Opinion

Do markets need integrity?

October 2007

For almost 40 years, Professor Michael C. Jensen has been a leader in elucidating the complex system of incentives and limitations that underlies business trends. Dean Joel Podolny spoke with Jensen about the market for corporate control, agency theory, and the benefits of integrity.

Joel Podolny: With your work on agency theory, you laid some of the academic foundations that helped to establish the market for corporate control as a disciplining mechanism for bad management. The question I'd like to start by asking is, in your view, what's bad management?

Michael Jensen: I think a good place to start would be with the work that Bill Meckling and I did on specific and general knowledge. That provides the background for the question you're asking.

One major issue that any society or any organization or, indeed, any individual faces is how to deal with the fact that information is not all instantly, easily, and cheaply transferable between people. Some kinds of information are easily and cheaply transferable, like prices and quantities and stuff that can be put into databases. On the other end of that spectrum, there is information that is very costly to transmit. This is the kind of idiosyncratic information Bill and I called "specific knowledge." The first category, we called "general knowledge." If something is easy and cheap to transfer in an understandable fashion, then it's going to be generally available to everybody.

Why is this cost of information transfer so important? Because we'd like to have the decision rights, however they get assigned in an economy or an organization, co-located with the specific knowledge that's critical or valuable to the exercise of those decision rights. If you can locate the decision rights with the specific knowledge, then that knowledge is going to get incorporated in the decision that gets made, as long as the people or person making that decision has the right incentives. The relevant general knowledge can then be inexpensively transferred to the decision maker as well.

The problem is, how in the world do we go about co-locating these decision rights with the relevant specific knowledge? Socialism and communism, the centralized approach, failed miserably for a number of reasons, but, I would argue, mostly because of these two major reasons: Is the specific knowledge that's relevant to a decision being used in that decision, and do the people have the right incentives?

Now, markets provide an amazingly powerful, yet not perfect, system that tends to end up co-locating the decision rights with the relevant specific knowledge. There are two general solutions to the problem. You can either think about moving the information, or you can think about moving the decision rights. But you'll never solve the problem solely by trying to move the information because there is specific knowledge that you will never be able to move effectively.

When you have tradable claims on assets, what that actually amounts to is tradable claims on the decision rights involving those assets, whether it be land, buildings, capital, whatever. In a private enterprise, capitalist, free market system in which assets are owned and are tradable (except for human capital, obviously, and that's a big imperfection), that creates a set of incentives where people who have the relevant specific knowledge for the exercise of some decision rights will tend to be willing to pay more for it than it's worth to others, and that creates a system which will tend to cause decision rights to move into the right hands, that is those with the relevant specific knowledge.

When you get down to the level of the individual organization from the level of the economy, the same problem exists, and very often in the past it's gotten solved in a pretty miserable way, for many of the same reasons that the socialist and communist centralized decision-making systems failed. It's because people tend to be knowledgeable about what they know and ignorant about what they don't know. That ends up causing lots of poor decisions, such that value is destroyed or opportunities are missed. (In fact, one of the highlights of wisdom is having enough self-knowledge to be aware of what I don't know and aware that there is a huge amount that I don't know that I don't know.)

That led Bill Meckling and me, when we started looking at the firm, to think about where the specific knowledge is and what the relevant incentives are. That project started when Bill and I were invited to give a paper about how profit maximizing companies in a market-based economy would solve all of the problems. And as we started to write that paper, we couldn't get to the same conclusion that we had been taught at the University of Chicago — that competition in a free-market system will solve all problems. We couldn't actually say that managers or firms would maximize value or maximize profits, as was then commonly believed by many from the Chicago School.

And that led to our agency paper, which opened up the black box of the firm so that we could see the incentive and information problems ["Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure"]. So that led to this focus on governance, and the conflicts of interest between managers, directors, shareholders, bondholders, employees, and lower-level managers in the firm. The agency problem exists at all levels in the firm, and, indeed, between any two or more individuals attempting to cooperate in activity in life — including marriage and parenting, which helps bring home to everyone the conflicts of interest that exist.

That brings us up to the point of the question you asked, and now I've forgotten the question.

JP: The question was how you think about bad management. And what I take from the answer that you've given is that it can come out of two things: it can come from the mismatch between somebody's knowledge and decision rights and, hence, their ability to utilize given assets as wisely as somebody else could, or it can come from poor incentives for an individual who actually has the appropriate knowledge.

