Can Markets Be Too Efficient?

My recent SocialEarth post on investing in waste discussed the chapter by Bergstrom, Kerr and Lachmann in the book, “Moral Markets.”  The chapter, which spans all of 10 pages, is so thought-provoking that I wanted to dig into it a bit more here.

How Wasting Time Changes Incentives

The basic idea, demonstrated in a game-theoretical manner by the authors, is that selfishness and “cheating” are only logical in a world where business partners are cheap and easy to come by.

Think, for example, of how easy it would be to cheat or abuse customers if they were a dime-a-dozen and virtually costless to acquire.

Lucky for us, this isn’t the case; new businesses owners quickly discover that customer acquisition is often hugely expensive.

It is this very fact – that building relationships requires an investment of time and resources – that enables most transactions between business “partners” to occur.  The sunk investment in the relationship makes exploiting a partner a costly decision. Not only would exploitation destroy the relationship and the investment of time it represents, but it would mean having to make a similar investment in a new relationship with a new partner. Social practices that require wasting time, then, create incentives that favor cooperation and build trust.

On the other hand, without this wasted time, the incentives would be such that it would make more sense for one partner to take the money and run, and then go find another partner and do the same to him.

Financial Crises and Overly-Efficient Markets

The irony here is that the authors lead us to the conclusion that making markets too efficient can actually be detrimental over the long-term.

How can that be?  Isn’t the goal to lower transaction costs?  Isn’t that one of the keys to economic growth? Not if the authors are correct and too-efficient markets skew incentives in favor of exploitative relationships that destroy trust and, ultimately, greatly increase transaction costs.

Is this starting to sound familiar? It probably should, as it could be argued that overly efficient markets were part of the cause of the recent financial crisis.

As Niall Ferguson discusses in his book, “The Ascent of Money,” the secondary market for mortgages and mortgage-backed securities (and their associated CDOs) were innovations that allowed the risks and liabilities associated with these loans to be effectively hedged and distributed throughout financial markets.

On the positive side, this meant that your local WellsFargo branch could hand out a virtually unlimited number of mortgages, since they would provide you with yours and sell it off almost immediately in the secondary market.  The fees collected on the transaction would bring nice profits, while selling off your mortgage would free up capital to provide yet another mortgage to someone else.

Throughout the early 2000s, mortgage lenders indeed repeated this process in an almost never-ending cycle that pushed rates of homeownership up to their highest levels in US history.

On the negative side, however, the fact that your local WellsFargo branch wouldn’t be bearing the risk of giving you a mortgage meant that they had little stake in the transaction. Lending relationships used to be established based on the kind of trust-building and “time wasting” discussed above, in order to protect lenders from risk of default. This new arrangement, however, allowed the old courting process to be tossed aside. After all, the person (or people) who would ultimately own your loan and collect your interest were likely to live hundreds if not thousands of miles away. So all WellsFargo had to do was collect your information and make sure you met the requirements on paper.

In fact, the distance between the actual borrowers and lenders made it easy for naive, risk-seeking “lenders” to extend credit to even the flakiest of borrowers. As we now know, the eventual result was to push even the most “sub-prime” of borrowers into homes and mortgages that they wouldn’t be able to afford. Once these individuals began to default on their loans en masse, the house of cards would come tumbling down.

Where To From Here

Bergstrom, Kerr, and Lachmann remind us that the social and cultural institutions, like courtship and time-wasting, that we have created over the centuries often play an integral role in making our societies and economies work. Yet, we also recognize that courtship is costly and inefficient, and we want to find ways to lessen these transaction costs so that our economies can continue to grow.  So what to do?

It’s tempting to simply say that we must make the courtship process more efficient.  That is, find ways to build trust while wasting less time, perhaps through more scientific and efficient vetting processes.  However, more efficient courtship, no matter how it’s done, still means fewer “sunk costs” in the relationship and therefore greater incentive to exploit.

However, what if courtship could be paired with reputational currency systems in such a way as to make the efficiency of the courtship process proportional to the strength of one’s reputation? We already approximate this in places like eBay and the job market.  On eBay, you might be willing to buy from a lower-ranked seller, but perhaps only after having the opportunity to communicate with him directly over the phone. In the job market, candidates who are referred by competent and reliable employees are likely to move through the hiring process faster than those who submit applications online.

So what if we could make our reputations more digital, portable, and universally accessible as well as acceptable/reliable?  Could we then eliminate some of the “sunk costs” associated with courtship for highly trustworthy partners while increasing the investment in “waste” required from less trustworthy peers?

It’s hard to say.  But the fact remains – until we can create new social institutions that allow us to reduce transaction costs without increasing the incentives for cheating, we must be wary of making our markets too impersonal and efficient.

Follow Up To: How We Push Our Organizations – and Our Societies – Toward Bad Behavior

A friend shared with me a fantastic story that emphasizes the lesson from my recent post, though in a very different way than I originally put forward.  If you missed it, here is the general take-away from that post:

When norms, policies, and institutions fail to evolve and stay relevant, people develop new norms and institutions that align with their needs and beliefs and compete, often “illegally,” with the established frameworks.

My friend works for a corporation that has been struggling to understand and leverage social networking technologies within the company in order to build a stronger sense of community and facilitate information-sharing.  They have tried a few officially-sanctioned tools, but nothing has really worked due to lack of adoption by the employee population.

Recently, however, a rogue group of employees began to build a company community using another, free and publicly available technology that works much like Twitter for the enterprise.  Perhaps not surprisingly, people took to it.  The community grew rapidly, reportedly with over 10% of the company’s employees opting in over the course of less than a week.

