Inflation? What is inflation? What the heck is it?

If you are interested in economics, you may realize that three most important figures are employment rate, interest rate and inflation rate. Frankly, I see these rates every single day, especially inflation one. More terrible, newspapers keep bombing us with fear and greed about inflation. I do not believe so. I just read a very good comprehensive article about inflation. I would like to put it into my blog for further reference. Inflation is not as fearful as we, normal people, have thought.

In a high-profile research paper titled "Understanding the Evolving Inflation Process," published recently, a group of private-sector and academic economists have endorsed the Fed's policy of price stability and transparency as an important tool in keeping inflation at bay.[1]
Economists have however, warned the Fed not to rely too much on inflationary expectations as the main tool for controlling inflation. The writers of the paper maintain that their research shows that inflationary expectations actually don't cause inflation, but that things are the other way around.
The heart of their analysis is a modified Phillips Curve equation, which is labeled the New Keynesian Phillips Curve (NKPC). What drives the inflationary process in this way of thinking is expected inflation, past inflation, the real output gap and some disturbances, i.e., irregular events. In this way of thinking an increase in the output gap — i.e. a relative increase in actual output versus potential output — gives rise to inflationary pressures.
Using the NKPC and two other equations that deal with the output gap and interest rate determination, the researchers have made an attempt to explain the reason behind the great inflation between the mid-1960s and the late 1970s. The economists have also produced an explanation for the fall in the pace of inflation since the early 1980s. The reason for the great inflation, according to the paper, is the lack of willingness on behalf of Fed officials back then to stick to the goal of keeping prices stable. While the reason for moderate inflation since the 1980s, according to these economists, is central bankers commitment to price stability.
Despite the use of sophisticated mathematical and statistical techniques, the research paper never gets to the heart of the phenomenon of inflation. Also, the paper deals with the description of price changes without acknowledging any role that money might have had in these changes. The entire framework is based on a dubious modified Phillips curve and a black-box, time-series analysis. Whilst the research paper mentions extensively the word "inflation," it never even attempts to define this term. The lack of a clear identification of what inflation is all about casts doubt on various conclusions that the writers of this paper have reached. Covering undefined terms with mathematical dressing cannot make the analysis more meaningful if the object of the analysis is not clearly identified.
Defining inflation
The subject matter of inflation is the debasement of money. For instance, historically inflation originated when a ruler would force the citizens to give him all the gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return to the citizens diluted gold coins. On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins for his own use. (He could now divert real resources to himself). In short, what was now passing as a pure gold coin was in fact a diluted gold coin. The expansion in the diluted coins that masquerade as pure gold coins is what inflation is all about. As a result of inflation, the ruler could engage in an exchange of nothing for something.
Under the gold standard, the technique of abusing the medium of the exchange became much more advanced through the issuance of paper money unbacked by gold. Inflation therefore means here an increase in the amount of paper receipts that are not backed by gold yet masquerade as true representatives of money proper, gold. Again the holder of unbacked money can now engage in an exchange of nothing for something.
In the modern world the money proper is no longer gold but rather paper money hence inflation in this case is purely the increase in the stock of paper money. Please note we don't say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.
Once it is established that the subject matter of inflation is the expansion of the money stock, we can attempt to ascertain whether the Fed is an inflation fighter.
Monetary inflation and prices
Most economists and commentators define inflation as a general rise in prices, which is summarized by the so-called consumer price index (CPI). While a general rise in prices may be associated with inflation, it is however not inflation. What is the price of a good? It is the amount of money asked per unit of a good. (Observe that without money one cannot even begin to discuss what prices are.)
Now, if for a given stock of goods an increase in the money supply occurs, this would mean that more money is going to be exchanged for a given stock of goods. Obviously then the purchasing power of money is going to fall, i.e., the prices of goods are going to increase (more money per unit of a good). In short, in this case inflation is associated with the general increase in prices.
But now consider the following case: the rate of growth in money is in line with the rate of growth in goods. Consequently, there is no change in prices of goods. Do we have inflation here or don't we?
For most economists, if an increase in the money supply is exactly matched by the increase in the production of goods, then this is fine, since no increase in general prices has taken place and therefore no inflation has emerged. We suggest that this way of thinking is false since inflation has taken place, i.e., the money supply has increased. This increase cannot be undone by the corresponding increase in the production of goods and services.
For instance, once a king has created more diluted gold coins that masquerade as pure gold coins he be able to exchange nothing for something irrespective of the rate of growth of the production of goods. In short, regardless of what the production of goods is doing, the king is now engaging in an exchange of nothing for something, i.e., diverting resources to himself by paying nothing in return. The same logic can be applied to money paper inflation. The exchange of nothing for something that the expansion of money sets in motion cannot be undone by the increase in the production of goods. The increase in money supply — i.e., the increase in inflation — is going to set in motion all the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the production of goods.
For mainstream economists, an increase in economic activity is almost always seen as a trigger for a general rise in prices, which they erroneously label inflation. But why should an increase in the production of goods lead to a general increase in prices? If the money stock stays intact, then we will have here a situation of less money per unit of a good — a fall in prices. This conclusion is not affected even if the so-called economy operates very close to "potential output" (another dubious term used by mainstream economists). Only if the pace of money expansion surpasses the pace of increase in the production of goods will we have a general increase in prices. Note that this increase is only on account of the inflation of money and not on account of the increase in the production of goods.
Another popular explanation for a general rise in prices is the increase in wages once the economy is close to the potential output. If the amount of money remains unchanged then it is not possible to raise all the prices of goods and wages. So again the trigger for a general rise in prices has to be monetary expansion.
Having established that inflation means monetary expansion, we suggest that the key factor behind the acceleration in prices in the period of mid '60s to late '70s is  the strong monetary expansion in that period.
In relation to its 12-month moving average, our measure of money AMS followed an exponential path (see chart). For instance, in August 1969 the differential between the AMS and its 12-mma stood at negative 0.5 against positive differential of 21 in December 1979. It is therefore not a big surprise that the gap between the CPI and its 12-month moving average jumped to 4 by December 1979 from 0.9 in August 1969 (see chart).
In contrast, since 1980 monetary expansion has not been as aggressive relative to its 12-month moving average. In relation to its 12-month moving average, AMS has been trend-less (see chart). So it is not surprising that the CPI in relation to its 12-month moving average has also been trend-less (see chart). The introduction of new technology has probably given a boost to the production of goods, which in turn has contributed to the lowering of the general increase in prices. Another positive is the strong increase in the supply of goods from various economies such as the former Soviet block and China.
Contrary to popular thinking, the Fed's preoccupation with price stability, by keeping the rate increases in the CPI at a particular acceptable range, can actually generate nasty surprises. For instance, as a result of strong monetary expansion and a correspondingly strong increase in the production of goods, prices remain stable. Notwithstanding this stability, various nasty side effects that emanate from monetary expansion are likely to emerge. Hence we suggest that Fed policy makers should pay close attention to the sources of monetary inflation rather than focusing on the symptoms of inflation.