MJ: That's it and now we can see another aspect of this issue. In our paper on specific and general knowledge ["Specific and General Knowledge, and Organizational Structure"], we drew a graph that I'm still in love with, which describes how one can think about centralizing and decentralizing decision rights in an organization.

We were looking at the organizational costs that arise from two phenomena, one that we call "information costs," or the costs arising due to poor information, and the other would be called the "control costs," that is, the costs arising due to inconsistent objectives. The costs due to inconsistent objectives rise as you move a decision right away from the CEO's office. And the costs due to poor information decline as you locate the decision rights lower down in the organization closer to the specific knowledge. And the equilibrium is where the sum of these two costs is lowest and that occurs when the increase in costs due to inconsistent objectives just equals the decrease in costs due to poor information.

So one of the messages you get from this analysis is that there's never going to be a situation, in a complicated environment, in which you get the problem solved so that there are no costs due to inconsistent objectives and no costs due to poor information. So what we're looking at is a world in which technological innovation, innovation in contracting, innovation in our models of management can shift those functions around, but we will never be in a place where both of those costs are zero. And therefore there will always be what appears to be "bad management" — that is errors of both kinds occurring.

JP: In the last three decades, how effective would you say the market for corporate control has been at either disciplining bad management or addressing the challenges for getting the incentives right so that the sum of the costs due to inconsistent objectives and the costs due to poor information are minimized — that is, getting the systems in place so that individuals have the specific knowledge that is most appropriate to the assets they are in control of?

MJ: In my opinion, the market for corporate control has had a huge positive effect, although nothing comes at zero cost. I've watched us go through the time of very large, monolithic, and inefficient organizations to much more efficient and productive organizations. There was the growth in conglomerates in the '60s and through the early '70s. In some cases, those organizations made sense, but in relatively few of them, and massive amounts of wealth was destroyed. We had organizations that were slow to change, fat, bloated, and inefficient. And, of course, if you're in a competitive product market, new competitors will arise that eat your lunch. But that's not a very efficient procedure. So the market for corporate control arose, which allowed individuals operating through the capital markets to gain control over the decision rights regarding the allocation of these resources. This mostly affected the conglomerates, early on, which, by my estimates, were destroying on the order of 50% of the total value that was possible in those organizations. That control market arose first with proxy contests, and then hostile tender offers, and on and on.

In the early days all of that was considered immoral, inappropriate, and unethical among the business elite. And now few, if any, organizations or even bystanders think it's inappropriate for one firm or one entity or collection of individuals to offer to buy the control rights in a firm, change its governance structure, throw out the board of directors, and reallocate the assets. And that's had an enormous, positive, dynamic effect on the fortunes of American industry and increased the welfare of consumers.

In the 1980s, it was clear to me that there was something important happening in what we now call the private equity market. At that time we were looking at what we called leveraged buyouts. I defined what I called leveraged buyout associations in the papers that came out of my 1989 congressional testimony ["Active Investors, LBOS, and the Privatization of Bankruptcy" and "The Eclipse of the Public Corporation"]. And what I saw happening at the time was that there was a new way to solve the agency problems of the public corporation — in effect what I then characterized as a new model of general management. This new model of general management is now generally called private equity, and it includes leveraged buyouts as well as venture capital organizations, and some include hedge funds in the category as well. I treat hedge funds as something separate.

This new model of general management and governance has enormous implications for the efficiency of organizations. Private equity has gone through some ups and downs, but it is now not only taken for granted here in the United States, but has also migrated to a great deal of the rest of the free world. And, as usual, since nothing comes for free, there have been problems and controversy, but the problems are small in comparison to the gains.

We now see thousands of private equity organizations with a trillion dollars of assets under management. Including the hedge funds (which I'm far less fond of than the venture capital and leveraged buyout arms) the total capital is far greater than that. And these organizations are having a huge impact, in many parts of the world. Indeed, these organizations now have access to so much capital that they can take virtually any public company private.

What also seems to be happening is that CEOs are beginning to realize that they might be better off in that environment.

The most important difference, to me, between the private equity model and the publicly held corporation model, is that in the publicly held corporate model, the CEO has no boss. We pretend that the CEO has a boss. We pretend that it is the board of directors. But it almost never is. Basically, the boards of directors of most organizations, even the so-called independent directors, see themselves as employees of the CEO. Mostly the only times CEOs of publicly held organizations have a boss is when a sufficiently large crisis occurs. At that point boards often wake up, but by then it is often too late — much of the damage has already been done.

