IP report excerpts, vol. 4: Moral diligence (part 1)

Post 1 of 2 posts with excerpts from one of our most-commented reports. We look back at a highly unusual year – a period of seemingly definitive change which proved, definitively, that some things never change. 2008 was one of those years that tested our mettle and reaffirmed old principles, the most cherished of which is our moral diligence. We kick off with two introductory texts, “Own Goal” and “Dolus Bonus”.

Q4 2008 report excerpts on moral diligence: Part 1 of 2

Introduction: “OWN GOAL”

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

Friedrich Hayek

During the Shell Caribbean Football Cup in 1994, two countries were fighting for classification for the second phase of the competition: Barbados and Grenada. Barbados needed to win by a difference of two goals. If it won by only one goal or if it lost, Grenada would be classified. But if there was a draw, the story could be different.

A new rule adopted by the organizing committee introduced a novelty. So as to make the spectacle more exciting, incentivizing the teams to be more aggressive in “tough”, close matches, the organizing committee came up with the following formula: if a game ended in a draw, there would be extra time. What is more, any goal scored during extra time (and while the “golden goal” was in force there could only be one per game) would be worth two when the balance of goals was counted; the key criterion for the decision, if the teams had reached the same number of points.

Because of this rule, the game became very interesting. Barbados was winning by two-nil up to the final minutes. But at the 38th minute of the second half: Grenada scored a goal, making it 2 x 1.

Now under the gun, Barbados tried to strike a third goal for a few minutes, but soon realized that it was not going to be easy. After scoring the goal, the Grenada team fell back, closed in and was firmly on the defensive. The pressure on Barbados was high. With the game almost over, its players were visibly tense. But after weighting their options, they acted rationally: thanks to the new rule, it would be much safer to score an own-goal and force the game to be extended (when one goal would be worth two), rather than try to score against the Grenada team, which were in heroic defense.

And that’s exactly what happened. After exchanging a few passes with his goalkeeper, Sealy, full-back of the Barbados team, kicked the ball into his own goal, causing the game to be drawn at two-all.

But that is not yet the strangest part of this game.

On kick-off, at the 40th minute of the second half, the Grenada players went on the attack, but were visibly downcast. After 2 minutes of a desperate attack, they reckoned the alternatives: if they scored an unlikely goal against Barbados during the last few minutes, they would be classified. But if they scored a goal against themselves, they would lose by a difference of one goal, a result that would also place them automatically in the next phase. Therefore, they launched themselves full steam ahead in pursuit of the saving own-goal.

What was seen after that was a true slapstick episode: the Barbados players anticipated the Grenada team’s move and divided themselves in the field between defending both their own goal and that of their opponents (from themselves). Sealy, the Barbados goal-scoring full-back, placed himself beside the Grenada goalkeeper in order to defend their goal from their own team!

The game ended in a draw, and at the fourth minute of extra time Barbados scored the golden goal and was classified. The players were not punished, because “both teams were genuinely trying to advance to the next phase, following the rules of the competition”.

The moral of the story: designing incentive systems laden with good intentions and believing in our ability to foresee the consequences (direct, indirect, and those that will arise way ahead, as the result of the autonomous interaction of the “agents” of the system in question), seems much easier than it really is.

In the present context, in which governments and regulating bodies appear as a lifeguard to restrain and remedy the limitations and disorder in the free market, it is good to have examples such as this as a reference, in order to recall the tremendous iatrogenic potential of regulations: the “remedy” very often kills rather than cures.

The list of curious examples of measures that backfired, though “carefully designed” by the most diverse entities and organizations, is rather long. In Brazil, the taxation of commercial flows between jurisdictions in accordance with the principle of origin, one of the main factors of the tax war that has overtaken our federalist system, feeds a well-known perverse incentive: the transport of goods between States follows a tax-efficient route, making our already precarious logistics system even more unproductive and inefficient.

In the United States, the institution of the Prohibition in 1920 to eliminate crime in the country proved to be a resounding failure: it was expensive to implement and enforce, generating, as collateral effects, a rise in violent crimes, an explosion in consumption of stronger, home-made alcoholic drinks (the number of deaths due to cirrhosis in the period remained stable) and a huge drop in tax collection.

In French Hanoi, a law created to end a plague of rats paid the “hunters” for each rat carcass. It ended up stimulating gigantic rat-breeding operations.

