Important work by cobrapost that illuminates high-powered incentives

The investigative journalism by cobrapost, their videos, and Monika Halan in Mint add up to an important story.

Most of us have enormous respect for the achievements of Axis Bank, HDFC Bank and ICICI Bank. But as Monika emphasises, there are also genuine problems there. We saw it first with the hard-driving mis-selling in recent years, particularly with ULIPs, and now we see it here, with staffpersons supporting illegal activities.

Ordinarily, a media outlet in India bringing such information out has to worry about brazen strong-arm tactics being deployed against them, such as filing of criminal cases. In this case, luckily, there is a certain decency about these three organisations which precludes such concerns. It is ironic that the Indian media vigorously reports on the misdeeds of civilised people, and tends to be silent about uncivilised people.

In India, most of us are reverential about the power of incentives. To make people work, we think, you have to have high powered incentives. We revere incentive packages, stock options, stock grants, which whip the staffperson into a frenzy of hard work.

Economists led this charge, starting with Jensen and Murphy, 1990. The notion that high powered incentives are a good thing came out of academia and went into the real world. But increasingly, it has become clear that there are problems. By 2004, Jensen and Murphy themselves were saying that we should be more circumspect about using high powered incentives.

A person facing high powered incentives tends to focus on one thing. There is an excessive pursuit of that one thing, and all other considerations tend to evaporate. Similarly, when there are quantitative goals alongside qualitative goals, high-powered incentives will generate a focus on quantitative goals and tend to crowd out qualitative goals. Employees of a bank that are given powerful incentives to hit targets for deposit growth (sacked if you don’t, given a 100% bonus if you do) are more likely to try to pull in that deposit growth by hook or by crook. If the internal controls of an organisation are weak, then employees are likely to achieve their targets by dubious means.

For all of us in India, coming from a backdrop of socialism and State, it is natural to have extreme hostility to the absence of incentive for a civil servant to do his job. We have seen how private organisations have triumphed by giving employees more incentive. But it’s easy for us to overdo this message. In many situations, I feel it’s better to go from no incentive to low-powered incentives, but not all the way to high powered incentives.

These issues are widely discussed in the global debate. When we transplant these ideas into India, a big difference lies in the weak governance environment. Super-charged employees in private firms seem to be willing to break laws in their pursuit of profit. Since CEOs weigh the costs and benefits of unethical behaviour, we may argue that when, in a weak governance environment, the expected punishment is small, an increase in the gains from unethical behaviour (through high-powered incentives) results in reduced fairplay.

This suggests two things. First, HR managers needs to be more sophisticated in how the objectives of an employee are defined. If we could be more nuanced in clarifying what the employee is to maximise, this could yield better results. The second issue is about internal controls. When internal controls are strong, they become a non-negotiable constraint within which growing sales or profit has to be done. Unfortunately, once the top managers of an organisation are really hard-driving, chasing growth and profitability, these kinds of niceties (of both kinds) tend to fall by the wayside.

One of the most important mechanisms through which we get high powered incentives is : an entrepreneur who manages a company with family members, and who has dominant shareholding. The one area where this gets us into the most trouble is: Finance. A series of papers that have analysed the Great Recession have found that financial firms where CEOs had more high powered incentives got into more trouble. I am a great advocate of less public sector and more private sector in finance, but we have to be cautious about high powered incentives e.g. those that go with dominant entrepreneurs in a family business.

A prominent example of this debate has been `financial market infrastructure institutions’ (FMIIs), a category that comprises organisations like exchanges, depositories, clearing corporations, all of which produce public goods for the financial system. In all these areas, the organisation is unique in that, alongside the goal of maximising profit, there is a regulatory function. This tiny handful of firms is unique, when compared with essentially any other part of capitalism, in that some government functions of regulation and supervision are placed in private, profit-maximising hands. High powered incentives to produce profit or valuation will lead to a dilution or worse of regulatory and supervisory functions. If profit-seeking owners/managers of these organisations under-emphasise or abuse the regulatory and supervisory functions in the quest for profit, this has far-ranging externalities. Failures of regulation and supervision at exchanges have given macroeconomic crises in India in 1992 and 2001. Hence, even though the revenues and profits of these firms is truly tiny on the scale of the economy, this conflict of interest is an important issue for policy makers.

Similarly, there has been a vigorous debate about entry by private banks. As a working approximation, we have to assume that RBI supervision is less than perfect. In this case, I feel that we should be quite circumspect about banks led by entrepreneurs.
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American Medicine is Sick

First, here’s this:

Cancer-busting chemotherapy can cause damage to healthy cells which triggers them to secrete a protein that sustains tumour growth and resistance to further treatment, a study said Sunday.

Researchers in the United States made the “completely unexpected” finding while seeking to explain why cancer cells are so resilient inside the human body when they are easy to kill in the lab.

They tested the effects of a type of chemotherapy on tissue collected from men with prostate cancer, and found “evidence of DNA damage” in healthy cells after treatment, the scientists wrote in Nature Medicine.

