This has not been given enough attention in our current financial crisis. People were given huge bonuses if their big risks paid off, but not given huge penalties if they tanked. So it was rational for them to make investments that had negative expected return for the people whose money it actually was.
This is important because pundits say that our current crisis proves that the markets need more regulation, because relying on self-interest failed. Actually, self-interest succeeded. The markets need more intelligent regulation, not more regulation. People failed to foresee the collapse (if they did) because humans are highly skilled at hiding the truth from themselves when properly incentivized to do so.
This has not been given enough attention in our current financial crisis. People were given huge bonuses if their big risks paid off, but not given huge penalties if they tanked. So it was rational for them to make investments that had negative expected return for the people whose money it actually was.
This is important because pundits say that our current crisis proves that the markets need more regulation, because relying on self-interest failed. Actually, self-interest succeeded. The markets need more intelligent regulation, not more regulation. People failed to foresee the collapse (if they did) because humans are highly skilled at hiding the truth from themselves when properly incentivized to do so.
Incentive structures are everything. What incentives do the regulators face?