It’s the Incentives, Stupid

In reading this article, thanks to Dave Schuler for the pointer (you can read Dave’s take on the article here), there is this interesting paragraph,

On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.

I can’t help but feel this is the wrong answer. The right answer is to take these large firms and break them up. If they are too big to fail, then create smaller firms that can be allowed to fail. Obviously this would have to take place after dealing with the current crisis.

Further, I think a review of regulations and laws would be in order to see if the government has done anything to promote this result of “too big to fail”. If it is found that this is the case, change those regulations and laws to help ensure it doesn’t happen again.

And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.

Well duh. Anyone who has any familiarity with the literatures on time inconsistency of discretionary policy or economic incentives would see how bailouts are a classic example. “Don’t get too big to fail and don’t take excessive risks…we will not bail you out.” The senior management at these firms realize that is and empty threat and proceed to expand and take greater and greater financial risks knowing that the downside will be covered by the government and any profits they get to keep.

I do think the name of the paper by Akerlof and Romer (“Looting”) is a bit unfortunate. Sure that is one way to describe the situation, but another is that we’ve set up a piss poor incentive structure via laws, regulations, and discretionary policy that has lead to the current situation. In other words, the looters were behaving in an entirely rational way given the situation they were in. Yes, we can be angry at the looters, but what about the people that created that situation to begin with?

At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

And therein lies the problem. As good as Mr. Leonhardt’s article is he still misses the larger point. When the government has discretionary powers, when politicians are self-interested and are subject to periodic popular elections you will have a hard time with “looting”. I’m not saying the government should have no role, but that we have to consider incentives, and politicians as makers of the rules of the game and being self-interested may not always respond in ways that will prevent these less than optimal outcomes. Kydland and Prescott, the two economists who put forward the idea of time inconsistency suggested policy rules rather than discretion. The idea that rules, even fairly complex ones, would at least provide a clear path and reduce uncertainty. I think this is right, for example consider this comment by Luigi Zingales,

The main difference between Keynes and modern economics is the focus on incentives. Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economics base all their analysis on incentives. In 1998, when the Fed coordinated the bail-out of Long Term Capital Management, it did not care about the impact this decision would have on the incentives to take risk and price liquidity appropriately. When Mr. Bernanke engineered the bail-out of Bear Stearns, he did not care about the impact this decision would have on the other investment banks’ incentives to raise equity capital at rock-bottom prices. When he changed his position twice in the space of two days, letting Lehman fail, but bailing out AIG, he did not care about the impact it would have on investors’ confidence and incentives to invest. It is this erratic behavior that has spooked the market and created the current economic crisis: in a recent survey 80% of Americans declare that they are less confident of investing in the market as a result of the way the government has intervened.

During Bill Clinton’s presidential election campaign one of the slogans was, “It’s the economy, stupid.” That was a brilliant slogan during a time when the economy was in recession. However, in economics on thing most economists now agree on is that incentives matter. They matter a lot. Today the slogan should be, “It’s the incentives, stupid.” I don’t feel this is given its due by the Obama Administration.

FILED UNDER: Economics and Business, Government, , ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Dave Schuler says:

    IMO there’s a mutually reinforcing relationship among Big Government, Big Finance, Big Business, and Big Labor. For one thing bureaucrats prefer dealing with a small number of big institutions rather a large, chaotic bunch of small ones. And, coincidentally, big business and finance provide much nicer opportunities for jobs after government.

    I honestly don’t see any practical way to correct that and if the hypothesis of looting is correct we’re going to see one titanic collapse after another.

  2. Steve Verdon says:

    I honestly don’t see any practical way to correct that and if the hypothesis of looting is correct we’re going to see one titanic collapse after another.

    If this is correct then it underscores a systematic failure of discretionary government.

  3. Dave Schuler says:

    It is not, perhaps, unreasonable to conclude, that a pure and perfect democracy is a thing not attainable by man, constituted as he is of contending elements of vice and virtue, and ever mainly influenced by the predominant principle of self-interest.

  4. legion says:

    The right answer is to take these large firms and break them up. If they are too big to fail, then create smaller firms that can be allowed to fail.

    I agree completely, Steve. A firm that’s “too big to fail” is _not_ a plus for a capitalist society. Such firms are – as we see right now – a clear economic threat to the societies they are allowed in; they should be prevented for the common good just like monopolies are. But don’t expect that alone to keep this from happening again. One of the major reasons the current banking collapse occurred was less insufficient regulation, and more lackadaisical enforcement of the regulations that already existed. Take a look at the current crop of Ponzi scammers – Bernie Madoff took in billions of dollars, never bought a single share with it, and the “business-friendly” SEC (despite several explicit tips) chose not to investigate. Take a look at the clearly corrupt and broken ratings industry that was supposed to independently establish risk, but was completely in the tank to the firms that paid their bills.

    Hell, a basic economic principle is that in fat times, you sock away a little extra to cover you during the lean times. And yet from 1996 to 2006 (that was when the stock market was going up, never to come back down, remember?), the FDIC apparently decided – despite a pretty clear Congressional requirement to do so – not to collect dues from many banks, so they’re really short of cash now to cover the ones that are failing.

    All the regulation in the world won’t help against that kind of attitude in government.