In China, in the 19th century, peasants received a reward from foreign paleontologists for each fragment of dinosaur bone found. In order to maximize their remuneration, the peasants used to break the bones into several small pieces.

Finally, a more current and universal example: the medical reimbursement system for insured patients which remunerates the treatment of illness, rather than its prevention, is one of the simplest and most harmful misalignments of interests that we know of.

Frédéric Bastiat, acclaimed by Schumpeter as “the best economics journalist the world has known”, called our attention to “the difference between a bad economist and a good one”. “The first only sees the direct, short- term consequences of actions, while the second observes the indirect consequences in the longer term.” According to Bastiat, “To understand the immediate consequences of a law is not enough to judge its efficacy. It is necessary to try to uncover, a priori, all its long-term consequences for society as a whole. The more politicians concentrate on solving specific problems, the greater the disaster becomes on a broad scale. An economic policy consisting of immediate measures, with its simple, miraculous promises, causes a much greater impression than an invitation to intellectual exercise.”

But the problem of incentive design is even more serious. Because the market is dynamic and operates as a complex adaptive system, it goes on “learning”, “evolving” and becoming “autonomous” over time, as its agents interact, cooperate and compete among themselves. Therefore, some of the consequences of new schemes and regulations, positive or negative, are by definition unknown at the time they are formulated.

What is more, it does not help, as we say in Brazil, “to hide the sun with a sieve”: any incentive scheme or system, tacit or explicit, can be bypassed. As Andy Grove says: “For every goal you put in front of someone, you should also put in place a counter-goal to restrict gaming of the first goal”. If you pay your programmers to solve bugs, do pay them also for quality and new features, or several of them will create real “bug factories”.

That is why it is important for us to use high moral criteria when selecting our business partners, associates, and even our clients, in order to restrain one-dimensional and undesired behavior.

Although Academia and the media focus mostly on financial incentives, we can roughly divide the types of incentives into three groups: material/financial, moral/social and punitive/coercive.

The punitive incentive is simple: going off the tracks implies being dismissed, imprisoned, sued, etc. Monetary incentives are old acquaintances: powerful motivators, they encourage people to wish… for more financial incentives. The problem is not that they don’t work. They work too well, encouraging people to focus their attention on a behavior that is directly associated with compensation. When money becomes more obvious, vivid, people find it much more difficult to see long-term dysfunctions or ethical dilemmas involved in the process of obtaining their results. People will tend to focus only on doing what matters in order to capture the incentive.

Finally, we have moral interests (doing the “right” thing because it is “right”, and full stop), as well as social and personal interests. No matter how much some theorists may lead us to think the opposite, people are not mere economic agents, acting with a view to maximizing their material interests. They have other aspirations and goals. They are moved by passion and ideals. They want to be inspired. To dream. To accomplish. They have interests that are sometimes ambiguous and conflicting. Competing motivations. They give in to peer pressure. Their ambitions and preferences varies over time and are subject to interference.

To believe that people only act because they want to retain or accumulate wealth is to suffer from extreme short sight in relation to what we are and do.

Curiously, exceptional performance, in several domains – including the financial market itself – does not necessarily originate from extrinsic rewards, but from intrinsic motivation. In the words of the serial entrepreneur Richard Branson: “I never, ever thought of myself as a businessman. I was interested in creating things I would be proud of.” Buffett himself refers to Berkshire Hathaway as his “canvas”, and likes to say that he feels like a Michelangelo.

Moreover, sometimes transactional incentives are in fact clearly subordinated to moral incentives. A recent example: six nursery schools in Israel imposed a fine in cash in order to encourage parents who used to be late collecting their children to arrive on time. The result of the measure was somewhat unexpected: instead of decreasing, the delays doubled in number. And they remained high even after the fine was removed. The relationship had changed from the social, personal sphere (“if I delay, the teachers will suffer, they will take longer to get home”), to the transactional realm. The moral cost of the offense became low.

Thus, the design of an incentive system is only successful – that is, when the resultant between the explicit incentives vectors and the different variables that influence the behavior of the agents that are the scheme’s target, points in the desired direction – if it is permeated by a clear set of solid principles and values.

Moral behavior is not exercised by creating ethics committees and drawing up codes of conduct. Hanging the mission, principles and noble values on the wall is also far from enough. Companies need a code of conduct, but one that is tacit, anchored by the reputation and behavior of their leaders.

