The economic crisis headlines are rife with CEOs and other executives behaving in ways contrary to the interests of shareholders. Business schools teach agency theory, an economic discipline that aims to solve the problem where an agent of principals (e.g. shareholders) needs to be given wide power to perform his job, but could abuse these powers in ways inimical to the principal’s interests, specially when accountability is difficult because the agent controls the information fed back to the principals. The standard recommendation of agency theory is to align the agent’s incentives with those of the principal by setting performance-based compensation such as stock option schemes.
In the real world, of course, the reaction of an agent given a set of incentives is not to act in the way they were designed (too much work) but rather to game the system. In the case of stock options, take large amounts of risk that mostly pays off, but in unlikely cases fails catastrophically, the opposite of insurance, in fact. In the most likely case, they deliver apparently excellent results, and pocket handsome bonuses. When the bets turn spectacularly bad, the shareholders foot the bill. The failure of agency theory is just another example of how intellectually bankrupt and disconnected from reality most B-School curricula are.
This is not a new problem. Historical rulers from Cyrus the Great to Alexander to Peter the Great to Stalin had to control power-hungry and untrustworthy satraps or barons. The way they solved the problem was invariably to set up a network of spies and run two parallel and competing chains of command constantly at each other’s throats, to keep each other honest. To a certain extent, the more arbitrary and capricious the ruler’s favor seems to be, the more effective it is at keeping the underlings in line.
Investors would be well advised to study the tried and proven methods of the great tyrants. The way to control untrustworthy agents is fear and setting up parallel information-gathering networks unbeholden to the agent, not by lavishing rewards that only motivate even worse behavior. Instead of relying on corporate governance consultancies like ISS, they should hire private eyes like Pinkerton to infiltrate their companies.