Reflections on Capitalism Part II - Harnessing the Power of Incentives

(Read the first part of this article here)  (9/21/2009) - How can we build a new economic system that could, eventually, lead us to sustainability (I say “could,” because I’m not convinced that anything resembling our modern way of life is sustainable, but I try to be optimistic about things I don’t know)?  I recommend taking elements of 20th century ideologies – specifically capitalism because it has the most to offer and is the most palatable in the current political environment – and using these as a basis for a new ideological system.  By taking proven aspects of a previous intellectual tradition, you not only take advantage of work that has already been done to others, but you can also position the new system as a continuation of an ideological system with brand power.

The first element of modern capitalism that I want to incorporate into my new economic ideology (I’m accepting name suggestions) is the use of individual incentives to drive a large scale system.  This, I believe, is one of the most compelling insights of capitalist ideology – the idea that individuals acting in their own self interest can often push forward the interests of society better than any centralized planning agency or bureaucratic structure.  Don’t get me wrong – Smith’s “invisible hand” isn’t better at central planning for everything, but for a specific and critical set of activities.  We need to recognize – and to some extent, systematize – the situations where the invisible hand works well, where it doesn’t, and what role a strong, fair, democratic government can and should have in establishing incentives.

To hash out how incentives can work well and poorly, lets look at two economic areas where incentives play a crucial role (for good or ill): the feeding of New York City, and the use of derivatives and investment hedging in the first decade of the 21st century. 

New York City (NYC), is the largest city in the United States, with a population of some 8.3 million.  As with most American cities, virtually none of the food eaten by New Yorkers is grown in the city.  The food is grown, processed, packaged, transported, prepared, and consumed without any sort of bureaucracy or centralized planning agency.   Not that government is completely absent from the process, but it plays no directive role.  NYC does have a food board, and regulations on where food can be sold, and in what condition it can be sold.  Food producers and processors are also subject to regulations by federal organs such as the FDA.  These regulatory bodies maintain the quality of the food supply and, by extension, trust in the safety of the food supply, trust that is critical for any free market to function. 

The system – from the farm to the plate – functions based on the actions and desires of millions of individuals and businesses.  At the most basic level, the incentive of profit motivates the growers, distributors, and retailers of food.  On the other side, the incentive not to starve motivates New Yorkers to purchase and consume food.  Though a central planning agency might be able to distribute food in a way that prevented mass starvation, history has shown that it would almost always be much less efficient and open to errors.  And it certainly wouldn’t provide New Yorkers with the variety of food that they want.

The free market system and the incentives it provides does not lead to success in all cases.  Perhaps the greatest failing of capitalist markets is that they often fail to help the poor.  Money is the lifeblood of capitalism, and if you don’t have it, you might as well not exist from the invisible hand’s point of view.  If you don’t have money in New York, your only legitimate, legal way to acquire food is to beg for it or accept hand-outs.  And even having money doesn’t guarantee easy access to specific types of food that you might desire.  Large areas of the city are considered “urban deserts” because of their lack of fresh produce. 

Why is it that incentives supply millions of people in NYC with food, but at the same time lead to the downfall of America’s financial system, a stumble that probably would have proven fatal to the current system if it weren’t for government intervention?  The answer will vary from case to case, but in general the problem is that sometimes the free market simply give people incentives to do things that are bad for society as a whole. 

This is especially true when the costs or risks an activity are externalized.  Why do corporations sometimes dump toxic substances into rivers or forests?  Because they don’t have to suffer the consequences of the toxic substances.  I don’t think Exxon Mobile would dump if it meant putting it in the CEO’s back yard, or polluting the Chairman of the Board’s favorite fishing hole.  But elsewhere, it might be alright.  In externalities, we find incentives at work.

Harmful Incentives

As with unincorporated externalities, incentives can be just as harmful as helpful.  If someone is late to a job interview, they are probably more like to speed or run a red light.  If a researcher is paid to do research by Philip Morris, they’re probably more likely to find that smoking doesn’t raise the risk of lung cancer than a researcher paid by the American Cancer Society.  But not all harmful incentives are as obvious. 

Brad Delong outlines some reasons that so many banks and investment firms came tumbling to the ground (or nearly did before they were bailed out) when the real estate market crashed.  Delong’s basic argument is that unlike individual in other professions and sectors (he uses Silicon Valley engineers as his foil), Wall Street traders and bankers receive most of their compensation up-front, or in annual “retention” bonuses – money paid for sticking around and not fleeing to another company.  Performance bonuses are also paid annually, but these are dependent on mark-to-market values of the bank’s portfolio, not the long-term sustainability or profitability of their business deals. 