The environment in which incentives are (re)created and propagated is absolutely crucial for the net result of behaviors not to point in the wrong direction. Very often some explicit incentives are subsumed by tacit incentives, which are undeclared but embedded in a company’s culture.

Social relationships are marked by the uncertainty regarding future reciprocity. The obligations of the parties involved are diffuse and uncertain – they bear risks of defection or exploitation/opportunism. It is our understanding that in any relationship, and especially in long-term ones, the material and financial incentives should be clearly subordinated to broader personal and social interests, and simple moral principles and values, such as honesty, integrity and respect, as long as they are genuinely experienced in everyday life. The logic of the transaction should be subordinated, as a matter of principle, to long-term relations. Always. And this must be unquestionable, not negotiable.

In our view, the best possible system of alignment is for us to select our associates and business partners with great zeal. They should be few and competent, well educated, ethical, and genuinely aligned and committed to our way of seeing things, to our long-term vision. This is far more efficient than trying to “sew up” incentive systems that are real strait jackets and that, at the end of the day, can be escaped from if the alignment between the parties is not genuine, legitimate.

Introduction: DOLUS BONUS

“The iron rule of nature is you get what you reward for. If you want ants to come, you put sugar on the floor.”

Charlie Munger

In the first half of the last century, some of the wealthiest university professors in the whole world were art historians, who earned their living less by their teaching gifts, and more by the strength of their opinions. As experts, they attested to the authenticity of works of art by the great masters, especially the old, classical painters. Their job: to certify that a painting was in fact a Rembrandt, a Rubens or a Titian.

At that time, documental study and technical laboratory analyses were still very incipient, and the attribution of authorship of a work of art was done with the naked eye, based merely on connoisseurship1, a very subjective process which required sensitivity and experience. Some specialists went so far as to smell and even lick the paintings – let’s agree, it worked at least to identify the “Botticellis” produced that same week – but the appraisal of works by means of photos was common practice, especially in intercontinental transactions.

The experts were true authorities. For the appraisal of a work of art, they would receive a commission, a percentage of the sales price that could range from 5% to 25%. Obviously, if they confirmed it as genuine, they would earn astronomical figures. If they belittled it as false or as a work by some other, “lesser” painter, their earnings were much more modest.

Great collectors such as J. Pierpoint Morgan, Andrew Mellon and Henry Clay Frick entrusted the selection of these experts to their dealers.

Competition was intense, and frauds common. Little by little, the tycoons were learning to protect themselves, selecting only the more reliable and experienced as business partners.

Among the dealers of that time, Joseph Duveen was undoubtedly the most famous in the intermediation of works of the great masters in the New York- London- Paris circuit. Through his company, Duveen Brothers, he was one of the protagonists and a great beneficiary of one of the largest transfers of cultural assets of all times: from 1890 to 1929, fast-rising American entrepreneurs, industrialists and bankers took possession, on a large scale, of European cultural treasures. And for the first time in History, not by force of sword or cannon, but by the “invisible hand” of capitalism.

Duveen’s internal intelligence service could be the envy of many contemporary organizations, capable of advising him of the first signs of any fatal illness in the Great Houses of Europe, or of imminent insolvency in the English or French aristocracy, besides always keeping him informed of the secret preferences of American tycoons. The “dealer king” recommended butlers, chamber-maids and chauffeurs to his clients, taking care to keep them on his own payroll.

Duveen had a spectacular eye for art objects (evidenced by the clearly positive outcome of countless legal battles about the authenticity of art objects in which he was involved), but in order to countersign the authorship in transactions involving works of art of the Renaissance period, he counted on the advice of the eminent professor of the history of art, Bernard Berenson, who endorsed pro homine the authenticity of the works in his collection.

Berenson was, in fact, the greatest authority on Renaissance painting at the time, and used all his connoisseurship and reputation as a historian and “independent” critic to validate the authorship of dozens of works of art in support of Duveen. A secret contract with the dealer guaranteed him the payment of a fat percentage for each work sold in the course of 27 years.

One of them, the “Madonna and Child”, was first appraised by Berenson as “in bad condition, without defined origin”, when Duveen acquired it in 1895, and a few years later it was re-classified by Berenson himself as an authentic “Bellini”, allowing Duveen to multiply tenfold the price paid for the work.

