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.