$29

On this Rothbard wrote,

The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the Great Depression caught them completely unaware.[2]

Similarly Mises explained in his essay "Inflation: An Unworkable Fiscal Policy,"

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term "inflation" to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. …  As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.[3]

But if the Fed were to acknowledge that inflation is actually printing money, then it would mean that the US central bank is not an inflation fighter but is itself the key source of inflation. After all, without the Fed's monetary expansion, the whole machinery of inflation would have fallen apart.

http://mises.org/daily/2525

You’ve Passed the Interview. Now Give Us a Presentation.

This interview with Chris Cunningham, co-founder and C.E.O. of Appssavvy, a social media-focused marketing firm, was conducted and condensed by Adam Bryant. (The New York Times has an ownership stake in Appssavvy of less than 5 percent.) 

Q. Do you remember the first time you were somebody’s boss? 
A. It was when I started a magazine in North Carolina called the Vagabond. And the vision was to enable business travelers and families to discover restaurants, hotels and golf courses in 50 top cities. It is the same theory that I believe in today with Appssavvy, which is to be really clear about the vision and how you’re going to get there, and tell people how their involvement will be meaningful. The more you can make people feel that they have a hand at the wheel, that they’re driving something, the more that they’ll participate and own it like you own it. 
 From my experience, if you have an army of people who believe as passionately about the goal and the vision, you’re going to find a lot more success than by using the theory of command and demand. 
Q. And what were some early leadership lessons?
A. I was born in Finland. My grandfather started a paper company in Finland, and I had experience in high school as an intern selling paper products internationally from a desk outside of Helsinki. And I didn’t really know what I was doing other than having a phone and a piece of paper and some sort of concept of the products. But learning how to sell internationally gave me confidence to do things at an early age. 
You also learn through sports — and I was a sports junkie, from hockey to football to lacrosse — what you have in your gut, in your heart, and you learn about your ability to get people to listen. Most of the time, people will listen to you not just because of the direction you set, but also because of the follow-through and the execution. 
Q. How do you hire?
A. We look for people who really want the job. And that sounds really simple to say, but some of the most important people in the organization who shine and are really transformative people were the ones who were almost jumping out of the chair, saying: “I have to be here. I’ve been studying this company. This is all I’ve ever wanted. And if I’m not here, I’m not going to be happy.” Those individuals took that extra step as well to follow through after the interview. We watch how quickly the person follows through, and how much thought they put into how they want to contribute. But how badly do they want the job — I can’t stress that piece enough. 
Their résumé, I believe, is one of the least-valuable components of an interview. For me, primarily it sits on the desk as a reference point, and to potentially make that person feel comfortable that I’m a professional C.E.O. But the truth is, I’m not interested in the résumé. I’m more interested in understanding the time that the person took in understanding our business, product and the industry landscape. 
I spend a lot of time asking about the challenges people have faced in prior work environments, and how they would behave or react in an unfamiliar situation where they might not be too comfortable. The people who are able to respond quite quickly and have very short, concise answers to how they would overcome a problematic situation typically are the ones who seem to possess leadership skills. You have to ensure that you’re not just hiring a person because you have an opening, but you want people who possess leadership qualities so that they could replace the person who’s hiring them. 
Q. Can you elaborate on this quality of facing down challenges?
A. I ask them to recall real examples. It can potentially expose something that we believe is very important, which is problem-solving. Great leaders can take the initiative and solve problems on their own. So we ask: Were you in a challenging predicament, and faced with a scenario that you were not used to? What did you do? Who do you reach out to? How did you go about handling this? How would you follow through on it?
Some of the biggest misses, I think, come from people not following through. A great idea or solution is only as strong as the follow-through. Nothing will potentially frustrate me more than if there’s no action item. If you follow through, that is a tremendous asset that a lot of individuals don’t necessarily possess. 
Q. What else is unusual about your hiring process?

 A. Every job candidate must present to five to seven people as the final step before we hire them. We will give them a real-life example from our company and ask them to make a presentation. That is literally where you can just make or break it, and find out if they’re an all-star or whether you just avoided making a bad hire. If someone can come up with a great idea for the proposal and present it without becoming nervous or uncomfortable, and hold their own in the Q.& A., you have a slam dunk.