In the private equity organization, every CEO has a boss. The CEO is often the only member of management on the board. One or more of the partners of the private equity firm are on the board and the senior partner is usually the chairman of the board of the private equity division. There's an effective working relationship between the board and managers on strategy in the company that seldom exists in large public organizations. It makes it more like a smaller, entrepreneurial organization.

Private equity is a remarkably productive new model of general management. Interest in the equity is still being held and distributed to individuals in the economy through college and university endowment funds, pension funds, insurance companies, etc. The public still has claims on them, but they're indirect, and that has been incredibly productive.

Now, let me say that we're going to go through some major scandals in the private equity world that are going to make it look like this is a bad model. Right now you have Fortress and Blackstone taking themselves public. My way of putting this is: the publicly held private equity firm is a non sequitur, not only in language, but also in economics. KKR is reportedly considering taking its private equity management company public as Fortress and Blackstone have, and they have also raised permanent capital to replace some of their non-permanent limited partnership capital in Europe.

Both of these moves are bad ideas, and Fortress and Blackstone have made serious mistakes. These changes will lead to increased agency problems with private equity and cripple their ability to create efficient organizations. I'm predicting that in the end these moves will prove to be mistaken, and the industry will return to something that looks more like the model that has been so successful over the last 20 years. But this presumes the regulatory and tax structure changes arising from the current and yet-to-come controversy do not permanently cripple this important organizational form.

The data indicate that these organizations are highly productive, generating — at least in the top-quartile firms — substantially superior returns. By the way, we don't find that kind of consistency anywhere else in the financial markets — we don't find it with hedge funds, mutual funds, or with other kinds of financial advisors. There's the temptation, when there are big amounts of money being earned, for learners to enter the scene. So we've had enormous entry into this business, a business that used to amount to a hundred or so firms, and now is well into the thousands.

The learners often don't get it. One of the advantages of this model is that the funds are not permanent capital (they have to be returned to investors in ten or so years), so if as a private equity managing partner you produce low returns on two funds, you're out of the market. But even the more successful firms are falling prey to agency problems, because they're now taking fees out in ways that are not proportional to equity claims — special dividends, deal fees, etc. — that threaten the integrity of this new management model. Consider how crazy it is to pay the private equity firm deal fees that reward them more for paying more for the deal. You can easily see the downside of that structure.

JP: It seems to me that almost an inevitable downside of any of these innovations — the leveraged buyout, private equity — is that the initial success leads to a set of expectations among those who hold financial capital, and the cost of capital becomes almost too cheap, and it flows too quickly. The initial disciplining device of the market goes away for a time.

MJ: That's a good way to put part of the problem. There is a substantial amount of this in the mutual fund industry. Funds that, for one reason or another — maybe pure luck — are successful, experience large capital inflows into them, and they subsequently produce low returns.

I'm predicting that private equity is going to go through some bad times in the not-too-distant future. There are going to be bad deals done, there are going to be bankruptcies, there will be scandals, reputations will suffer, returns will be low, and the industry will get a bad name — as will happen with hedge funds, and as happened with hostile takeovers, some of it deserved, much of it not. Like what we're seeing happen in the sub-prime mortgage market. And that will be too bad, but it will be a corrective mechanism that serves to eliminate a lot of the marginal players who don't know what they're doing, or some of the non-marginal players who have just proved to be too greedy.

The danger here is not that they've asked for higher compensation, but that they've done it in ways that are going to cause damage to the superior structure of this new model of general management. These disproportionate fees, fees paid in the wrong way, will turn out to have been a bad idea. The participants would have been much better off to just raise the 20% performance fees (called carry in the industry).

JP: I'll ask one follow-on to that. There's obviously nothing in agency per se that legitimizes overly greedy behavior. In fact, a tight reading of agency theory would say that part of the incentive problem is that people are too greedy. And yet, it does seem to be the case that practitioners pick up on the language of agency theory, and the importance of strong incentives as a justification for forms of compensation which aren't high-powered incentives, but are very extreme in the aggregate amount of compensation.

MJ: You know, in 1990 Kevin Murphy and I wrote a couple of papers on CEO compensation and argued that, even though there was lots of controversy going on, CEOs, inflation adjusted, weren't being paid much more than they were in the 1930s. And if you looked around at alternatives in the law profession and sports and entertainment, it was difficult to argue that CEOs were being overpaid ["CEO Incentives: It's Not How Much You Pay, But How" and "Performance Pay and Top Management Incentives"].