The majestic Villa i Tatti, Berenson’s property in Florence, is a most beautiful witness to the degree of wealth he attained through his agreement with Duveen and others. It is important to observe that, in the course of time, several of his ascriptions eventually proved to be wrong, though most of them were correct.

In short, during the formidable “bull market” in the art sector at the beginning of the last century, a real virtuous circle of incentives was closed: the favorable opinion that made the professor rich also endorsed the dealer and the seller. What is more, the buyer was not left out either: with the expert’s guarantee, he became the owner of a certified work of art. To have a “Raphael” certified by the seal of Berenson was worth much more than just a “simple Raphael”. Finally, if we add to all that the tax benefits granted at that time for donations to public collections, we have a true “heavenly feast”.

It was not by chance that the period prior to the First World War was a Golden Era for art dealers, when the prices of some works of art reached levels that would only be seen again in the eighties. Not only was demand high, but also Duveen and his team were always trying to keep the market up by nourishing the rivalry between the legendary Fricks, Altmans and Huntington family with information and intrigue, using the contemporary press with great skill (especially the New York Times).

The similarity between this “virtuous” circle of fees and commissions and the merry-go-round led by brokers, investment banks, rating agencies, investors and companies of the modern world is evident. So is the vast range of misalignments and conflicts of interest inlaid in the model. And if Duveen went so far as to sell the work “Aristotle contemplating Homer’s bust” four times, always pushing the price up, Avis, the car rental firm, has been bought and sold no less than 18 times since it was founded in 1946 – probably handing to lawyers and banks, in fees and commissions, a good deal more than the value of the whole company at today’s price.

With regard to the chain of US sub-prime loans, consumed from Oslo to Bangkok in their re-securitized clothing, or the IPO feast here in Brazil, they are very similar in general lines. With an aggravating factor: the relationships, and the processes of placing, packaging and selling securities, have been “industrialized”. There was a loss in art and romantic style, but a gain in scale and productivity. And simple but powerful ideas, such as “Europe has art, America has money”, may be exploited and geared up today in a much more efficient way – at least for some time.

Systems such as the financial markets, which depend on cooperation and exchange, are founded on a framework of reciprocal trust. Whether working for institutions or for their own account, people must trust their counterparts.

At the heart of the natural credit system, in particular, lie two fundamental aspects: personal reputation and the community. The crucial decision in granting credit is “will this guy pay me?”. It is not just a matter of cash generation capacity, but of character and reputation. The roles played by those who grant the loan and those who take it are important, very important, in the local social network. The purpose of the credit is key.

In today’s financial system, relations between the agents exist more and more on a strictly transactional basis. Technology, interconnection between markets, de-regulation, securitization, and with them the profusion of new, increasingly complex products, which nobody has the time to decipher but everybody wants to consume, have created a gigantic efficiency machine. If on the one hand this efficiency has permitted huge scale “gains”, on the other, it has reduced relationships and credit to their transactional dimension, multiplying the moral hazard exponentially, changing social and local links into pasteurized transactions that are global in their reach but without anyone socially responsible for them. The system’s gears gave us the right to act physically, without doing so politically or morally. There is no “personal” responsibility, reputation cost, when promoting a credit that is going to be re-packed, priced, ratified and consumed very far from where it originated.

Innovations such as mortgage pools extinguish the social element in transactions. Derivatives and swaps too. The direct relation between the person who lends and the person who takes the loan is dissolved. Social pressure disappears. And the result is that, adding the markets’ transactional steamroller to the greed of the agents, geared up by incentive systems where conflicts of interest are obvious and the vigilance of regulating bodies is insufficient and inoperative, Alabama sub-primes end up being thrown outspread out, together with their tranche fellows, reaching remote beaches on the other side of the world, in the hands of investors hungry for higher but guaranteed returns. Credit scores and agencies’ ratings have shown themselves to be very bad proxies, not only for payment capacity (cash-flow), but also for “reputation”.

After being reduced to one dimension alone, limited to its transactional component, credit had its real risk disguised for creditors and borrowers. This, added to the opacity and high leverage of financial institutions with laughable risk controls, and the excessive complacency and credulity of agents throughout the consumption chain, instead of efficiently promoting the much-celebrated transfer, re-distribution and dispersion of risk, ended up contributing, as a catalytic agent, to a real metastasis of the system’s liquidity.

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Note: Also read Part 2: “On Moral Diligence”

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