SEALs, CEOs, Milton Friedman, and Fraudulent Incentives

By William K. Black
Quito: May 31, 2015

I saw an intriguing squib in the Wall Street Journal about an article in the Harvard Business Review entitled “How the Navy SEALS Train for Leadership Excellence.”  The article offers an, unintentionally, useful insight into the pathologies of elite business schools, their “leadership” faculty, and our elite C-suites.

The most interesting comment in the article is by Brandon Webb, a former senior SEAL sniper trainer.

“For training to work it has to be effective and incentives have to be in place (financial, personal growth, promotion, etc.) for training to be effective in the work place and in order to get employee ‘buy in,’” Webb notes. “I’m a big fan of economist Milton Fr[ie]dman… it’s as simple as creating alignment through incentives and that’s what we did by creating an instructor/student mentor program. The instructors had accountability (they would be evaluated on their student’s performance) which created the right incentive for them to pass.

The author of the article, Michael Schrage (a research fellow at MIT’s Sloan School of Business) and Webb miss the key implications of Webb’s observation for B schools, their students, and the CEOs whose interests they typically represent.  The behavior the CEO will produce in “his” firm is created by the incentives that the CEO crafts.  The employees will overwhelmingly “align” their behavior with the incentives crafted by the CEO.  It is, therefore, “simple” for CEOs to create “accountability” by shaping the incentives to produce the behavior that the CEO desires.

The critical points demonstrated by the fraud epidemics at our most elite financial institutions is that the incentive structures crafted by the banks’ controlling officers were:

  1. Obviously perverse from the standpoint of the bank and/or its customers,
  2. Pervasively perverse – perverse incentives were made widespread
  3. Intensely perverse – the rewards to criminal and abusive conduct were large while honest conduct was punished and derided
  4. Maintained despite internal reports that they were producing widespread abuse
  5. Crafted in direct opposition to “best practices” developed in the trade and by scholars
  6. Maintained despite external warnings that they led to pervasive abuses
  7. A radical change from the historical compensation system that had far better aligned the interest of loan officers with the interests of the bank and its customers

The obvious, critical question is: why did elite financial CEOs characteristically do these seven things?  It is “simple” for CEOs to “align” the interests of the employees and officers with that of an honest corporation.  It is “simple” for the CEO to predict and to observe the inevitable harmful results of misaligning these interests.  It is “simple” for the CEO to correct the incentives even if the CEO is so incompetent that he cannot initially design the incentives properly and cannot predict the inevitable results of his initial incentive system that systematically “aligns” the employees’ and officers’ incentives with criminal and abusive conduct.

There are two possible answers.  One, every CEO of our elite financial institutions is not simply stupid, but so in the thrall of what the Catholic Church refers to as “invincible ignorance” that they were incapable of understanding that if you incentivize your employees to act criminally and abusively they will tend to so – even when the CEOs observed that inevitable result.

Two, the CEOs acted in this manner because they too had perverse incentives (of their own design) to act criminally and abusively.  More precisely, they had perverse incentives of their own design to create the perverse incentives that would (1) make them wealthy through the “sure things” of fraud and abuse, (2) incent their employees and officers to do the dirty work for them, and (3) create plausible deniability for their own misconduct.  Given modern executive compensation, once a few CEOs engage in this criminal and abusive behavior it can generate a “Gresham’s” dynamic that makes the fraud pervasive.  The CEO who refuses to mimic his criminal competitors will not simply make far less money, his bank will report far lower profits and he may lose his job.  In a Gresham’s dynamic “bad ethics drives good ethics from the marketplace.”  Whenever an unethical practice becomes pervasive one can be sure that a powerful Gresham’s dynamic arose.

My readers are well aware of the fraud “recipe” for a lender or loan purchaser and the resultant three “sure things.”  The key takeaway is that the elite bank CEO makes far more money, with far greater certainty, and with minimal risk of prosecution if they can induce their people to make (or purchase) vast amounts of bad loans with a premium nominal yield or to rip off the customer (as with PPI sales in the UK).