Those presentations are an extra layer of protection. The process gives us the confidence that this person actually understands the market, and it also makes us feel confident that the training wheels won’t be on for that long. Because in a small start-up company, there isn’t a lot of time for training. There isn’t a handbook sitting on the coffee table. There isn’t somebody who’s going to be your mentor. 
Q. What else is important in the culture you’re creating?
 A. I think another important component is treating people well, making them feel that they’re cared for, they’re looked after — good days and bad days — and that the door’s always open. There’s so much more, I think, that most companies probably don’t get out of their people because they just go to work for a paycheck, and they look at the clock, 9 to 5. People want to feel like they’re part of building something. So you treat people well, and make sure that they fundamentally understand that you do care about them as people. And you do what you say. I often hear stories from people in interviews where they’ll say, “Well, I was promised this, but I didn’t get it.”
So if you do everything you say you were going to do, then you’ve just cemented additional trust, which means you’re going to find another 25 percent or so of work ethic and commitment that most organizations don’t have. You can’t extract that 25 percent through command or demand or force or threats or anything else. The only way you can extract that 100 percent threshold or even 110 percent — with somebody wanting to work on a weekend or wanting to get in early, whatever the case may be — it’s because of those commitments and promises, and the follow-through that they’ve experienced, and that their peers experienced. If you don’t have that, then you’re only going to get 75 percent of that employee. That follow-through and that commitment is absolutely critical. If you don’t do it, there could be a potential domino effect. 
Q. You’ve talked a lot about the importance of follow-through. Is that because people promised things to you that they didn’t deliver on?
A. Yes, I’ve had a few experiences where there were big promises made, and there was just an overwhelming amount of commitment that I personally made, and an overwhelming amount of sacrifice. And the leadership did not follow through on their promise. That was a big never-do-what-that-guy-did lesson. That left a very bad taste in my mouth, and one where I think I learned a lot of the things that you don’t want to do. So you don’t overcommit, you don’t overextend, and the commitments that you do make, you actually follow through on.
Q. In reading some materials about you, it said one of your favorite expressions is “crush.”
 A. I started saying “crush” three years ago — it’s just a word that I’ve used. We’re going to crush it. We’re going to crush it this year. There aren’t that many words that I think sort of embody the sense of confidence, that we’re going to go for it. And people want to hear that. I think part of leadership is saying, “I’m going to go into battle with you.” For whatever reason, crush just feels like the essence of what we’re going to do. We’re going to crush the competition. The next thing you know, you hear another person saying crush. And then they’ll sign off “crush” on e-mail. And then you go into a meeting and three people will be talking about crushing it. It’s literally part of our culture right now. It’s funny how this one word has literally just carried through everything we do. People want that level of energy. 
Q. What would you tell other entrepreneurs about building a culture early on?
 A. It’s important to celebrate every minor accomplishment. When we got a couple, three chairs in a shared office space, that was a moment to open some beer. And the first check is on the wall. Make sure that you recognize the early accomplishments, because it’s very easy to work for eight months straight and wonder why you’re working on Saturdays and Sundays. Whatever your metric is — traffic, or revenue, or whatever — celebrate those things, because those actually kind of help you stay alive and survive. And it could be the smallest win, but celebrate those wins, and celebrate them often. 
Q. What advice would you give to business school students?
 A. The biggest piece of advice I could give a business school student is that if you want something, tell them that you want it. There was one guy I interviewed — he works at the company now — but he was really soft-spoken. I said after the interview, “Let’s go get a beer.” And we were sitting there, and I said: “Dude, do you want this job? What’s wrong with you?” He said, “What do you mean, what’s wrong with me?” I said, “You’re giving me nothing.” 
Q. Obviously he said something that won you over, since you hired him.
A. He said, “I really want to be here.” Some people just need that pinch. They need to be sparked. Not everyone’s going to jump up out of their chair and say “I want the job, this is my job, and no one else should have this job.” But sometimes there are ones who you really like, and there’s something about this individual that makes you feel they can be instrumental in growing the business, and it’s important to give them a nudge.  

