, even if formal laws are enacted to take their place. Since laws can sometimes undermine and sometimes reinforce informal codes of conduct, finding the right balance between norms and laws is not an easy task. I suspect that legal scholars are acutely aware of such tensions, but (to my knowledge) these trade-offs have received limited attention in economics.

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Update (4/1). In response to a lively discussion of these issues on Mark Thoma's blog, I have posted a few clarifications. Here's a slightly edited version of my comment:

In hierarchical contexts there can be oppressive norms that serve to reinforce and entrench status. Axelrod has a 1986 paper in the APSR with some examples from the Jim Crow period, and many vivid cases can be found in rural parts of South Asia even today, related both to gender and caste. The fact that oppressive norms can be more effective than oppressive laws makes them less rather than more desirable. I should have been more careful on this point.

For norms backed by sanctions to work, group boundaries have to be well-defined, although communities need not be close knit... For example, norms against plagiarism are pretty effective deterrence mechanisms in academic circles.

This is why the distinction between common property and open access is so critical in resource economics. Open access resources would be depleted in no time without laws backed by state power. But a huge number of people living in rural areas of developing countries own little more than the rights to use common pool resources. Privatization or nationalization of these can have massive welfare consequences. So it's important to know whether or not these resources can be managed sustainably by the populations whose livelihood depends on them.

To me, this is the main message emerging from Ostrom's work.

The Future of Academic Publishing

Theoretical Economics is among the most prestigious journals specializing in economic theory, with a stellar editorial board and high quality submissions. It is also an open access journal: every published article may be viewed, downloaded and printed freely worldwide without subscription. And authors release their work under a creative commons license that allows users to "copy, distribute and transmit" the work provided that this is done with proper attribution, in the "manner specified by the author."

The founders of the journal clearly see this as a template for academic publishing more generally:

The advent of the web has made free dissemination of research feasible and financially viable. Because existing specialty journals obtain revenues from selling subscriptions, primarily to libraries, access to the research they publish is limited. The attractive revenue stream that such subscriptions provide makes it unlikely that these journals will convert to Open Access. Thus a need exists for new refereed Open Access journals to replace existing journals. We believe that the establishment of a major Open Access journal in economic theory will lead others to establish Open Access journals for other fields of economics, reclaiming full control for the profession of its research output. We hope that this will lead the profession to a new norm in which all research is freely available.

Under the open access format the size of the user pool (and the aggregate consumers' surplus) is maximized, but none of the benefits that accrue to readers can be appropriated by publishers. This would ordinarily make financial viability difficult. But in the case of journal articles there is very little value added by the publisher in any case: from the point of view of most readers, a working paper is usually a near perfect substitute for the typeset article. Hence the lion's share of the product's value is created by authors, referees and editors for little or no direct financial compensation. As a result, relatively modest fees for submission or  the processing of accepted papers can be enough to cover the costs of production and online dissemination.

The attractiveness of this business model has not escaped the attention of commercial publishers. Bentham Science, for instance, is already publishing more than 200 open access journals, including one in economics. The Hindawi Publishing Corporation (in collaboration with Sage Publications) also has a portfolio of comparable size, and has just launched Economics Research International. And such initiatives exist side by side with non-commercial ventures such as the e-journal Economics, which operates not only under open access but also uses an innovative public review process involving a large community of registered readers.

So far, the major academic publishers have managed to maintain their lucrative subscription based model, although they now allow articles to be accessed free of charge if the author pays an additional fee (the publisher typically retains copyright and imposes restrictions on redistribution). It is doubtful that this hybrid model can be sustained. For one thing, libraries will be increasingly reluctant to pay for bundled journal subscriptions when much of the content could be accessed freely in any case. More importantly, when given a choice, authors will surely prefer retention of copyright, avoidance of exorbitant fees, and the broadest possible dissemination of their work.

Accordingly, if some of the major economic societies and associations make the transition to open access, the floodgates will open. Traditional publishers will find themselves in a pincer like grip, with highly prestigious society journals weighing down upon them and new entrants nipping at their heels. The giants who currently dominate academic publishing and own vast numbers of important titles will then be faced with a choice. They could themselves fully adopt the open access format and continue to compete effectively (but with diminished profit margins), or watch the value of their holdings gradually decline. Either way, open access seems destined to be the future of academic publishing.

This would be a welcome development. In an earlier post, I claimed that the proliferation of blogs is leading to a democratization of discourse in economics, as non-specialists and autodidacts bring fresh perspectives to bear on theoretical disputes and policy questions. This process depends critically on the ability of outsiders to eavesdrop easily on conversations among economists. Unfettered access to academic research not only increases the visibility of ideas, it also increases the scrutiny to which they are subjected. And this should result in the development of better, more interesting, and more robust ideas in the long run.

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Update (3/29).  Theoretical Economics is now an Econometric Society journal, so its status and survival are both secure. The Society has also launched a more empirically oriented counterpart, Quantitative Economics, that also has a first rate editorial board. I find it puzzling that the American Economic Association did not choose the open access format for its four new journals; this was a wonderful opportunity missed.

For anyone interested in the economics of academic publishing, Ted Bergstom's journal pricing page is a comprehensive source, featuring links to articles, news, comments and data. In an email to me, Ted points out that open access is not without its own problems:

Your mention of Bentham publishing reminds me that there is a "dark side" to open access publishing as well.  There are some slimy types who are trying to profit from open access publishing by spamming for authors and editors and publishing without any form of quality control. Bentham seems to be one of them. 

In support of his claims, Ted points to a couple of revealing interviews by the British journalist Richard Poynder (also discussed here) and an extraordinary post on the acceptance of a meaningless computer generated article by a Bentham journal. Separating the scam from the genuine article is clearly going to be a challenge in the early stages of this transition.