Under neoliberal economic theory, only the second answer can be possibly be the correct one.  Neoliberal assumes, precisely because the financial CEOs receive staggering compensation, that they must be society’s most productive members who are the supreme winners in an economy that is a “hyper-meritocracy.”  Naturally, therefore, neoliberal economists almost invariably choose the first answer, implicitly declaring that all of their theories are so nonsensical that they do not themselves believe them.  What is really going on, of course, is the intersection of neoliberal economists’ dogmas and self-interest.  The economists could, logically, retain their theories, but only by admitting that their heroes, ideological allies, and patrons (elite bank CEOs) are the leaders of massive criminal enterprises.  There is, of course, no chance that neoliberal economists will choose logical consistency and reality over personal self-interest.  Their incentives align with the most criminal of our financial CEOs and they will torture and ignore their own theories rather than even discuss the reality.  They certainly will not propose serious policies to stop the frauds or warn their students against working for criminal enterprises.

This pathology is particularly acute at MIT because it is the birthplace of “modern finance” – the dogmas posing as economics that proved so disastrous (again) in the most recent financial crisis.  Schrage is simply a minor illustration of this terrible problem that helps explain why our most elite B schools have become “vectors” spreading these epidemics of elite fraud.  He doesn’t even mention the facts, in his ode to corporate incentives, that (1) CEOs blew up the global financial system and (2) did so through creating and maintaining powerfully criminogenic incentives.

Conclusion

It is a good thing that Webb reads Friedman and takes incentives seriously.  It is a very bad thing that he and Schrage are in denial about the perverse nature of those incentives in most of the corporate sphere (and universally in elite finance).  It is a sad thing that Webb and Schrage show no awareness that the incentives that Friedman championed continue to cause catastrophic harm to the world because they systematically misalign the interests of the CEO and society in order to make the CEO wealthy at the expense of society.  Webb isn’t alone in being “a big fan” of Friedman – the world’s worst CEOs worship Friedman because he helped make them wealthy.

5 responses to “SEALs, CEOs, Milton Friedman, and Fraudulent Incentives

  1. Jerry Hamrick

    If I understand your analysis correctly, there is something missing. I cannot find an explanation for the apparent fact that CEO’s are mostly dishonest—at least the CEO’s of big financial companies. My working life required me to understand the internal operation of health and life insurance companies (big and small), title insurance companies, HMO’s, BC/BS plans, self-insured companies, state insurance commissioners, credit life insurance companies, mortgage companies, saving and loan companies, association group insurance companies, bottling companies, factoring companies, telephone companies, trucking insurance companies, and a few more. My assignment in each case was to apply computers to the enterprise to lower costs, to enable new products and services, to develop more information about the enterprise, and support new ways of doing business. In thirty years of doing this work I did come across a few CEO’s who were dishonest, and many CEO’s who were willing to cut corners. Because I was not an expert in the laws that might have applied to the various situations, I doubt that I recognized all of the lawbreaking. But in order to do my job, I needed to understand why all of these different enterprises operated in very similar ways. The only possible answer was that human nature was the same everywhere. I began to observe the actions of people in many enterprises, at different levels within those enterprises, over decades, from coast to coast, and I concluded that there are two kinds, two living varieties, of human beings: democrati, who are timid and altruistic, and tyranni, who are aggressive and selfish. Democrati naturally work for the common good, tyranni naturally work against it. As tyranni naturally, aggressively push forward to take power, democrati naturally, timidly step back to let them pass. Tyranni use that power to indulge their selfish interior urges, innocents (democrati and tyranni alike) needlessly suffer and die, a great commotion occurs, tyranni-outs seize power from tyranno-ins, and the cycle renews. These varieties and this cycle apply to all human organizations.