The Problem with Financial Incentives -- and What to Do About It

Bonuses and stock options often improve performance. But they can also lead to unethical behavior, fuel turnover and foster envy and discontent. In this opinion piece, Wharton management professors Adam Grant and Jitendra Singh argue that it is time to cut back on money as a chief motivational force in business. Instead, they say, employers should pay greater attention to intrinsic motivation. That means designing jobs that provide opportunities to make choices, develop skills, do work that matters and build meaningful interpersonal connections.
Enron. Tyco. WorldCom. The financial crisis. As corporate scandals and ethical fiascoes shatter the American economy, it is time to take a step back and reflect. What do these disasters have in common? We believe that excessive reliance on financial incentives is a key culprit.
Starting in the mid to late 1970s and 1980s, the view emerged in management thinking that the primary role of corporate leadership was to maximize the interests of shareholders. In time, this view came to be known as financialization, and maximizing shareholder value became the reigning mantra. Over time, the belief became almost axiomatic; questioning it was tantamount to heresy in many schools of thought.
This broader perspective translated at lower levels of organizations into an emphasis on rewarding employees with financial incentives contingent upon performance. The thinking seemed to be: Get the incentives right, and people will be motivated to perform better, resulting in better performance for the firm. Researchers Brian Hall of Harvard Business School and Kevin Murphy of the University of Southern California found that less than 10% of total executive compensation at publicly held firms was contingent on stock prices in the early 1990s, but by 2003 that share had ballooned to almost 70%. And despite the bad press and public uproar that big payouts generated in the wake of the financial crisis -- when critics pointed out that many top executives had been heavily rewarded for short-term performances that ultimately proved disastrous -- the system marches on. CEO bonuses at 50 big U.S. companies rose more than 30% last year, a gain not seen since before the recession, The Wall Street Journal reported in mid-March.
To be clear, we are not suggesting that companies abandon financial incentives. Indeed, there is a wealth of evidence that these incentives can motivate higher levels of performance and productivity. To assess results across multiple studies, researchers have used a technique called meta-analysis. As Sara Rynes of the University of Iowa and her colleagues summarize, on average, individual financial incentives increase employee performance and productivity by 42% to 49%.
But these gains come at a cost. Our concern is about the unintended consequences of financial incentives. What do they mean for unethical behavior, jealousy and turnover, and intrinsic interest in the work? And what measures can be taken to lessen their negative impact?
Three Important Risks
Several years ago, Green Giant, a unit of General Mills, had a problem at one of its plants: Frozen peas were being packaged with insect parts. Hoping to improve product quality and cleanliness, managers designed an incentive scheme in which employees received a bonus for finding insect parts. Employees responded by bringing insect parts from home, planting them in frozen pea packages and then "finding" them to earn the bonus.
This is a relatively benign example, but it points to a serious problem. Incentives can enhance performance, but they don't guarantee that employees will earn them by following the most moral or ethical paths. Research by Wharton management professor Maurice Schweitzer and colleagues demonstrates that when people are rewarded for goal achievement, they are more likely to engage in unethical behavior, such as cheating by overstating their performance. This is especially likely when employees fall just short of their goals. Harvard Business School's Michael Jensen has gone so far as to propose that cheating to earn bonuses -- such as by shipping unfinished products or cooking the books to exceed analysts' expectations -- has become the norm at many companies.
When strong financial incentives are in place, many employees will cross ethical boundaries to earn them, convincing themselves that the ends justify the means. When we value a reward, we often choose the shortest, easiest path to attaining it -- and then persuade ourselves that we did no wrong. This tendency to rationalize our own behavior is so pervasive that psychologists Carol Tavris and Elliot Aronson recently published a book called Mistakes Were Made (but not by me) to explain how we justify harmful decisions and unethical acts.