  5. Raoul says:

    A couple of observations: Too big to fail may be a problem but also when companies get bigger they tend to become more efficient- perhaps this is one of the many contradictions of capitalism. Blaming the government for lack of oversight is like blaming the police when bank robbers rob-it is too easy and incorrect. It is almost a self-fulfilling prophecy: any action taking by any entity can always be blamed on government because the government allowed it to happen. I seriously doubt that companies were contemplating their own demise and that they were looking at government to bail them out if necessary. After all, it was these companies that mostly created their own regulatory scheme.

  6. Rick DeMent says:

    The right answer is to take these large firms and break them up. If they are too big to fail, then create smaller firms that can be allowed to fail.

    Well I agree with this, but this idea is regulation. Any legislative effort to deal with this will be regarded by the self interested politicians you decry as “interference in the free market”. I get pretty cranky hearing about whether or not we need more or less regulation in the market. Markets themselves are created by regulation on all levels from two 5th graders swapping bubblegum cards all the way up to global trade agreements. More or less regulation is never the point, it’s creating regulation that does what you want, not what will allow one group or another a loophole to exploit.

    Heck we can’t even agree on who legislation is supposed to protect. Shareholders? Consumers? Labor? Commerce? All of these groups have competing interests and many people belong to most of these groups at the same time. I find it funny that the “looters” in Atlas Shrugged were always portrayed as “consumers and labor” when the reality is that more $$$ has been “looted” by the corporatists and the uber wealthy then all the welfare queens and labor thugs put together.

    anti-trust notions put in place by TR have been gutted precisely because government increasingly has served big business almost to the exclusion of any other group (and this was true in Ayn Rands Day as well she was just too naive or too co-opted to recognize it).

    Not only are businesses to big to fail but they are too big for the government to do anything about. I mean when legislators need to get “buy-in” from Citigroup to pass ledgislation what does that tell you.

    My biggest criticism of Steve’s view is that he has the fundamental problem wrong. It not that Government is too strong and stupidly pushes business around, it’s that government is too weak to pass effective legislation for fear their campaign money will dry up. Because it will. Every once in a while (after major crisis, scandal) government can pass some muddy, stupid bill that will attempt to address real problems, but invariably the legislation will be written in such a way that the biggest companies will not really be effected and the smaller guys will bear the brunt.

  7. Dave Schuler says:

    Too big to fail may be a problem but also when companies get bigger they tend to become more efficient

    There’s no reason to believe that’s true for every company or in every industry. Do you have a concrete, non-hypothetical example?

    I think, contrariwise, that companies become very large almost exclusively through government intervention and the large ones tend to be inefficient due to deadweight loss.

  8. Raoul says:

    DS: When I used the word “tend” it was not meant to suggest an absolute. As to examples- just about every M&A- including this week- Merck & Schering-Plough.

  9. C Stanley says:

    Blaming the government for lack of oversight is like blaming the police when bank robbers rob-it is too easy and incorrect.

    It’s not always incorrect though. Sometimes the police are to blame if they were hanging out at the donut shop while the heist occurred- which seems to be what was going on with the SEC in recent years.

  10. Raoul says:

    CS: We are getting close to reverse Panglossian territory- where every action simply happens and when it happens it must be the fault of someone or something- that’s not to say there may be instances of contributory negligence- and from what I read, the SEC is partly complicit on the Madoff Ponzi scheme- but ultimately, the blame lies on the perps and no matter what regulatory scheme we develop there will always be perps. I so support robust oversight but at the same time I recognize this is no panacea.

  11. C Stanley says:

    Agreed, Raoul- I just think it’s important to recognize corrupt or incompetent oversight in addition to the culpability of the perps if we’re going to have any hope at all of a functional system.

  12. odograph says:

    Further, I think a review of regulations and laws would be in order to see if the government has done anything to promote this result of “too big to fail”. If it is found that this is the case, change those regulations and laws to help ensure it doesn’t happen again.

    I get where you are coming from, but I think it wasa more likely a missing strategy in regulation. Government bought Value At Risk etc. (or pretended to), and so did not have any deeper or more conservative strategy to protect against systemic risk.

    I’m pretty sure to follow this through to ensuring that no publicly insured company is too big to fail is going to require real policing, including of future financial innovations.

  13. Steve Verdon says:

    Blaming the government for lack of oversight is like blaming the police when bank robbers rob-it is too easy and incorrect.

    Thankfully that isn’t really what I’m doing. It isn’t merely a failure of the regulator agencies, it is that regulatory discretion and politicians acting with discretion have set up incentives to engage in this behavior.

    To use your analogy the cops are not only holding the doors for the robbers, they are driving the get-away-car.

  14. Drew says:

    DeMent posted it this way:

    “I mean when legislators need to get “buy-in” from Citigroup to pass ledgislation what does that tell you.

    My biggest criticism of Steve’s view is that he has the fundamental problem wrong. It not that Government is too strong and stupidly pushes business around, it’s that government is too weak to pass effective legislation for fear their campaign money will dry up.”

    After my belly laughing session ended:

    When you finally exit Kansas, Dorothy, you will understand that the very nature of government and its processes means that your first paragraph inevitably follows your second.