(Cross posted at Benzinga.com)

Introduction

This article begins a project to critique the work by economists concerning regulation that has led to the award of Nobel prizes.  The prize in economics in honor of Alfred Nobel is unique.  It is not part of the formal Nobel Prize system.  It was created by a large Swedish bank and it is the only “science” prize frequently given to those who proved incorrect.  The theme of my series is how poorly the work has stood the test of predictive accuracy.  Worse, it has led to policies in the private and public sector that are criminogenic and explain our recurrent, intensifying financial crises.

I want to stress that the reason that the work has proven so faulty is not that the Nobel Laureates in economics are incompetent or evil.  Indeed, that is part of my theme.  Economics is not a hard science and its pretensions that it is have helped make even brilliant economists vulnerable to grievous error, particularly those who were most dogmatic about their hostility to even democratic governments.  A recurrent defect that will emerge is the failure of economics to take ethics seriously.

This article responds to the Prize Lecture of Roger Myerson, who was made a Laureate in 2007 for his work on “mechanism design.”  Mechanism design theory was developed in parallel to Michael Jensen’s work that led to modern executive compensation.  Jensen criticized existing executive compensation as paying CEOs as if they were “bureaucrats” and argued that it led CEOs to shirk effort and avoid taking productive risks.  These variants of the classic “unfaithful agent” problem were reminiscent of Ayn Rand’s premise of the CEOs going on a mass strike, but here the strike was against the board of directors and the cause was their “inadequate” pay.  Myerson’s Prize Lecture uses a variant of CEO compensation as central to his argument on mechanism design.  CEO compensation is the subject of Myerson’s most interesting policy recommendation – the CEOs of large firms need to be billionaires and his most controversial conclusion – capitalism’s unique strength is plutocracy.

Myerson’s Prize Lecture returns repeatedly to the theme of demonstrating the inferiority of what he refers to as “socialism” (but appears to be referring to communist systems) and to advancing the views of Friedrich August von Hayek.  Hayek’s most famous work warned that the democratic governments of the West were headed inexorably on The Road to Serfdom because of their mixed economies.  Myerson’s Prize Lecture’s twin laments are that economics had proven unable to prove the inferiority of government programs and Hayek’s dismissal of the utility of mathematical economics.

Ethics, we don’t need no stinkin’ ethics

At first glance, it might appear that mechanism design involves an emphasis on ethics.

“First, to the extent that our social plan depends on individuals’ private information that is hard for others to observe, we need to give people an incentive to share their information honestly. This problem of getting people to share information honestly is called adverse selection. Second, to the extent that our social plan requires people to choose hidden actions and exert efforts that are hard for others to monitor, we need to give people an incentive to act obediently according to the plan. This problem of getting people to act obediently to a social plan is called moral hazard. If it is a rational equilibrium for everyone to be honest and obedient to the central mediator who is implementing our social coordination plan, then we say that the plan is incentive compatible.

There are two important things to say about such incentive-compatible coordination plans. First, they can be characterized mathematically by a set of inequalities called incentive constraints that are often straightforward to analyze in many interesting examples. Second, although we defined incentive compatibility by thinking about honesty and obedience in communication with a central mediator, in fact these incentive-compatible plans characterize everything that can be implemented by rational equilibrium behavior in any social institution or mechanism. This assertion of generality is called the revelation principle.

The revelation principle asserts that any rational equilibrium of individual behavior in any social institution must be equivalent to an incentive compatible coordination plan. Given any possible informational reports from the individuals, the equivalent incentive-compatible plan recommends the results of simulated lying and disobedience in the original institution or mechanism, as illustrated in Figure 1. Thus, without loss of generality, a trustworthy mediator can plan to make honesty and obedience the best policy for everyone” [pp. 322-323].

It is a bit subtle, but Myerson’s position on ethics is that we can never rely on ethics and must instead consistently create financial incentives that reward ethical behavior with increased wealth if we wish to have people act ethically.  If a CEO can increase his wealth through unethical conduct then his “rational” behavior is to act unethically.  If CEOs have a financial incentive to cheat, and fail to do so, they are acting irrationally.  Myerson predicts that CEOs will act “rationally” by cheating whenever doing so would increase their wealth.  I have criticized this approach in prior articles as “Mankiw morality.”

Myerson and Economists’ Naïve View of Fraud

It is essential, therefore, that Myerson prove that markets inherently and consistently create financial incentives for CEOs in which unethical conduct does not increase their wealth.  Ethics provides no constraints on CEOs (or anyone else) in Myerson’s models.  Fiduciary duties disappear even though Myerson’s claim is that CEOs will violate their core fiduciary duties unless they are bribed to act as if they were honest.  Myerson claims that ensuring that only honesty pays for a CEO is a simple process:  “these incentive-compatible plans characterize everything that can be implemented by rational equilibrium behavior in any social institution or mechanism.”  Further, “a trustworthy mediator can plan to make honesty and obedience the best policy for everyone.”  The mediator is primarily an expositional construct for Myerson.  What he is claiming in these two clauses is that the markets can shape the incentives to ensure honesty by market participants, even elites like CEOs.  Further, he claims that the principals (shareholders in this context) will shape the CEO’s incentives to be “incentive-compatible” in order to produce a “rational equilibrium” that is wealth-maximizing for the principals.

