Financial Crisis, Incentive Structures & Politics



Edon Shaqiri
President









The Rules of the Game is an exclusive monthly series lead by Mark Roe, a professor at Harvard Law School and Luigi Zingales, a professor of Entrepreneurship and Finance at the University of Chicago. The series attempts to make sense of the post-recessionary financial world by focusing on a myriad of different causes and effects of the 2008 financial meltdown.

In a recent commentary titled The Perverse Politics of Financial Crisis, Prof. Zingales questions the incentive structures behind the interconnected world of politics and finance. As the world moves toward the recovery path, we are constantly being reminded more and more how political factors shape financial developements in different markets. This is an all-enompassing phenomenon affecting every country around the globe. It seems as if today, political posturing and brinkmanship tactics are integral parts of sound economic decision making. However, if recent history is of any lesson to all of us, political incentive structures are rarely aligned perfectly to result in economic stability.

In his piece, Prof. Zingales illustrates the timing of the US government intervention during the crisis:

After the collapse of Bear Stearns, it was clear that more problems were coming, yet the United States government did nothing. In July 2008, when Fannie Mae and Freddie Mac (the government-backed housing-loan agencies) were found to be insolvent, then Treasury Secretary Hank Paulson promised a “bazooka,” but delivered what turned out to be a slingshot. It was only after Lehman Brothers collapsed that Paulson went to Congress seeking $700 billion to stabilize the financial system. Even that turned out to be insufficient.

He then points his lens to the EU sovereign-debt crises:

The same travesty appears to be playing out in Europe. If European officials thought Greece needed to be saved, an immediate European intervention in favor of Greece would have minimized the resources required. If they thought Greece needed to go bankrupt, an immediate decision to that effect would have minimized the cost as well. Now we are already at the second rung of intervention, and there seems to be no end in sight. In the meantime, Italy is sinking.

In a way, Prof. Zingales argues that the economic nature of crisis is an opportunity for politicians to unleash their perverse incentive structures and utilize them to their own benefit by accumulating political points amongst their constituents. Fighting a preventive war on the financial front could spell disaster for a political campaign.

 He warns that these incentives are present in all democracies. Here we are, less than a week away as the debt-ceiling deadline looms and perverse incentive structures are again the biggest obstacles that our national decision makers must overcome. What is worst is that within these structures, constituents are treated as anything but constituents. They are not being ignored, they simply do not exist within a politician's perversed incentive structure.