We cannot say anything like that in the book that we're in the process of finishing now. Moreover, what we would say now is that CEO pay is currently in a bit of a mess.

I believe that the movements towards equity-based incentives that occurred in the last couple of decades have been generally very desirable. They've been associated with substantial improvements in incentives and have resulted in large organizations being much more flexible and much more willing to make major changes, so that we don't have to go through the slow death that's brought about by the loss of competitive position in the product markets.

But the practices in executive compensation, while generating many benefits, have overshot the mark. It's generating lots of costs. Of course, you have political costs. Even if you have an economic system that's ideally perfect, when you put things into the political domain, the worst side of humanity begins to arise — jealousies, misinformation — and that will cause controversy and punitive action in the political system. And that's going to be even worse when there's legitimate over-reaching or inappropriate behavior on the part of managers and compensation committees as there has been recently.

Some wise person said that the seeds of tomorrow's problems are always contained in the solutions to today's problems. But I would have been shocked, if I'd seen the view into the future, at the level of the problems that have been created by the shift in executive-compensation practices. And a lot of it is not even visible to the public. Here's an example. Historically, most executives were "at will" employees serving at the pleasure of their boards of directors. However, the 1990s witnessed an explosion in the prevalence of "employment agreements" that provided multi-year employment terms, guaranteed minimum bonuses, and large severance payments for executives terminated by their companies without "cause," and extremely limited definitions of termination "for cause" that make it almost impossible to terminate an executive for cause.

These now almost universal CEO em-ployment contracts were stimulated by the law regarding golden parachutes that came into existence during the Clinton admini-stration, as well as restrictions making executive pay in excess of $1 million non-tax deductible to the corporation — anything more than $1 million had to be performance-based or it was non-deductible. CEOs are no longer at-will employees, and the results of this have been quite undesirable.

Some examples: 96% of CEOs now cannot be fired for cause for breaching their fiduciary duties, 94% cannot be fired for unsatisfactory performance, 91% cannot be fired for malfeasance, 65% cannot be fired for willful or gross misconduct or breach of contract, 46% cannot be fired for willful failure or refusal to perform duties, 44% cannot be fired for dishonesty, fraud, or embezzlement. I could go on but you get the point ["CEO Pay and What to Do about It: Restoring Integrity to Both Executive Compensation and Capital Market Relations," forthcoming 2008].

Understand that if I fire you for something other than "for cause" as specified in your contract, I have to pay you the total compensation associated with your contract for its entire life, including bonuses, etc. CEO Bob Nardelli received over $200 million in severance pay when he was dismissed from Home Depot "without cause," and Michael Ovitz received $130 million after being fired in 1996 for incompetence but "without cause" after 14 months on the job as president of the Walt Disney Company. He received more pay for being fired than he would have received had he remained employed for his entire contract.

There's no way that you can look at this data, without seeing that there's something dramatically wrong with the compensation process. It is truly astonishing that 96% of CEOs cannot be fired for breaching their fiduciary duties. A CEO's job begins with an obligation to fulfill a set of fiduciary duties!

JP: Do you worry about either the attention effects or the selection effects of these compensation packages? It seems to me that what has happened with compensation leads CEOs who otherwise may have been focused on building their legacy in terms of the tangible organization... How could they think about anything other than the compensation when it's so high?

MJ: I think it's an important issue. The way a legacy got converted into incentives, which is what I believe happened with CEOs in the old days, is they got paid more if they had bigger organizations. That made CEOs very reluctant to shrink their companies, and it gave them all sorts of incentives to make them larger, way beyond the point at which they were producing value for society.

Now we've shifted that. The possible rewards that are available through compensation swamp other incentives. And I think you put it in a very good way. That now has the potential to become top of mind for many CEOs, and that can have undesirable as well as desirable effects.

We know that incentives and high pay do not have to destroy a CEO's effectiveness. You can take Warren Buffett and others like that, who seem to use those metrics as just a scorecard, but not as something that drives their life.

The bottom line, in my book, is a new set of issues has arisen, a new set of problems, a new set of agency conflicts. And as the old ones get resolved, these new ones start to migrate to the top of the new problem set.