Myerson presented his Prize Lecture on December 8, 2007 – as the financial world was exploding from the most spectacularly incentive incompatible mechanism design and the greatest epidemic of accounting control fraud in history.  The Riksbank either has a wonderful sense of irony or spectacularly bad timing in its awards.

Billionaires only need apply to be CEOs

Economists do not study control fraud and do not read the criminology literature on control fraud.  Even when they write about fraud they do not research the most relevant literature.  The idea that one can create a contract that will make it impossible for CEOs to increase their wealth through fraud indicates that Myerson views markets as nirvana.  Myerson premises his claim on the advantages to society of wealthy CEOs and returns to praising Hayek.

“Second, we consider a simple production example, involving moral hazard in management.  This example illustrates how incentives for good management may require that managers must have a valuable stake in their enterprise.

Third, we consider an example that introduces politics into a productive economy, involving moral hazard in the government. This example shows how unrestrained power of government over the economy can be inefficient, as capital investors require credible political guarantees against the government’s temptation to expropriate them. The latter two moral-hazard models here may particularly illustrate the kinds of theoretical frameworks that can be used to exhibit practical disadvantages of socialism, which Hayek sought to show” [p. 324].

Myerson provides two examples of how the CEO could choose to deliberately harm his principals (shareholders).   The first example is moral hazard.

“[H]ere we can introduce problems of moral hazard, because valuable inputs that are required for production may be misused or diverted by the manager of the production process” [p. 332].

Myerson asserts that the answer to the CEO’s perverse incentives is to require him to invest in the firm.  Myerson claims that if the CEO invests enough of his personal wealth in the firm the principals will know that he will act to maximize their wealth.

Myerson fails to understand the most elemental aspect of accounting control fraud.  His naïve view of such frauds is revealed in this passage:

“The manager’s pay cannot depend on his hidden effort, which is not directly observable, but his pay can depend on whether the project is a success or not.”

Myerson concedes that pay cannot depend on matters that can be “hidden,” but assumes implicitly that the “success” of a firm is obvious.  No one with the faintest understanding of firms or accounting could have such a naïve view.  By December 2007, as Myerson was delivering his Prize lecture, scores of mortgage banking firms specializing in making fraudulent loans that had once reported superb earnings had failed – and that ignores their massive liability for the fraudulent sale of fraudulent loans to the secondary market.

Adverse Selection

Myerson has a limited concept of how “bad” CEOs can be.

“To compare moral hazard and adverse selection, we might consider an analogue of the above problem where the incentive constraint is about the manager’s hidden information rather than about the manager’s hidden action. In this analogous adverse-selection example, the project’s probability of success depends on the manager’s hidden type, which may be good or bad” [p. 332].

Myerson defines “bad” CEOs as “incompetent” CEOs.  Incompetence is a problem among CEOs, but fraudulent CEOs cause vastly greater harm than mere incompetents – and the frauds are often incompetent and venal as well as fraudulent.

Myerson’s treatment of adverse selection is exceptionally poor.  He assumes that the principals can differentiate between good and bad CEOs.  He provides a flawed claim that socialism might be superior in preventing adverse selection because “socialist” systems supposedly do not differentiate between competent and incompetent managers.

Pandering to Plutocrats

It gets better.  The CEO not only needs to be wealthy and gets to leverage his investments with the firm’s assets, if he is “not very rich” (relative to the size of the firm) he needs to be paid a bonus for making such investments beyond the profits he receives from the investment (in what used to be condemned as an “usurpation of corporate opportunities”).  Myerson asserts that if the CEO is “not very rich” he “must be allowed to get a moral-hazard rent” from the firm when he invests in the firm.

I noted that Myerson’s argument defines “not very rich” CEOs relative to size of the firm and the perverse incentive CEOs have because of moral hazard.

“That is, to deter abuse of power without an expected loss to the rest of society, the manager must have stakes in this project worth at least 40% of the cost of the capital input here. If no one has such a large personal wealth to offer as collateral to this investment, as might be the case in an egalitarian socialist society, then society at large cannot profitably undertake this investment.

Thus, moral-hazard incentive constraints can also provide an analytical framework where the initial allocation of property rights may affect the possibility of productive investments. Indeed, this simple example may provide an analytical perspective on problems of socialism, as Hayek was seeking.