Of course, it should be fairly obvious in the first place that chemotherapy is going to have rather toxic effects on the body since it is rather toxic.  Thus, it should surprise no one that its effects are toxic.  This then begs the question of why Chemotherapy is so widely used in combatting cancer.  The answer, unsurprisingly, is that chemotherapy is incredibly profitable to doctors (specifically, oncologists).  As to why, this is the case, consider:

This unique payment system started years ago because Medicare and insurers wanted to save money by moving cancer treatments out of the hospital. But it has come under increasing scrutiny as prices for some cancer drugs skyrocketed to tens of thousands of dollars a year.

Consider also this story:

A tuberculosis vaccine in use for 90 years may help reverse Type 1 diabetes and eliminate the life- long need for insulin injections, say Harvard University researchers raising money to conduct large, human studies.

The vaccine, a weakened form of the tuberculosis bacteria, stimulates production of TNF, a cell-signaling protein that plays a role in cell death. With more TNF, the body can attack those harmful immune cells while leaving the rest of the body’s defenses intact. The vaccine is approved by the U.S. Food and Drug Administration for tuberculosis though it isn’t generally recommended for use in the U.S. The vaccine also is approved to fight bladder cancer. [Emphasis added.]

Faustman and her colleagues at Massachusetts General in Boston are working to get the vaccine to market. After their early findings in studies with mice, she said they tried to interest every major drugmaker in developing the vaccine as a possible cure for diabetes. All told her there wasn’t enough money to be made in a cure that used an inexpensive, generically available vaccine, Faustman said.

So now, she is trying to raise money to pay for the expensive larger human trials. Her lab so far has received $11 million of the $25 million needed to pay for the next stage of testing. All of the money is coming from private donors, the largest of which is the Iacocca Family Foundation.

Notice how, in both cases, government intervention creates perverse incentives that are harmful to those who are suffering from illnesses.  In the case of chemotherapy, Medicare wanted to control cancer treatment costs, and so urged doctors to administer medicine directly, which encouraged doctors to mark up drug costs and, in order to increase profitability, overprescribe, with apparently little concern for their patients.  In the latter case, the FDA has not yet approved a drug for use in combatting diabetes, even though that same drug is approved for other uses.

Furthermore, this doesn’t even begin to consider how farming subsidies impact what food is brought to market, nor does it consider how corporate law encourages the production of highly processed frankenfood, nor does it consider the myriad regulations governing (and in some cases outlawing) unprocessed food.  And there are even more interventions beyond this that encourage people to eat unhealthy food, which makes them sick and unhealthy, which is then treated with expensive poison drugs that tend to mask symptoms rather than address the underlying pathologies.

Anyway, it’s no wonder Americans are so sick and unhealthy. Their government is trying to poison them.

Welfare programs change behaviour

Many people like to envision worlds where the State will tax the rich and help “the needy” – this ranges from free health care to unemployment insurance to disability insurance, etc.

There are many problems with these schemes. One of them is the fact that people respond to incentives. We are not bricks, we are not stones, but men, and being men, we will optimise. When unemployment insurance is offered, people will try less hard to find a job, to acquire skills that will get them a job, to migrate to a place where jobs are more easily found, etc. When health care is free, people are more inclined to be fat or smoke or otherwise take less care of themselves. And so on.

Among economists, it’s considered obvious that people drive in a more rash manner when wearing a seat belt, but in the wider discourse, this raises hackles. When researchers found that drivers pass closer when overtaking cyclists wearing helmets as compared with overtaking bare-headed cyclists, economists were among the few who were not surprised. Laypersons generally recoil from the idea that the presence of a government giving out free open heart surgery increases obesity.

The first element of the behavioural change is lying and misrepresentation by citizens. When a government says it will give out disability insurance, people have an incentive to go to a civil servant and claim that they are disabled. I remember hearing a story from Holland, when a certain set of rules were constructed to give an early pension to the disabled, and policy makers had estimated that 1% of workers would be eligible for those benefits. In a few years, 10% of workers tried to claim these benefits, and front-line civil servants were placed in the difficult situation of having to identify the few genuinely disabled within the large pool that was claiming to be disabled.

The second layer is genuine changes in behaviour. Ljungqvist/Sargent have emphasised the damage caused by European-style welfare programs, which encourage or support withdrawal from the labour market. Some of these problems are now coming about with NREG. Migration out of villages is central to India’s future, but NREG is reducing the incentives of people to engage with the urban labour market and ultimately to leave.

I just came across an example of behaviour distorted by incentives that veers on the fantastical: An unemployed Austrian man sawed his foot off, to avoid being found fit enough to go back to work. We find it incredible that Aron Lee Ralson cut off his right arm (to avoid certain death). But sawing your foot off to avoid going back to work?

This is a colourful story and only an anecdote. The man is most likely a nutcase. It is nobody’s case that such extreme responses will come about on a large scale. The claim of the microeconomics literature is more limited: that on average, fairly significant behavioural changes come about in response to changes in the rules of the game. Through this, welfare programs have unintentional consequences that go far beyond those visible at the surface.

