In1986 Michael Milken received a bonus of $550 million as a senior vice president of Drexel Burnham for a single year’s performance. Drexel Burnham was a revered name on Wall Street with a long history. In 1990 shortly after the record bonus of a half billion dollars paid to a single employee, Drexel was bankrupt.

Milken served two years for securities violations and paid $200 million in fines and retuned $400 million to shareholders through an SEC settlement. He was worth over $2 billion in 2007. His is still revered by many as a financial innovator and a noted philanthropist.

I do not mean to imply that Milken’s bonus was directly or solely tied to the demise of Drexel. This bonus was approved by a board of directors and likely a compensation committee who had hired a very high priced compensation consultant. This bonus made sense to them because they believed that such high rewards would motivate high achievement and that all of the shareholders would therefore benefit.

They never seemed to consider that when a single employee can earn 50 lifetimes worth of income in a single year, that maybe his long term interests and the long term interests of the shareholders and the company would not be in sync. Such blindingly insane sums may not make some sacrifice their scruples, but it will certainly color their beliefs. It is amazing what you can get someone to believe if you pay them enough money.

Hedge funds typically charge 1-3% of assets and 20% of profits for the money they manage, yet hordes of the wealthy line up to give them millions. In 1998 Long Term Capital, a hedge fund with Phd’s and Nobel Prize winners at the helm, went bust losing billions of dollars in less than a few months. The Federal Reserve under Greenspan engineered a bailout by getting several Wall Street firms to pony up $250 million a piece to help liquidate the holdings in a way to mitigate more serious damage.

Yet ten years later, in the unraveling of our current crisis, Greenspan expressed dismay that the CEO’s of the investment world would NOT look after the best interest of the shareholders.

There is more to these disasters than mere greed and even arrogance. At the root of these disasters is a school of thought based (very poorly in my opinion) on a school of behavioral psychology that we are motivated by immediate rewards. It is based on the Pavlovian response of conditioned reflex, exampled by getting to dogs to salivate upon stimuli such as a bell, in expectation of actual food. The representation of Pavlov’s dogs signified the response of conditioned reflex rather than critical thinking.

The work of B.F Skinner expanded conditional reflex to include other environmental influences. Skinner’s work is closely associated with behavioral psychology. Management theory carried the idea to a preference of behavior modification over rigid rules and structure. It evolved into an incentive system that often replaced management judgment with extraordinary reward.

I doubt that Skinner or Pavlov would have approved of their research and philosophy being used to approve half billion dollar bonuses, but the creators can not be held responsible for how others pervert their ideas.

Alfie Kohn wrote in the appropriately titled “Punished by Rewards” that such motivation is short lived and less effective than higher level motivations such as joy and even altruism. He noted that misguided educational programs that rewarded children who read with pizza parties only resulted in fat kids who hated to read. Kohn rejected the belief in the Skinnerian approach when applied to all human activities.

While I do not agree with all of Kohn’s conclusions (in a conversation he dismissed all business incentive pay), such extremes as Milken’s bonus and our current financial catastrophe underlies a fundamental misunderstanding of human behavior.

Emanuel Derman, a retired quantitative analyst writing about his career on Wall Street (“My Life as a Quant”) after a career in academics and physics, noted, “Catastrophes strike when people allow theories to take a life of their own and hubris evolves into idolatry.”

We suffer the results of business and political leaders who expected talented people to behave like dogs.

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