    So, I suggest that your analysis needs to move back to the point where CEO’s are hired, or even better, to the point where corporations are structured. Right now too much power is delegated to too few men for far too long—in finance and in government, and in almost all other human organizations. For example, the debacle, I guess it is actually a tragedy, going on in Europe is more a reflection of human nature than anything else—and so is the “science” of economics. The schools of economic thought reflect the human natures of their founders and they attract humans of the same nature.

    Power does not corrupt, and absolute does not corrupt absolutely. There are many men who have held great power and were not corrupted by it. But it is true that power attracts tyranni, and absolute power attracts tyranni absolutely—they will wreck the lives of innocents and even kill to get it.

    I see your work, at least as far as I can understand it, as that of a democratus who finally said “Stop, and stop right now.” This is the ultimate saving element of human nature, and of our species. Democrati will suffer much before they push back against the aggression of tyranni, but they do finally act. Unfortunately they act so late in the game that blood must be spilled, and because democrati greatly outnumber tyranni most of that blood belonged to them. We humans have not learned to watch for tyranni and stop them as soon as possible. We humans have not learned how to structure our systems to control tyranni.

    Unfortunately, tyranni have the power to finally destroy all of us. Atomic bombs and global warming are more than sufficient to do the job. We democrati know this, we understand it very well. But we are still not willing to act. I fear that it may already be too late.

    I view you and the other principals of this site, this school of economic thought, as democrati and that accounts for the timidity I see. You are an exception, but the rest of your group are very timid. They may have the right ideas, but someone else has to put them into action.

    In order to combat global warming we need an unlimited supply of money—the world needs you and your associates to persuade the world that we have such a supply.

  2. roger erickson

    Very useful article Bill.

    I’d summarize these observations as examples of overly-isolated & narrow military/management training run amok.

    If you don’t listen to ALL feedback, you inevitably drift to a perverted definition of “success” which is tilted to personal benefit while ignoring communal responsibility. The resulting aggregate-outcome statistics inevitably lead directly back to something analogous to your list of 4 ingredients of mortgage fraud (defrauding one’s own aggregate via banking)

    1) Grow rapidly [by ANY means; since growth is alluring] …
    2) … e.g., by making (and hiding) really bad loans at a [initially] premium interest rate,
    3) … while taking on extreme (initially hidden) risks, and…
    4) … while setting aside only the most trivial reserves or allowances for the inevitable losses that extremely risky behavior [eventually] produces.
    [And, of course, getting out of Dodge before “eventually” arrives.]

  3. Whenever I think of the SEALs now, two crucial data points come to mind: Chris Kyle’s acknowledging that the man he was about to hand a loaded Glock to was flat out crazy; and that given the extremely large number of special ops forces operating today through the US military, they simply cannot be all that elite!

    Great article, sir!

  4. madame de farge

    And this is exactly why the Board of Directors is so important. There is an audit committee and a compensation committee, but they are run by the crony capitalist BOD….. This also explains the collusion that is NOT found in Germany where the employees are WELL represented on the Board of Directors for most companies…. Directors should be held personally liable in spite of having insurance that is paid for by the corporation…..only half of the liability should be able to be off shored…. That might and I say might put the fear of god in them…But then you have to remember that Exxon Valdez took almost 30 years to be litigated because the corporation was waiting for the ethics of the SCOTUS to be abrogated…

  5. roger erickson

    Madame de farge: “This also explains the collusion that is NOT found in Germany”

    That explains Deutsche Bank and its role in the international mortgage scams & the “Irish/Greek etc gov guarantees” of DB liars loans 🙁

    and of course also the actions of the Deutsche Bundesbank and their notorious Governor Jens Weidmann in regards to the rest of Europe (notably Greece) 🙁 🙁

    Not to mention the remarkable corporate/labor income disparity in Germany (& lagging consumption & stifled aggregate demand)

    Workers may be WELL represented on German BoDs, but whether their real WELFARE is represented is an entirely separate question.

    It’s always more complicated than superficial titles suggest.