Modern industrial production requires integrated managerial control over large scale assets, and whoever exercises that control will have great moral hazard temptations, which are represented by the parameter B in this model.

When managers have great temptations B, the moral-hazard incentive constraint cannot be satisfied unless managers have large stakes in success of their projects” [p.334].

The adjective Myerson chose to describe the intensity of the perverse incentives CEOs inherently have is “great.”  He describes the “abuse of power” CEOs would engage in as causing “an expected loss to the rest of society.”  He emphasizes that the CEO of a large firm must have immense wealth to avoid causing this “great” “abuse of power.”  The example he gives is that the firm must “design” a “mechanism” requiring a CEO must make a personal investment of 40% of the firm’s total cost of capital to create an “incentive-compatible” mechanism.  Recall that Myerson’s position is that markets will insure that firms adopt “incentive-compatible” governance systems. (Anything else would not be a “rational equilibrium.”)  Myerson argues that it would be inefficient (and that is forbidden in his model because it would be irrational) for a large firm to employ a mere multi-millionaire as its CEO because such a “not very rich” CEO would have to be paid a “rent” equivalent to the scale of his “great” moral hazard in addition to his investment profits.

For large firms, the Myerson example would require CEOs to be billionaires.  Under Myerson’s theory, the larger the firm the more perverse the CEOs’ incentives and only plutocracy can counter the CEOs’ endemic, perverse incentives.  Myerson asserts that the unique benefit of massive inequality provides the proof of capitalism’s superiority to socialism that “Hayek was seeking.”  The plutocrats love the idea – and we do not have to pay them “great” “moral hazard” “rents.”  We just have to make them plutocrats with billions of dollars in net worth – you know, “efficient.”  We couldn’t just have CEOs receive exceptionally high incomes (say $600,000) and work hard and honestly.  Only a chump would do that.  Myerson tells us that if large firms hire mere millionaires as CEOs they will loot the firm – yet this poses no ethical issue worthy of note by Myerson.

Having explained that Hayek’s “market” solution is an invitation for CEOs to loot “their” firms and that the only way to prevent this is to ensure that large firms employ only billionaires as their CEOs one might expect Myerson to condemn this result as a travesty.  Myerson, however, treats his paean to plutocracy as proving Hayek’s claims that markets are marvelous.  Myerson saw his plutocracy plan as the ultimate indictment of “socialism.”  Myerson claims that an “egalitarian” nation is inherently inferior to a plutocracy.  CEOs of large firms that are “not very rich” (mere multi-millionaires) are so rapacious under market systems that they can only be bribed not to loot “their” firms through expensive payments of “rents” by the principals to the CEO.

“If, unlike capitalist entrepreneurs, socialist managers do not have substantial personal assets that they can invest in their projects, then the necessary stakes can only be achieved by allowing socialist managers to take a large share of the benefits from successful projects. So considerations of moral hazard cast doubt on the egalitarian socialist ideal that profits from industrial means of production should all belong to the general public” [p. 334].

Myerson’s policies optimize the criminogenic environment for control fraud

The most fundamental problem with Myerson’s analysis of moral hazard and adverse selection is that they both predict accounting control fraud and Myerson assumes that his mechanism design prevents accounting control fraud.  It does not and cannot.  Indeed, by creating complacency through the fabulous claims that plutocrats are pure and principled, markets self-correct, and regulators cause injury Myerson’s proposals would make our economy even more criminogenic.  Firm outputs are “hidden” by fraudulent accounting and as George Akerlof and Paul Romer explained in 1993, accounting control fraud is a “sure thing” (“Looting: The Economic Underworld of Bankrutpcy”).  Indeed, if a large firm is failing the billionaire CEO who has hundreds of millions of dollars invested in the failing projects has a powerful incentive to falsify the accounting to declare the project was successful and pay himself off with a firm buyout of his “profitable” interest in the project.

Myerson ignores the fact that plutocracies produce crony capitalism, making “free markets” and real democracies impossible.  Plutocracy greatly increases the ability of corrupt CEOs to loot with impunity, making a mockery of incentive-compatibility.

Myerson’s pro-plutocracy policy is even more criminogenic with regard to other forms of control fraud.  The “dominant strategy” of a plutocrat CEO who has hundreds of millions of dollars invested in a firm project is, according to Myerson’s theory, to engage in anti-purchaser, anti-employee, and anti-public control fraud because each of these forms of fraud add enormously to firm and the CEO’s personal profitability.

Bill Black is the author of  The Best Way to Rob a Bank is to Own One  and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.

Bill writes a column for Benzinga every Monday. His other academic articles, congressional testimony, and musings about the financial crisis can be found at his  Social Science Research Network author page  and at the blog  New Economic Perspectives .

Follow him on Twitter:  @williamkblack