I wrote an article a few years ago, just as all the corporate scandals were starting to come into the press, entitled "Agency Costs of Overvalued Equity," in which I was doing my best to point out to the world and my finance colleagues that we had to be much more careful than we had been in teaching value-creation or value-maximization as an appropriate objective function for the corporation. We had not actually considered the incentives that are created, and the potential dangers to an organization of having its equity be overvalued.

It turns out that true value-maximization does not mean that you want to have your stock prices and bond prices as high as possible. Now, how does that work out? What is the problem? Let's just concentrate on equity for a moment: if for whatever reason — the market makes a mistake, or you encourage the market to think that the equilibrium stock price is higher than what it should be — your equity becomes substantially overvalued, my claim was (and this has been substantiated by the last bust) that when your equity becomes overvalued — and, by the way, I'm not talking about 5 or 10%, I'm talking about 100%, or 500% — it releases a set of organizational forces that are almost certain to destroy part, or even all of the real, core value of the organization. And those organizational forces will be very, very difficult to stop.

JP: I'll give you an example that supports your point. I had a guest speaker in class once. He was the former CEO and president of a company that believes in a set of principles — but they lost their way for awhile. One of the students asked him about that. And he said that at some point your share price gets so high.... He said, "I remember we made a $200 million acquisition with six minutes of diligence, because it was just so easy to do." He said, "I think back on it now and I know how ridiculous it is, but that was what it was worth in terms of time, given what our share price was." He said he gave it as much thought as you would give if you were deciding whether to spend $20 or $25 on an entrée. I always remember that.

MJ: That's a very, very good example. One way of characterizing it is, overvalued equity is to managers as heroin is to a drug user. At the beginning, everything is great. It feels really good. The capital market is open to you. Your stock price is going up. If you've got equity-based compensation, that's going up. You begin to appear on television. The press is writing about you.

Now, let's look at what happens. If your equity is actually overvalued, what that means, by definition, is that you will not be able to deliver the financial performance that justifies that valuation. So, as time goes on, and the capital markets are expecting these results to become available, you and the rest of the organization begin to see that it becomes increasingly difficult to deliver on the cash flow and earnings expectations, or whatever dimension the market is evaluating you on. And that pushes you to make all kinds of decisions within the legitimate gray areas of accounting to postpone the day of reckoning and, somehow, figure out how to deliver those results. But, if it's overvalued, it is impossible for you to deliver those results. And now you can't go to the board and tell them that your company's value has to fall by 50% in order for it to survive, because the board will fire you. They will say something like, "If you can't do it, we'll get someone who can." And, by the way, the market thinks you can do it, since you've been a partner in misleading them. Warren Buffett is one of the few CEOs who's ever regularly told the market when he thinks his stock is overvalued.

And what then happens is if you can't solve the problems — and this goes down through the organization, not just at the level of the CEO — if you can't solve the problems by the accounting manipulations, then you look to mergers and acquisitions and other investment opportunities, other strategies which you hope, by gambling, to produce the results that the market is expecting. And you then begin to move around the corner to fraud, to make it appear you are generating those results for the market, hoping all the time that you're actually going to somehow produce the results that will justify the stock price.

And in the end, as we've seen with Xerox and Enron, and with many others, it ends up being a total disaster. So you not only lose the overvaluation (which was going to go away anyway), you lose much more. Enron was valued at $70 or $75 billion at its peak. The true value of the equity was worth something less than half of that. But it was a valuable entity. And all of it was destroyed by the actions that were taken to justify the price at the top. The scandal at WorldCom had similar sources. And we need to be teaching this to our students, as part of teaching them about true value maximization and the importance of both personal and organizational integrity.

JP: This takes us to the most recent work you've been doing on integrity, which I interpret as part of a focus on character, but character-as-lived. And Warren Buffett is a very good example. I never thought about this until listening to you now: There's this interesting irony, which is that there is a limit to how much Warren Buffett is motivated by incentives. He's imposing those limits on himself, right? "I'm not going to spend all the disposable income or lead a lifestyle consistent with 30 billion of net worth. I will use it as a scorecard." The scorecard is an incentive, but at that level it's a muted incentive that's not going to lead him to engage in behaviors like those who are more driven by the attention of the press and conspicuous consumption and so on. So it seems to me that there's this important complementarity between the individual character that we need to be developing in MBA programs, on the one hand, and the market systems that we're helping to create, on the other.

MJ: I wouldn't have put it in that exact way, but I like the way you put it. And I would sign on to it in a moment. So let me say a little bit about integrity.

