The Perverse Impact of Financial Incentives: Watch this film

We’re often asked about how ADF members can better educate themselves about the mysteries of economics and the financial markets in which they’re investing their hard-earned savings.

A common assumption behind these questions is that key economic and financial decisions are made by hard-nosed, risk-averse, experienced and respected experts acting in the interests of their clients. It’s understandable why members of the public might actually believe this to be true because the financial services industry spends millions of dollars seeking to create this impression.

Sadly, there are many situations in which nothing could be further from the truth, a point that was starkly illustrated in the 2015 film The Big Short. Based on Michael Lewis’s 2010 book,The Big Short : Inside the Doomsday Machine, this film depicts the creation of the biggest housing credit bubble in history through the packaging of thousands of risky housing loans (aka sub-prime mortgages) into products called Collateralised Debt Obligations (CDOs).

As the story unfolds, a few maverick American investors are shown to have concluded that the bubble is about to burst. They successfully place bets against the respected Wall Street banking system (aka “shorted”) and make hundreds of millions of dollars in profits as a result.

The film shows how the world’s financial system quickly fell apart when the bubble did burst, leading to the Global Financial Crisis of 2007-08 and eventually to the bailing-out by the US government of some of the world’s biggest banks and financial institutions that were judged to be “too big to fail”. Similar actions were taken by governments in Australia and in most other economies. The world is still paying the price.

As often happens in these situations, the principal losers were millions of ordinary citizens who lost their houses and their jobs as a result of negligence in an industry of “experts” who should have seen the train wreck coming (maybe they did, but failed to act). The bail-outs popularised the view that governments had rewarded bad behaviour by “socialising the losses and privatising the gains”.

So how did this happen? There’s a clue in these words attributed to American investor Charles Munger: “If you wanted to predict how people would behave, you only had to look at their incentives”.

On the impact of incentives on the actions of some of the participants in the financial services industry, the Centre has a short film called Financial Advisers – The Facts and the Fiction. It’s recommended viewing (along with The Big Short) for anyone who wants to have a realistic and well-informed view about the world of economics and finance.