Perverse economic incentives: not good for society

My uncle was a damn fine teacher, beloved by his students. He taught several generations of kids over the course of about 40 years, and imparted not only knowledge but also love of learning. His contributions to a better society are indisputable.

This same uncle also bought a piece of land several years ago and held onto it, performing no development on it. Now, years later, that piece of land is worth a few million dollars. Holding onto that piece of land for several years contributed exactly nothing to society. Society is not one iota better due to my uncle holding onto that piece of land for all those years. And yet, given the system we have in place, he is “rewarded” with a few million dollars.

Forty years of contributing to society by being a great teacher to countless children brought him much less money than simply holding on to some land and contributing nothing to society.

On a similar note, I recently bought some Apple stock and within two days sold it and made a few thousand dollars. By buying and selling the stock within a couple of days, I was contributing nothing to society. One may argue that I was helping provide “liquidity” to the market by participating in the purchase and sale of the stock, but the amounts I was working with were a drop in the ocean, and also, any liquidity I was helping to provide was only being used by other useless traders. I was not an investor, contributing by providing capital to a company in order to bring a product to market. I was simply a gambler, contributing nothing to society. And yet, with the system we have in place, I was “rewarded” with a few thousand dollars.

The above are simple examples of the types of perverse economic incentives that are in place in our current system. There is a far more severe trend that is quite troubling for the future prosperity of our society. The trend is that bright young men and women, people who would otherwise have chosen a productive career in science, medical research, or other scientific path, are now choosing a career in finance.

This trend has been noted in many articles, can be seen by how finance/quant firms/hedge funds target science and engineering grad students for recruitment, and can be measured by the high percentage of science and engineering students who end up at a hedge fund or quant firm for their first job.

What’s happening is of course rational. Why go one route (e.g. science), where you do math and research all day and make decent money, when you can go another route (quantitative finance), where you do math and research all day and potentially make a ton of money?

So, yes, at the individual level, the behavior is rational. But, from society’s point of view, it could be catastrophic. If more and more people go from researching and inventing the technology and medical breakthroughs that will dominate the next few decades, to coming up with mathematical models to extract as much money from the stock market as possible, then

• (a) society as a whole will not progress as much, and
• (b) if other countries continue to pour resources into science and technology and medical research then they will be the ones inventing the technology and medical breakthroughs that will dominate the next few decades. This means that they will be the dominant countries of the world in the next few decades, and not the countries whose brightest talents were wasted coming up with stock market trading algorithms.

To put it bluntly: The US will lose its competitive edge and global preeminence if the best and brightest continue to choose non-society-advancing careers.

Of course, the answer is not communism, state-mandated career paths, or salaries that are a function of the societal benefit of each job. These sorts of things have been tried and have clearly failed, since, among other reasons, they go against human nature (especially against ingrained instincts on what motivates us to excel and to produce).

The answer should be a system that is designed in such a way that it works in concert with human nature to produce the desired outcome. No easy answers here. However, a great guide is how entrepreneurship works withing the capitalist system. We have entrepreneurs that compete against each other in order to maximize their profits, and the result of the behavior of selfish rational agents in this system are better products for the consumer. We now have better homes, more reliable cars, better communication devices, and better medicine than at any time in the past, and this is all due to the system that allows competition among entrepreneurs to maximize their profits.

When hedge funds and quant firms compete to maximize their profits, there is no gain to society. The firms make billions and society is not one iota better as a result of all the work that was done to maximize the profits of these firms.

In addition, such firms greatly contribute to a “leaky bucket” problem in the stock market: Yes, it’s OK to take a cut for providing liquidity to the market, but when the cut they take is in the hundreds of billions or more per year, then the market just becomes a leaky bucket with money from investors flowing in and then draining out to the hedge funds and quant firms. The amount that is leaking out of the bucket is way out of proportion to any liquidity benefits that may be resulting from the trading practices of these firms.

It’s not clear if we can design a system that elegantly and efficiently solves the problems with the perverse economic incentives currently in place. However, doing nothing will not be good for the future prosperity of society.

Originally published at https://andrewoneverything.com. Original responses

• trulov24 responded: Well said. Too bad we have no good solutions yet.
• asdflk responded: I think the problem is a system that is gamed to favor the financial industry. Isn’t that what the 99% movement is trying to bring attention to? Obama tried to reform the finance industry after the 2008 crash, but the Republicans and banking lobbyists fought him back, and the results were timid.