‘Tis the season to waste money. Joel Waldfogel at Yale University has estimated that “gift-giving destroys between 10 per cent and a third of the value of gifts”: recipients on average value them at less than the giver paid. With the average household spending almost £740 at Christmas, this implies that some £2bn will be wasted.
You might think this is just a trivial bit of cutesy economics.
It’s not. It speaks to an issue which concerns all equity investors – the agency problem.
This arises whenever somebody acts in somebody else’s interests, such as company bosses acting on behalf of shareholders. In a famous paper in 1976 Michael Jensen and William Meckling argued that bosses did not serve shareholders well: they didn’t put in enough effort into finding profitable projects or learning about new technologies; took too many perks; and increased the size of their empires rather than profits.
That paper inspired a generation of efforts to align managers’ interests with owners through share options and bonuses – although few of these moves, strangely, had the effect of reducing bosses’ pay.
Waldfogel’s research, however, suggests that all this is at best only part of the story. Even when people are trying their best for others they fail. This is not because of bad incentives, but because of lack of knowledge.
This problem isn’t confined to grannies buying socks. It was true of the financial crisis. The University of Toronto’s Ing-Haw Cheng and colleagues have shown that in the run-up to the crisis bankers working in mortgage securitisation were as likely as others to buy over-priced houses themselves. They didn’t see the crash coming. The crisis was, in the title of Nicola Gennaioli and Andrei Shleifer’s book, “a crisis of beliefs”, not of incentives.
Much of the “shareholder value” movement has therefore gone down the wrong track. The problem is not the wrong incentives but plain ignorance. Many of you have had bad experiences with financial advisors or fund managers. Only rarely, I suspect, was this due to them having the wrong incentives; more often, they just didn’t know what they were doing.
Waldfogel’s findings, however, are controversial. They were based on a study of Yale University students, who are a mean-spirited over-entitled bunch. Sara Solnick and David Hemenway found, using a more representative sample of folk, that people on average value gifts at more than they cost. Which suggests there’s no agency problem.
One reason for this is that we value gifts not just for what they are, but for the love they represent. Also, it’s because givers have a quality stressed by Adam Smith – sympathy. The ability to put ourselves in others’ shoes helps us pick out good gifts.
But this only one of several virtues which enable people to overcome the agency problem. There’s also fiduciary duty, professional pride or simply the pleasure of doing an interesting job well.
Such motives, however, can often be weakened or even displaced by financial incentives. The Nobel laureate Jean Tirole has shown that bonus culture can cause bosses to chase targets that can be easily measured, such as earnings per share, to the neglect of things vital to the company’s longer-term health such as maintenance spending, risk management, corporate culture or research. Narrow-minded shareholder value ideology can thus backfire.
People are not merely economic units who respond predictably to financial stimuli. Christmas should remind us of this eternal truth.
