Let’s take a quick look at Ireland. International banks, mainly European, lent oodles of money to Irish banks, who in turn lent it to customers to buy houses. House prices increased faster than inflation, promising big returns on investment and enticing more people to buy more houses. So the banks lent more and more money, often without carefully checking if the borrower was a good risk because the banks were satisfied that the collateral – the houses – fully covered their exposure. In the process, one of the biggest asset bubbles in decades was created. When the bubble burst, the Irish banks pressurized their borrowers to repay, but a large number couldn’t The Irish banks in turn couldn’t repay their loans to the international banks, thus threatening a collapse of the banking system in Ireland and the viability of the euro.
With variations, this scenario was replicated in many countries, most notably the US, Spain, and the UK. Its repercussions are ongoing and will be felt for decades. Many individuals and institutions share responsibility: the banks, who lent recklessly to each other and then to the retail customers; the politicians, who didn’t ensure that the responsible authorities properly controlled the banks’ activities; and the ratings agencies who gave top scores to the most dubious assets. The vast majority of the population in each country had no responsibility for the problem, yet picked up the entire tab. Those taxpayers didn’t even know they were in the game till they got the bill.
In a classic case of moral hazard, the real players, the ones who ran it and signed off on its outrageous risks had – to coin a phrase of Warren Buffett – no “skin in the game.” They had nothing significant at stake, so nothing significant to lose. Yet the game was so grotesquely rigged that they had everything to gain. Many of them made immense personal fortunes betting with other people’s money – fortunes that they never had to forfeit even after their later bets went disastrously wrong. Sure, a few of the more blatantly negligent were sanctioned. But the “punishment” usually meant early retirement with outrageously generous pensions and severance deals. Most of the top people who oversaw the most reckless activities still hold top positions in banks, regulatory authorities, ratings agencies, government, and elsewhere. Meanwhile, the economies of the affected states and countries are struggling. Many of the people who were left with the bill – the taxpayers – have lost their jobs, and the rest have seen their wealth and income diminish.
The financial crisis exposed many types of moral hazard as well as hypocrisy. Bankers took huge risks they knew would be covered by the taxpayer if something went wrong. Cynically, the same bankers later cited moral hazard to resist partially forgiving the mortgage debts of people most badly hit by the economic downturn.
Moral hazard – not having skin in the game – is not unique to the financial world. It permeates most areas of society and is one of the main reasons much of the world under performs Politicians, generals, heads of federal agencies, civil servants, union leaders, lawyers, doctors, business consultants, auditors, and top executives of big companies rarely have skin in the game. They seldom suffer real personal consequences when their decisions are wrong. The ordinary people pay for their mistakes.
That’s the way the world works and it’s obviously unfair. But the implications go far beyond inequity. The world’s full potential can never be reached because the major decision makers don’t take personal risks; they have no skin in the game. If they had, they would up their game dramatically because nothing promotes efficiency and concentrates our minds better than the possibility of real personal loss. It’s what makes entrepreneurs different, and is why start-up companies produce so many innovative products and ideas. And it’s why many fail. Ironically, when companies become successful and grow very big, many lose their edge because they end up being run by accountants and lawyers who lack entrepreneurial vision. They use the company’s financial clout to fend off competition for as long as possible. Most of those top executives don’t have skin in the game. They’re highly paid employees with gilt-edged contracts guaranteeing huge salaries and golden handshakes if they leave for any reason, even bad performance.
The Soviet Union collapsed because nobody had skin in the game. The state was the sole employer and banned virtually all free enterprise. People who worked hard got the same pay as those who did the absolute minimum. Not surprisingly, most people just went through the motions of working and the economy paid a terrible price. The factories produced outdated, unreliable industrial and consumer goods unsalable outside the Soviet bloc. The highly inefficient collective farms were unable to feed the population, resulting in frequent food shortages and occasional famines.
Obviously, the capitalist world is different not least because enough people still are entrepreneurial. Yet it’s not as different as some might like to believe. We have allowed a work culture to develop where many players have no skin in the game. From the top down, fewer people take responsibility for the advice they give or the work they do. This undermines efficiency across society, which all but guarantees a poorer world for all of us in the future if we don’t change tack soon.