Joseph Stiglitz: Testimony Banks Have Failed Their Basic Societal Mission

Original Link: http://www.huffingtonpost.com/2010/01/22/joseph-stiglitz-testimony_n_433119.html

By Grace Kiser

In his testimony about compensation in the financial industry this morning, Columbia University economist Joseph Stiglitz told the House Financial Services Committee that banks have "consistently failed to fulfill their societal role" and criticized Wall Street pay.

It was precisely the industry's compensation schemes, Stiglitz said, that encouraged the reckless risk-taking that nearly "brought us to the brink of disaster."

The social benefits created by the sector are unclear, Stiglitz said, yet it is society that "repeatedly" bears the responsibility for Wall Street's failures. "Financial markets are a means to an end, not an end in themselves":

Market economies work to produce growth and efficiency, but only when private rewards and social returns are aligned. Unfortunately, in the financial sector, both individual and institutional incentives were misaligned.
Incentive pay in the financial industry, Stiglitz says, rewards short-term gains, but protects managers from the pain of longer-term negative profits, since the consequences of excessive leverage often become apparent only over extended time periods. Moreover, incentive compensation spurs predatory behavior, hinders innovation, results in the deterioration of product quality and encourages deceptive accounting procedures:

There is an ongoing dispute: was it poor models (which predicted that events such as those that occurred in 2007‐2008 would occur less often than once in the lifetime of the universe), poor risk management, or the off‐balance‐sheet shenanigans that nearly brought down our banking system and with it the global economy? None of these possibilities puts a positive light on our bankers. But incentives played a key role in each of these interpretations. They had an incentive to engage in excessive risk taking, they had an incentive to engage in deceptive accounting, and they had an incentive to use--and seemingly believe--models that allowed them to undertake excessive risk. They had an incentive not to enquire too deeply into the assumptions used in those models. And they had an incentive not to think too deeply about how their incentive structures distorted, and continue to distort, behavior.