The G20 meeting in Toronto brings the leaders of the major 20 countries together to discuss critical economic concerns - the global economic recession and when we will climb out; the size of government deficits as countries tried to spend their way out of recession; high and sustained unemployment; the unstable financial sector worldwide; and options for new regulations.
What kind of economists should be accompanying the G20 finance ministers to the summit? Certainly good ones, but beyond that, should they be experts in banking, financial markets, economic growth? We believe more micro economists - those who specialize in individual incentives and understanding principle-based behaviour - should be at the summit, indeed in all global economic meetings.
Economists are generally divided into two types: macro economists who study the overall economy and its global interactions; and micro economists who analyze the behaviour of individuals, companies and product markets. It appears sensible that in examining the global economy and what went wrong, we turn to macro economists. However, we are calling on those who study behaviour and actions at the individual level to offer insights into both the causes of and solutions to the economic and financial tsunami that engulfed us.
It is the aggregated individual decisions that make up the macro results. Understanding the individual is the key to predicting the macro.
Behavioural economists, micro economists and psychologists would bring a vitally needed mindset and a critical box of analytical tools to the G20 table. Solutions to the worlds' pressing problems must be built on an understanding of what went wrong, and on a policy set consistent with how people act.
What occurred globally was a misalignment of rewards incentives and consequences leading to individual decisions inconsistent with the public good. The U.S. subprime crisis experienced this misalignment at many crucial levels. U.S. law allowed individual mortgage holders to walk away from their mortgage debt (but no other); that was compounded by misalignment in the reward system for many who sold toxic mortgages, and the misalignment in the risk-and-reward structure of rating agencies who were only paid if the client financial agency agreed with the assessment.
The failure of Lehman Brothers and the need to bail out AIG, Fannie Mac, Freddie Mac and many other financial intermediaries, as well as the current huge problems at BP, show that the appetite for risk can be misaligned within an organization - the incentives to accept risk are not well balanced against the realistic gains and losses. The gains are exaggerated and the losses are underestimated.
Psychologists and behavioural economists (such as Nobel Prize winner Daniel Kahneman) have shown that individuals would rather not win if it means a chance of losing: People are by nature risk-averse. Thus, it is the manipulation of the behaviour of individuals within a system of incentives that can be the source of trouble.
It is evident that the systemic financial failures were not simply a case of a few bad apples in the barrel, or a failure at the corporate level: What went incredibly wrong was the reward system itself.
Passing new rules for banks that don't change incentives on how profits are earned will not prevent another financial storm. They simply will add new roadblocks that clever people will work around.
Without a good dose of psychology and behavioural micro economics, we cannot provide the needed safeguards. More regulations won't work unless we get to the heart of went wrong - the actions of thousands of people who were spurred by a system of excess rewards that carried little individual downside.
Why did Canada fare so well? It is not because we are "better" than other people or that we work for less pay. Canadian officials insist that the reason that we did relatively well in the global recession is that regulation is not rules-based but rather principle-based. What does that mean in reality? We think the Canadian system is far better at aligning incentives with performance - which is what a principle-based environment means. There is not, in general, incentives at the individual level to try for excessive rewards by looking for a way around a particular rule.
The world needs principled-based regulation, which is based on an understanding of what drives individuals and aligns incentives toward a macroeconomic, socially responsible corporate outcome.
Eva Klein is a professor at the Haskayne School of Business, University of Calgary. Leonard Waverman is dean of the school.
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