Everyday we navigate a sea of incentives in the form of sales commission, hourly wages, stock options, tax rebates, buy-one-get-one-free sales and so much more. When it comes to altering people’s behavior, logic can only get you so far. Incentives and punishment can promote social cooperation, protect the public and discourage ethically dubious actions within the marketplace. Good rules create a code of conduct that keeps systems running smoothly, but once humans are added into the mix, unintended consequences may arise.
The complexities of human nature
An example from Harvard Business Review, outlines a daycare with a persistent tardy parent problem. As a solution, the daycare began to fine latecomers in an effort to correct the inconvenient behavior. Seems reasonable, right? Well, not when human nature is involved. After the rule was implemented, the number of late parents actually doubled. The new fee caused parents to view being late as something to buy, consequently lowering their ethical obligation to be on time for the teachers.
It’s possible to design a perfect system on paper, nicely inked with consequences and incentives, but once humans are introduced into the mix, all bets are off. Incentives don’t always motivate people as well as we’d think, and consequences seem effective only when the result is sufficiently painful. If not, it risks being exploited as an incentive. Nonetheless, consequences can be a net positive when it comes to promoting social integrity, efficacy and equity.
Accountability can motivate positive cooperation
In the absence of consequences, poor performance flourishes. We suddenly become the safest driver on the road when a cop is near, and thieves are going to think twice about breaking into a shop if there’s a security system with HD cameras on the premises. Accountability is effective motivation to align our behavior with the outcomes we desire.
We saw this in practice when the British were exporting their prisoners to Australia during the 19th century. Passengers on these treacherous journeys faced a bleak 40% survival rate, which prompted public outcry to improve the conditions. Captains weren’t motivated to budge because they got paid for each passenger who walked onto the ship. When change was restructured so captains got paid for each passenger who walked off the ship, suddenly survival rates jumped to 98%. This is exactly what we’d see with diversity in the workplace, if a company were ever brave enough to tie executive compensation to the hiring and retention of diverse candidates.
In our modern society, doctors pledge to obey the Hippocratic Oath, but there are also boards that certify and regulate their licenses, causing doctors to seriously gut check their moral and ethical behavior. Professions like medicine hold tremendous power, as such, we don’t blindly trust its members to act with integrity — they are held accountable through skin in the game. Doctors, for example, are faced with losing their ability to practice medicine, which also carries extensive social fallout. Aside from the immeasurable financial exposure, the professional and social cost of malpractice is designed to be very high in order to protect the public and dissuade bad actors.
Regulations are often written in blood
Advertising is regulated. Insurance is regulated. Building codes are regulated. It wasn’t always this way. During the 1920s-30s, American drug safety regulations were non-existent, which allowed every Tom, Dick and Harry with a “bathtub and chemistry set” to call themselves a pharmaceutical company. Naturally, this posed a problem for legitimate drug companies, who faced eroding consumer trust, which impacted bottom lines. In 1938, the Pure Food and Drug Act was passed to address and rectify these issues.
After the roaring 20s stock market crash, Glass-Steagall legislation — which effectively separated business and investment banking — was introduced in 1933. After Enron and Worldcom imploded in 2001, Congress created the Sarbanes-Oxley Act in 2002 to fix auditing rules that enabled such high profile and damaging financial scandals. Interestingly, Stanford researchers found that almost immediately after this regulation was introduced, investors “responded more strongly to earnings news” and “credibility in companies’ financial statements increased.” Imagine that. It’s almost like financial regulation is a two-way street!
Separate rules for you and me
We can see this in practice over at Tesla. Unable to profit from its business of…you know, selling cars, they rely on selling regulatory credits instead. In 2020, Tesla would have posted a loss had it not been for $1.6B in tax credits “that far outweighed” their net income. A business unable to turn a profit doesn’t necessarily deserve staggering tax credits, it needs to innovate.
In this case, regulation is stifling the requisite innovation by enabling mediocrity and not allowing an underperforming company to face the real-world consequences of their poor business decisions. This is achingly familiar to the Great Recession, in which we remember that “Bankers who lost more money than ever earned in the history of banking, received the largest bonus pool in the history of banking, less than two years later, in 2010.” The absence of consequences, accountability and skin-in-the-game means no one owned what they broke, and the public was left holding the bag.
And while we’re always caught standing here looking like fools, when it really matters to us, it’s like trying to open the gates of heaven just for American citizens to get the necessary financial support during a f*cking pandemic. Government and their benefactors would rather us eat cake in hell, than pay what’s owed to the citizens who bear the brunt of their failures and suffer the consequences of their decisions.
Regulation is certainly not a magic bullet, but rules protect society, improve safety, offer social credibility, and can motivate positive change. The entire business landscape benefits from proper accountability and appropriate consequences. To a larger degree, in the financial industry, it appears we are in an era of deregulation for some and more regulation for others, and the cliff is rapidly approaching. By erecting appropriately equitable guardrails and enforcing rules (equally) across the board, the business and investment landscape is poised for a strong bounce back from the pandemic-induced slump.
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