Asset Bubbles, Relative Performance, and Individual Incentives

Robert Frank makes a lot of sense:

"Asset bubbles...have been occurring with increasing frequency. If we want to prevent them, we must first understand their cause.

"It isn’t simply “Wall Street greed"...a puzzling attribution, squarely at odds with the cherished belief of free-market enthusiasts everywhere that unbridled pursuit of self-interest promotes the common good....Greed underlies every market outcome, good or bad....The forces that produced the current crisis actually reflect a powerful dynamic that afflicts all kinds of competitive endeavors. This may be seen clearly in the world of sports.

"Consider a sprinter’s decision about whether to take anabolic steroids. The sprinter’s reward depends not on how fast he runs in absolute terms, but on how his times compare with those of others. Imagine a new drug that enhances performance by three-tenths of a second in the 100-meter dash...The sums at stake ensure that many competitors will take the drug, making it all but impossible for a drug-free competitor to win. The net effect is increased health risks for all athletes, with no real gain for society.

"This particular type of market failure occurs when two conditions are met. First, people confront a gamble that offers a highly probable small gain with only a very small chance of a significant loss. Second, the rewards received by market participants depend strongly on relative performance.

"These conditions have caused the invisible hand to break down in multiple domains. In unregulated housing markets, for example, there are invariably too many dwellings built on flood plains and in earthquake zones. Similarly, in unregulated labor markets, workers typically face greater health and safety risks.

"It is no different in unregulated financial markets, where easy credit terms almost always produce an asset bubble. The problem occurs because...an investment fund’s success depends less on its absolute rate of return than on how that rate compares with those of rivals.
If one fund posts higher earnings than others, money immediately flows into it. And because managers’ pay depends primarily on how much money a fund oversees, managers want to post relatively high returns at every moment.

"One way to bolster a fund’s return is to invest in slightly riskier assets. (Such investments generally pay higher returns because risk-averse investors would otherwise be unwilling to hold them.) Before the current crisis, once some fund managers started offering higher-paying mortgage-backed securities, others felt growing pressure to follow suit, lest their customers desert them..."

As they say, read the whole thing.