In addition to encouraging bad behavior, financial incentives carry the cost of creating pay inequality, which can fuel turnover and harm performance. When financial rewards are based on performance, managers and employees doing the same jobs receive different levels of compensation. Numerous studies have shown that people judge the fairness of their pay not in absolute terms, but rather in terms of how it compares with the pay earned by peers. As a result, pay inequality can lead to frustration, jealousy, envy, disappointment and resentment. This is because compensation does not only enable us to support ourselves and our families; it is also a signal of our value and status in an organization. At Google in 2004, Larry Page and Sergey Brin created Founders' Awards to give multimillion-dollar stock grants to employees who made major contributions. The goal was to attract, reward and retain key employees, but blogger Greg Linden reports that the grants "backfired because those who didn't get them felt overlooked."
This claim is supported by rigorous evidence. Notre Dame's Matt Bloom has shown that companies with higher pay inequality suffer from greater manager and employee turnover. He also finds that major league baseball teams with larger gaps between the highest-paid and lowest-paid players lose more games; they score fewer runs and let in more runs than teams with more compressed pay distributions. The benefits to the high performers are seemingly outweighed by the costs to the low performers, who apparently feel unfairly treated and reduce their effort as a result.
Similarly, Phyllis Siegel at Rutgers and Donald Hambrick at Penn State have shown that high-technology firms with greater pay inequality in their top management teams have lower average market-to-book value and shareholder returns. The researchers explain: "Although a pay scheme that rewards individuals based on their respective values to the firm does not seem unhealthy on the surface, it can potentially generate negative effects on collaboration, as executives engage in invidious comparisons with each other."
Other studies have shown that executives are more likely to leave companies with high pay inequality. The bottom line here is that financial incentives, by definition, create inequalities in pay that often undermine performance, collaboration and retention.
A third risk of financial incentives lies in reducing intrinsic motivation. In the 1970s, Stanford's Mark Lepper and colleagues designed a study in which participants were invited to play games for fun. The researchers then began providing rewards for success. When they took away the rewards, participants stopped playing. What started as a fun game became work when performance was rewarded. This is known as the overjustification effect: Our intrinsic interest in a task can be overshadowed by a strong incentive, which convinces us that we are working for the incentive. Numerous studies spearheaded by University of Rochester psychologists Edward Deci and Richard Ryan have shown that rewards often undermine our intrinsic motivation to work on interesting, challenging tasks -- especially when they are announced in advance or delivered in a controlling manner.
Autonomy, Mastery and Purpose
So, the good results generated by financial incentives need to be weighed against the bad: encouraging unethical behavior; creating pay inequality that reduces performance and increases turnover; and decreasing intrinsic interest in the work. To limit the negative effects, we recommend that financial incentives should be (a) used primarily for tasks that are uninteresting to most employees, (b) delivered in small sizes so that they do not undermine intrinsic motivation and (c) supplemented with major initiatives to support intrinsic motivation.
Stanford's Chip Heath has shown that managers tend to have a strong bias in favor of extrinsic incentives: They rely too heavily on financial rewards, underestimating the importance of intrinsic motivation. In Drive: The Surprising Truth About What Motivates Us, Daniel Pink summarizes a rich body of evidence that intrinsic motivation is often supported by three key factors: autonomy, mastery and purpose. High effort and performance often result from designing jobs to provide freedom of choice, the chance to develop one's skills and expertise and the opportunity to do work that matters. Evidence also supports the importance of a fourth factor: a sense of connection with other people.
Autonomy involves freedom of choice in what to do, when to do it, where to do it and how to do it. Extensive research has shown that when individuals and teams are given autonomy, they experience greater responsibility for their work, invest more time and energy in it, develop more efficient and innovative processes for completing it and ultimately produce higher quality and quantity. For example, in a study at a printing company, Michigan State's Fred Morgeson and colleagues found that when teams lacked clear feedback and information systems, giving them autonomy led them to expend more effort, use more skills and spend more time solving problems. Numerous other studies have shown that allowing employees to exercise choices about goals, tasks, work schedules and work methods can increase their motivation and performance.
