You gain karma points if you write something that people value, and you lose karma points if you write something that people think is inappropriate.
Except people sometimes use karma in ways that do not conform to this story. For example I had a case of a single person downvoting an entire page (from the user view) worth of comments of mine in the space of about 1 minute. These comments were quite different topically from each other. What are the chances that this user read all these comments, found each of them objectionable, and then voted accordingly? Near zero. What more than likely happened is either:
(a) an emotional reaction
(b) some sort of game theoretic defection or response to a perceived defection (?)
(c) Someone really didn't like something I said, and so decided a "greater punishment" was in order.
Karma is at best a noisy measure. But it's worse than that because there are no enforced standards for how karma should be used. If I look at a post and see that some users voted it down, that gives me no information about what went wrong with the post. Not only do people have different interpretations/thresholds for when something should be downvoted, but also people downvote "globally," regardless of merits of individual posts, based solely on user name.
The best interpretation for karma I can find is "a number that roughly correlates with how you [note: not your specific post!] are keeping all the coalitions on lesswrong happy." Is this a useful number? Not really. I generally ignore karma ratings on my posts, and generally (not always) don't vote myself.
My suggestion is to have clearly articulated community norms about when something ought to be upvoted or downvoted. Luke's quote above is not clear enough, and as a result, the karma measure is far too noisy/meaningless, especially considering that you build other things on top of it, like the controversial -5 point rule for threads. The other suggestion is that the mods should make a distinction between what the karma system ideally should be, and what it is.
We don't know who came up with the ancient Indian idea of karma or why they did so, but one of its social functions is to motivate people to behave better. If people really believe that they will suffer for their evil actions and prosper for their good actions due to a law of nature, this probably motivates them to do more good and less evil.
Less Wrong, of course, has a karma system. You gain karma points if you write something that people value, and you lose karma points if you write something that people think is inappropriate. At low levels, gaining karma points gives you new posting privileges. At high levels, karma points indicate something like your status in the community.
Recently I noticed that I post better comments on Less Wrong than I usually do on my own site. I think this is partly due to Less Wrong's karma system. When I draft a comment or a post for Less Wrong, I'm more likely to (1) talk to others charitably and with respect and (2) go out of my way to provide useful links and context than I when I draft a comment for my own site!
And now I find myself motivated to bring a stronger emphasis on those qualities to the writing on my own site. So the Less Wrong karma system is having a trickle-down effect into other areas of my life.
Which got me thinking... it might be helpful to have a karma system in "real life," beyond the pages of Less Wrong (or reddit). Maybe something like Facebook karma. People could anonymously add and subtract points on people's Facebook profiles according to whether or not that person acted like a douche in daily life. This could be done by a smartphone app, and plugged into Facebook via an opt-in Facebook app that users could voluntarily choose to add to their profiles.