I've been motivated partly by seeing so many examples of people making themselves and their families and their organizations worse off by decisions that, after some passage of time, turn out to look ridiculously foolish. What has puzzled me is how that happens. It's too easy to explain it away by saying that it happens to evil people or foolhardy people. It happens to the best of people.

I'm also driven by this quest that I have. The four things that matter to me in life are individual freedom; efficiency (that is, no waste); integrity and honesty; and joy. So everything that I do is about furthering one or more of those things. What I've come to understand in recent times is how integrity and honesty play an incredibly important role in bringing about efficiency and joy.

So what is that all about? I'm two years into this work entitled "Integrity: A Positive Model that Incorporates the Normative Phenomena of Morality, Ethics, and Legality," with my coauthors Werner Erhard and Steve Zaffron. I see this work as revealing to human beings and to organizations the incredibly productive power of integrity —
in economist language, the power of integrity as a factor of production. And I don't mean as a factor of production just in organizations or in commercial activity. I mean as a factor of production of happiness in people's lives.

This work on integrity is based on a purely positive concept of integrity meaning an individual or organization being whole and complete. There isn't anything inherent in how we distinguish integrity that is either good or bad, either right or wrong. It's just integrity (being whole and complete), and if an organization or an individual behaves this way, it leads to workability. And workability in an organization leads to value or whatever performance index you are trying to maximize.

The amazing thing, to me, is that behaving with integrity — and in the case of humans and organizations we define that simply as honoring one's word — will lead to increases in productivity on the order of 100 to 500%. But then there arises the question, if integrity is that important as a factor of production, and if economists and others throughout the world have been unaware of it for so long, how is it that that unawareness can occur? We call this phenomenon the "veil of invisibility" that prevents us from seeing the impact of out-of-integrity behavior on all aspects of life.

What happens is the following: people dedicated to increasing their performance, and/or the performance of their organization, will end up taking actions that reduce their integrity and reduce the integrity of the organization in order to increase performance. They are unaware that, when they take those out-of-integrity actions, they are guaranteed to reduce their opportunity for performance (or that of the organization). And why they don't see this is the puzzle that has to be solved in order to make this factor of production important and visible in people's lives.

Now, in the individual's life, I think performance, in the end, means joy. And joy, as everybody who's been there knows, doesn't come from mere wealth.

What delights me is to see both what's happened in my own life since I've been working on integrity, but also what's happened in my small organization, SSRN [Social Science Research Network]. I love SSRN not only for what it does, but also because it is a little laboratory that I get to experiment with. Over the last couple of years, we've seen increases in productivity and efficiency on the order of 300% on the part of the organization and the wonderful people that work with us, as well as further increases in the joy of working with and around SSRN.

The goal of my coauthors and me is to unearth the rigorous foundation of this factor of production and make it available to the world.

JP: I find the work you're doing on integrity very persuasive, and I'm trying to figure out how I take the earlier work and bring it to the later work, in the sense of what's the mechanism that we should be looking to, to drive integrity broadly, given the productivity benefits? Will the initial demonstrations of its effects, at SSRN and other places, be sufficient to prompt the principals out there to insist on greater integrity from agents? Or is it more the burden of business schools, management schools? I'm thinking now about the question posed by Q1, the first issue of this publication: "Can we make management a profession?" Is it the burden of the profession to inculcate an ethic of integrity among its members?

MJ: I think it's all of those things. It's not one route versus another. The key is to reveal, both for people and organizations, what integrity is and the impact it can have on their lives. In our definition it isn't a virtue, but it has desirable results. If we can actually pull back this veil of invisibility, if we can penetrate it, then my claim is that it is privately and individually optimal for us to shift our behaviors. When people see that, it won't even be a decision. It just becomes obvious.

So, the first step is to make this available in a way that's understandable and implementable by people. You know, the golden rule would create a world that would be wonderful, but it has no power. In this world of integrity that Erhard and Zaffron and I are working on, I claim that it's privately optimal to implement integrity in all aspects of your life because it makes you and your organization better off. And there's an actionable pathway to do it.

One of the surprising results that came to us in this research was that if you apply the principle of cost-benefit analysis to your integrity, that is to honoring your word, you are guaranteed to be an untrustworthy person. And you are virtually guaranteed to be a person that's out of integrity. (By the way, honoring my word means I let you know as soon as I know that I'm not going to keep it, and then I clean up the mess in your life and everybody else's life who was depending on me to keep that word. And if you are going to be a person of integrity you must do a cost-benefit analysis on giving your word.) If you're out of integrity, then the opportunity for performance, however you define performance in your life, is going to go down, because workability will go down.