In normal accounting, assets are valued at standardized rates – such as purchase price –  which don’t change under normal circumstances except perhaps for an arbitrary depreciation (i.e. a car’s book value might fall 10% of the original purchase price every year).  While this means that the asset’s book value might not be equal to what you’d get if you were forced to sell it, the value is insulated from the day to day fluctuations of the market.  If there’s an extraordinary event that effects the asset’s value, such as a house burning down in a fire, you can still record it as a loss. 

Mark-to-market, in contrast, pairs the value of an asset to what you’d get if you sold it on the open market.  At the end of every accounting period (I’m not sure if its every quarter or every year), you change the value of your assets based on what their value would be if you sold them at that moment in time.  So if you’re working at a company in the middle of a real estate bubble, you will record huge gains every year if you invest in securitized sub-prime mortgages.  But, as we’ve seen, those homes and their mortgages weren’t actually worth as much as the market thought 2 or 3 years ago. 

Because bankers and traders were paid based on how the company did in the previous year, they had every incentive to buy into the bubble and ride it high.  Even if they suspected the bubble would one day crash, there was every reason for them not to stop and think about it.  Lets say Gretchen is a trader in 2003, when some began to see a bubble forming from Greenspan’s low interest rates.  She prudently refuses to invest in securitized mortgages, and makes a little bit of money for your company.  Tim, one desk over, makes a lot of money investing in the housing bubble and gets a much larger end-of-year bonus.  Next year the same thing happens, and Tim is promoted.  Then the same thing happens in 2004.  Everyone investing in securitized mortgages, and Gretchen can’t keep up.  At the end of 2005, as housing prices rise even higher, Gretchen begins to doubt herself, and goes with the flow.  In turn, she’s rewarded with huge bonuses in 2006, 2007, and if the government had stepped into save her employer, Lehman Brothers, she probably would have gotten her 2008 bonus as well.  But they didn’t so poor Gretchen is out of a job, with only her hundreds of thousands of dollars in bonuses from the past two years to sustain her.

Here, the wrong incentives lead to a very harmful outcome, and Lehman Brothers is worth nothing.  How do you fix this?  Delong proposes adopting a different set of incentives.  Instead of rewarding employees up front, they should be mostly compensated in restricted equity (part-ownership in the company that won’t be saleable until a certain date) that won’t be worth anything until a point far in the future where it will be clear whether or not the company’s business model will be profitable.  Then, only after years of hard work building a solid company, do the engineers receive their bonuses.  

Incentives Harnessed - California’s Electric Market

Every policy and law passed by the government creates or reinforces existing constituencies, sometimes on purpose, sometimes not.  Military spending during World War Two and the beginning of the cold war contributed to the formation of the military-industrial complex.  New laws that proscribed stiff penalties for drug convictions during the 1980’s and early 1990’s led to an explosion in prison populations, which in turn helped create powerful prison guard unions that lobby against reducing prison terms. 

Not all government policy leads to wasteful or counter-productive interest groups (as I would categorize the examples above).  In a recent article in The Atlantic, Ronald Brownstein writes that regulation-based incentives dating back to the late 1970’s and early 1980’s has helped make Californian utilities leaders in energy efficiency. 

In California, the electric utilities operate what is in effect a government sanctioned monopoly.  But under California law, the profits the utilities earn has been “decoupled” from what they actually produce.  Instead, a state energy commission sets target revenues and profits for the utilities, as well as the rate paid by consumers.  They also estimate how much electricity should be required.  If the utility sells more than the board deems necessary, money is returned to customers (and the utility makes less money because their expenses were greater).  If they sell less electricity, rates are increased to maintain the same amount of revenue needed.

The result is that the utilities have no incentive to sell more electricity – in fact they have incentives to sell less because if they sell too much they will need to invest a lot more money in infrastructure.  The result is that the amount of electricity consumed per capita has not risen in the past 30 years, even as citizens use more and more electronics every day.  In 1973, Californians used 17% less electricity than the rest of the country.  Today they use 40% less.  True, California’s utilities are far from perfect.  California is the only state I know of that has had a significant number of rolling black-outs.  But I think that’s a price worth paying to produce billions of dollars in savings from reduced electric costs and reducing our carbon emissions.