The Incentive Bubble

The past three decades have seen American capitalism quietly transformed by a single, powerful idea—that financial markets are a suitable tool for measuring performance and structuring compensation. Stock instruments for managers, high-powered incentive contracts for investors, and the rise of alternative assets have dramatically altered the nature and level of incentives and rewards in our society, on both sides of the capital market. These changes have contributed significantly to the twin crises of modern American capitalism: repeated governance failures, which lead many to question the stewardship abilities of American managers and investors, and rising income inequality. When risk is repeatedly mispriced because investors enjoy skewed incentive schemes, financial capital is being misallocated. When managers undertake unwise investments or mergers in order to meet expectations that will trigger large compensation packages, real capital is being misallocated. And when relative compensation is as distorted as it has been by the financial-incentive bubble over the past several decades, one can only assume that human capital is being misallocated, to a disturbing degree. Awakening our monitors to their responsibilities and to the flaws of market-based compensation provides the best hope for correcting these imbalances and strengthening the U.S. economy for the challenges of this century.