Mastery involves the chance to develop specialized knowledge, skills and expertise. Research shows that when employees are given opportunities for mastery, they naturally pursue opportunities to learn and contribute. For instance, research by the University of Sheffield's Toby Wall and colleagues documented the benefits of giving operators of manufacturing equipment the chance to develop the skills to repair machines, rather than waiting for engineers, programmers and supervisors to fix them. The operators took advantage of this opportunity for mastery to create strategies for reducing machine downtime, and worked to learn how to prevent problems in the future. As a result, they were able to complete repairs more quickly and reduce the overall number of repairs.
Purpose involves the experience of contributing to a meaningful effort or cause. Adam Grant (one of the authors of this piece) has shown that when employees meet even a single client, customer or end user who benefits from their work, they gain a clearer understanding of the purpose of their jobs, which motivates them to work harder and smarter. For example, when university fundraisers met a single scholarship student who benefited from the money that they raised, the number of calls they made per hour more than doubled and their weekly revenue jumped by 500%. And when radiologists saw a photo of the patient whose X-ray they were evaluating, they felt more empathy, worked harder and achieved greater diagnostic accuracy. In The India Way, Wharton management professors Peter Cappelli, Harbir Singh, Jitendra Singh (one author of this piece) and Michael Useem observe that Indian companies have found success in motivating employees by cultivating a strong sense of purpose and mission. As Adam Smith, the father of economics, wrote in A Theory of Moral Sentiments: "How selfish soever man may be supposed there are evidently some principles in his nature which interest him in the fortunes of others, and render their happiness necessary to him, although he derives nothing from it except the pleasure of seeing it."
Connection involves a sense of community, belongingness and being valued by others. Although financial incentives can support connection for star performers, they often impede it for the rest of the organization by creating pay inequality. Studies consistently show that the strongest driver of turnover is not pay, but rather the quality of an employee's relationships with supervisors, co-workers and customers. In a meta-analysis led by Rodger Griffeth of Georgia State University, the quality of relationships with their direct bosses explained more than twice as much variance in employees' decisions to quit as did their objective pay levels or satisfaction with their pay. Even a small but genuine gesture of thanks can help employees feel valued. In a study conducted with Francesca Gino of Harvard Business School, Adam Grant found that the effort of call center employees increased by 51% during the week after an external manager paid them a single visit to express appreciation for their work. In short, relationships matter for retention and motivation.
Finding the Right Context
Researchers Amy Mickel of California State University, Sacramento, and Lisa Barron of the University of California, Irvine, have argued that managers should think more carefully about the symbolic power of financial incentives: who distributes them, why they are distributed, where they are distributed and to whom they are distributed.
When incentives are given by high-status leaders, employees may see them as more meaningful. For example, blogger Greg Linden notes that "Google rarely gives Founders' Awards now, preferring to dole out smaller executive awards, often augmented by in-person visits by Page and Brin." When incentives are awarded in public, they confer greater status but also make inequality more salient. Carefully designing financial incentive programs to carry symbolic meaning can be an important route to enhancing their effectiveness and reducing their adverse consequences.
So what does the overall picture look like? We believe that financial incentives have an important role to play in employee motivation, but the reality of human motivation is more complex than the simpler vision built into the financialization model. Excessive reliance on financial incentives can lead to unintended consequences that sometimes defeat the very goals they are designed to achieve. We feel that it is also important, for instance, to create cultural contexts that help shape norms, values and beliefs specifying guidelines for inappropriate actions, regardless of financial incentives.
Perhaps such an approach would have saved the school board members in Kenosha, Wis., from losing a large chunk of their teachers' retirement plan in risky investments called Collateralized Debt Obligations (CDOs). These investments should never have been sold to them. Although the financial incentives for all the actors in the decision chain were well aligned, what was apparently missing was the necessary ethical restraint.