Now, that's a very powerful proposition, and it's also counterintuitive. The thing I struggled with for close to a year was that I don't know how to think about a world in which I'm not doing cost-benefit analysis of everything. I mean, how do you run a business without that?

I'll summarize the argument with this explanation. Suppose I give you my word that I'm going to do something. And suppose also that when it comes time for me to honor that word, I intend to do a cost-benefit analysis of whether to honor it.

Here's the rub. When I gave you my word and did not tell you that I intended to do a cost-benefit analysis on honoring my word, I lied to you by not telling you of my secret intentions, and I'm therefore out of integrity. Suppose on the other hand that I tell you that I'm going to do that cost-benefit analysis when it comes time for me to honor my word. I am now in integrity. However, in this case I have basically told you that I am an unmitigated opportunist. You will then know that my word means, literally, nothing. You will have to guess what costs and benefits I will be facing when it comes time for me to honor my word to you. And that means my word means nothing to you or to me. It's all a matter of what I find desirable when it comes time to keep my promise to you.

As my partner, Sue, said to me to make the issue perfectly clear: "Michael, if you have declared that you are a person of integrity, you have no choice when it comes time to honor your word." And that is the bottom line. But it took me a long time to become comfortable with the notion that there was a place in life in which the sine qua non of economics (and what many believe is simply rational behavior) is plain and simply inappropriate. And, by the way, this unconscious application of cost-benefit analysis to honoring one's word is an almost universal behavior trait. It is not unique to economists.

Cutting through it all we can say with confidence that as a person all you have in life, really, is your word. That is who you are. And by the way, being in integrity with yourself is incredibly important. Do you honor your word to yourself? Doing so is the hallmark of a person who is whole and complete. Integrity is the foundation of effective leadership.

I believe the most important job we have in management, and particularly in management schools, is to communicate this simple proposition about the importance of integrity in providing the maximum opportunity
for performance in a powerful way to our students, our faculty, and our alumni, and, thereby, to the rest of the world. This simple, unintuitive point — unintuitive at some level, but very intuitive at other levels —
would dramatically change the world. And if there were to be a profession of management, and I would hope to see something like that arise, I would like to see this be one of its primary principles.

JP: Would it be too much to say that, while we are trying to create markets, as institutions that are responsive to the incentive problems that arise because those who have specific knowledge are not always going to be the ones who have the decision rights, we also want to cultivate character in a way that doesn't make individuals so responsive to short-term incentives that they'll fall prey to those negative after-effects?

MJ: That's a wonderful way to put it, and I hadn't actually seen it in quite that way. The short-termism would come into play when it comes time for me to honor my word. If I choose not to honor it, I have sacrificed something very important in my life for what's going to turn out to be a small pay-off (no matter how large it is). It means I become out-of-integrity and untrustworthy, and everything that flows from that. I don't think of it so much as developing character, but rather in getting people to see what the actual outcomes are from their behavior. When they truly see that, their behavior will change and what we see as short-term behavior that sacrifices much in life will go way down.

In an organization, where people need to cooperate to produce some outcome (and that's the essence of modern society and modern business), then being able to count on the word of others, the promises of others, becomes critically important. That is what we call trust, and we show that integrity is the direct actionable pathway to creating trust.

You know, if I'm out in the woods and don't have to cooperate with anybody — I kill what I need to eat, or grow it, or whatever — these problems don't come up (except in relation to myself). But as soon as I'm in partnership or cooperation, whether it's at the level of the family, the community, or the organization, being able to count on the word of others becomes incredibly important to accomplishing results from cooperative behavior. And that is what we mean by trust.

But I have to say that I'm uneasy with using the language of building character, because that seems to treat integrity as a virtue, and virtues don't have much power in life. I think the pathway to widespread practice of integrity is not seeing it as a character virtue but as a pathway to personal and organizational accomplishment and joy.

Put another way: I like to think about integrity not as character-building, but like what we do when we teach people net-present-value analysis or how to price uncertain and contingent claims. Once you have this ability to do this thing, you have a tool in life that's very, very powerful.

Interviewed by Joel M. Podolny, Dean and William S. Beinecke Professor of Management,
Yale School of Management