The growing popularity of the tool, however, and the fact that it was not controllable by corporate IT, created a stir.  Within days of catching the wind of the non-sanctioned corporate community, the company blocked access and threatened to take action against any employees caught using it in the future.

Amazing.  Textbook, in fact. Relating it back to our above lesson, you can see how Corporate IT (i.e. government) failed to keep up with employee needs to communicate and share information, and provide tools that employees found relevant and useful (i.e. norms and institutions), and so employees went outside the system to have their needs met.

In this case, however, “illegality” was not left to fester and produce long-term negative dynamics/norms.  But nor did institutions adapt.  Instead, the corporation apparently had the means, at least in the short-term, to enforce existing policies and quash the “illegality.”

Certainly, it will be interesting to hear how this develops.  Will the norms and institutions developed by the employees prevail?  Stay tuned!

How We Push Our Organizations – and Our Societies – Toward Bad Behavior

I recently wrote two SocialEarth posts – one on short-termism in the private sector and another on starvation in the nonprofit sector – that randomly and beautifully came together the other day in the form of Hernando de Soto’s book “The Other Path.”

“The Other Path,” Perverse Incentives, and Social Devolution

Hernando de Soto is a highly regarded and sometimes controversial Peruvian economist who is given significant credit for the downfall of the Shining Path, Peru’s Maoist guerrilla group known for its brutal tactics.  Written in 1986, De Soto’s work highlighted the entrepreneurial qualities and aspirations of Peru’s poorer urban classes, as well as the mercantilist policies and laws that were preventing these classes, and Peruvian society overall, from prospering.  He brought to light, for example, the amount of time and money required to legally secure land, build a house, and start a business (often years and amounts of money that equated to many times an average salary).

As indicated by its title, “The Other Path” re-framed the struggle of Peru’s poor from one of proletarian suffering and revolution (espoused by the Shining Path) to a fight for markets and policies that were inclusive and universally enabling rather than at the service of the politically-connected.  His message resonated and, importantly, gave Peruvians an alternative war to wage in the battle against poverty and inequality.

The other critical lesson to be gleaned from De Soto’s work, and the one pertinent to this post, is the following:

When official laws and policies exclude large groups of people or otherwise fail to be relevant to large sectors of society, these excluded groups are given incentives to create their own norms and institutions, in line with their own needs and values, in competition with the formal framework.

We see this all the time in the world around us – both in developing and developed nations.  In the U.S., people who believe in small government find “creative” ways to avoid taxes.  Underage individuals nonetheless consume alcohol.  Gays and lesbians find churches who will marry them, despite laws that prohibit or do not recognize same-sex marriage.  Across Latin America, poor urban families “invade” public and private lands in efforts to acquire property and housing where these are otherwise very difficult to attain.  In Peru, according to De Soto’s research, street vendors developed complex associations with other vendors to procure high-traffic locations and then protect their presumptive right to these locales, even when laws did not permit such action.

The common thread tying these examples together is the idea that when laws, institutions, and norms fail to stay relevant, people begin to systematically act in illegal ways, their actions justified by moral philosophies that are different and/or more progressive.  In instances where the law and institutions eventually adapt, these episodes of illegality are temporary.  Society accepts the moral basis for the formerly illegal action, we adapt our laws, and we go back to behaving legally.  This was the case with the civil rights movement in the U.S. and is likely to be the eventual outcome of the battle for same-sex marriage.

When laws and institutions fail to adapt effectively, however, and when government does not have the means to control illicit behavior, laws lose their legitimacy, illegality in general becomes increasingly acceptable, and whole generations can start to adopt the notion that ends justify means.  In other words, if you believe you have just reason for breaking the law, go ahead and do it.

Illegal actions are, indeed, justified by higher-order rights and moral philosophies in certain cases (the U.S. Declaration of Independence, for example, openly promotes revolution in the face of despotism).  However, the “moral drift” that results when laws and institutions fail to adapt and people are left to behave illegally can have disastrous long-term societal consequences and be incredibly hard to recover from.

Creating Another Path for Our Organizations

Okay, so where does that leave us?  Well, to bring this down to a very immediate and practical (and perhaps more mundane) level, I believe that, as a result of the unrealistic expectations we place on our organizations, both for- and nonprofit, we create incentives for them to behave badly.

In the case of for-profit organizations, our expectation that companies produce greater returns quarter after quarter drives “short-termism” and creates:

• Disincentives to act in environmentally and socially sustainable ways
• Incentives to engage in unethical, “creative” accounting
• Incentives to make questionable business decisions, such as acquisitions that more-often-than-not destroy value

In the case of nonprofit organizations, our unrealistic expectations regarding overhead create:

• Incentives to engage in unethical, “creative” accounting
• Incentives to not give employees adequate  job training and competitive wages
• Disincentives and an often an inability to invest in the sustainable growth of the organization

In these cases, we are the short-sighted lawmakers and government bureaucrats who have failed to adapt.  We have created norms and institutions that have failed to keep up with the needs and best interests of our organizations and our societies.  And our failure is both inhibiting the creation of a better world and encouraging our leaders to make unethical, undesirable, or simply questionable decisions that become more and more “normal” every day.

Time to stop pointing the finger.  We got ourselves into this mess.  What are we going to do to get ourselves out?  How are we going to create new norms and institutions that recognize reality and pull our societies and organizations away from the ledge?