As various diagnoses and prescriptions for ailing financial markets continue to issue from the world’s governments, it is worth remembering that all such tinkering has limits. Human motivation is too complex to be controlled by the intentions of policymakers.
In a recent seminar on the financial crisis in my native Finland, one lawyer, a capital markets partner, made an interesting point. He argued that the tightening regulation of financial markets has over the years fostered a mentality whereby market participants only comply with rules when necessary, and think that anything is acceptable as long as it is not expressly forbidden. What might have prompted such a lamentable mentality?
In his book Not Just for the Money, economist Bruno Frey sheds some light on the question. Invoking research in motivational psychology, he argues that external compensation or punishment does not always produce the desired results. Human persons are more complex actors than traditional homo economicus models suggest.
Frey writes: ”Intrinsic motivation is of great importance for all economic activities. It is inconceivable that people are motivated solely or even mainly by external incentives.” There is more: according to Frey, the use of monetary incentives and threats of punishment crowds out intrinsic motivation under identifiable and relevant conditions.
For example, giving monetary compensation to a child for doing household chores is likely to result in decreasing contributions made without compensation. Or if, at the end of having dinner at a friend's place, you insist on paying for the dinner, you may destroy your friendship. Similarly, given that some university professors work harder than others, imposing strict working hour regulations will probably provoke those better workers to reduce their effort and dedication.
Frey talks about the hidden cost of reward or regulation. When an external intervention is perceived as controlling and not respecting the rightful autonomy and reasonableness of the person, extrinsic motivation tends to crowd out intrinsic motivation. When people feel that they are being forced to act in a certain way, their behavior becomes more extrinsically guided.
Incentives are not always harmful, of course. External interventions may enhance intrinsic motivation when they are perceived as supportive. When the father gives a present to his daughter who has been helpful in the house, he may reinforce her willingness to help, as the gift is a token of affection and gratitude rather than a payment conditional on specific performance.
When you go to a restaurant and leave a generous tip, the diner-waiter relationship is strengthened. Hard-working professors will work even harder if their dedication and effort is rewarded with, say, being elected to form an official delegation to an important conference in an attractive city.
According to Aristotle, a good ruler is much like an educator. A skillful educator does not focus on external conduct alone, but seeks to instill a sense of the good so as to encourage virtue chosen freely. Putting too much weight on external incentives – sticks and carrots – has hidden dangers that often reveal themselves later. Vice is the common fruit of the manipulator and the tyrant.
Is lighter regulation the solution to present and future economic crises? It depends. Let it first be noted that some over-the-counter financial derivatives are practically unregulated at the moment, so there is nowhere to cut regulation. It might be more appropriate to cover such clear gaps in existing rules in a principled manner so as not to lead people to the temptation of recklessness.
But a few clear and fast rules are often better than numerous rules that are hard to understand – especially if they are poorly enforced. The latter is arguably the state of the art in financial markets regulation.
When designing rules for a game, one must take into account the moral character of the players. But there needs to be adequate variation: general laws designed for crooks will not produce any saints.
Soft measures are sometimes more productive in the long term. Strict regulations imposed by law tend to damage the intrinsic motivation of better managers; in contrast, their motivation can be enhanced by explicitly acknowledging the value of those who maintain sound policies. The support principle could be applied in numerous ways in economic and regulatory policy.
Intrinsic motivation can also be supported by promoting more personal relationships, and by providing greater participation in decision-making. These are important reasons to defend the principle of subsidiarity in all areas of politics and government, and to favor small businesses and decentralized government. They are reasons to oppose global regulation, massive faceless institutions, and other manifestations of centralized power. Moves in those directions neglect human nature and will not benefit the long-term health of our financial markets.