Politicians and bureaucrats in India like to roll out out more welfare programs. It would be useful to bring alternative perspectives on these questions, which are mainstream worldwide but are considered cutting edge in India: about the limited governance capacity of the State, about the fiscal crisis that the State faces, and about the behavioural changes induced by welfare programs. In this field, you may like to see a paper by Vijay Kelkar and me.

Why Collectivism Fails

In the first place, it is helpful to define collectivism and failure. Collectivism refers to any and all economic and political systems where goods and services are publicly owned and operated; it is also popularly known as communism and socialism, among other terms. Failure is defined as failing to satiate the maximum number of persons’ desires as feasible, or, more generally, failing to supply persons with their basic needs (healthy food, clothing in good repair, shelter from the elements).

There are many theories as to why collectivism fails, most of them having to do with incentive structures. This view is not necessarily wrong, but it is very limited, and does not account for the range of human emotions and motivations. Monetary incentives do impact human behavior; this is not in dispute. However, it is foolish to assert that human behavior is always and ever motivated by monetary incentives—as some economists seem wont to do—or that it is always a primary motivation. As such, it is helpful to look at the failure of collectivism more broadly.

One thing that is interesting about those who are more inclined toward the collectivist persuasion (henceforth called leftists) is that they are generally observed to be hypocrites, in the sense that they often demand collective action for something—say, welfare to help the poor—but do not themselves make any individual effort towards that end. More commonly, those of the leftist persuasion believe that their personal contribution to relieving the plight of the less-fortunate—however defined—is “raising awareness.” Thus, leftists often talk about helping the poor, in the name of raising awareness, but never themselves get around to actually helping the poor.

Ultimately, this is nothing more than status-mongering. Instead of actually doing something, the collectivists live in a world of ideals, wherein it is better (read: higher-status) to signal one’s affiliation to an ideal than to actually live by it. It is therefore better to preach selfless sacrifice in the name of helping others than to teach profit motive. While profit motive, as Adam Smith observed, can be a significant motivator, it is, in the eyes of leftists, a morally inferior motivator. Thus, one must call for selfless concern, and raise awareness for said type of concern. But one need not concern oneself with getting one’s hands dirty.

Thus, one potential explanation for the failures of collectivism is that a collectivist society places more emphasis on signaling group affiliation than actually getting things done. This stands in contrast to an individualist-oriented society, which by definition avoids group affiliation. The individualist society, then, has only personal accomplishment as a status signal, which strongly encourages productivity because the only way one has status is to create it for oneself. Collectivists, though, always try to appropriate others’ status for themselves. In essence, the collective identity enables some individual to credit for something even though said individuals have not actually done anything that can be meaningfully described as productive.

The collective political economy, then, is one based on higher-order status signaling, and not more direct (and productive) lower-order status signaling. As such, it is more likely to fail because most participants are too busy chasing status to make things. Basically, it’s better to signal status and identity than do actually do something.

Why Not Sell?

Alex Tabarrok, in reference to encouraging people to become organ donors:

I am not in favor of messing with the insurance system for this purpose but have argued for a more direct approach. Under what I call a “no-give, no-take” rule if you are not willing to sign your organ donor card you go to the bottom of the list should you one day need an organ. Israel recently introduced a version of no-give, no take which gives those who previously signed their organ donor cards points pushing them up the list should they need an organ transplant–as a result, tens of thousands of people rushed to sign their organ donor cards.

This doesn’t strike me as a difficult issue to solve. Open the market up, and allow people to buy and sell their organs. I realize that this sounds crude, and possibly exploitative to some. But if this increases the number of organ donations, and consequently the number of lives saved, wouldn’t it be worth it? Or must we insist on moral posturing at the expense of human life?

Here’s The Problem

No Child Left Behind requires all students to be proficient in reading and math by 2014. Obama’s action strips away that fundamental requirement for those approved for flexibility, provided they offer a viable plan instead. Under the deal, the states must show they will prepare children for college and careers, set new targets for improving achievement among all students, develop meaningful teacher and principal evaluation systems, reward the best performing schools and focus help on the ones doing the worst. [Emphasis added.]

The reason the college bubble exists is due in large part to the federal government’s actions, predicated on politicians’ assumptions that college is a universal good to be enjoyed by everyone. This is, of course, predicated on several fallacious assumptions, including the belief that a college education increases one’s knowledge, that a college education improves one’s intelligence, that a college education is either evidence of or brings improvement in one’s work ethic, and that there is a general correlative or causal link between a nation’s collective level of education and its economic output. As such, this continued emphasis on college will only lead to higher college costs, and have nothing to show for it.

Book Review

Tabarrok focuses on four policy areas in which changes could yield very positive results. He kicks off the short eBook by focusing first on patent reform, noting that many areas of patent coverage (software, technical processes e.g.) have low innovation costs and, as such, are not worthy of patent protection. In fact, his recommended patent reform is basically total abolition of all patents, save for medicine and a handful of other fields. This seems rather viable given that most inventions and innovations are generally cheap and likely inevitable. He also has a few short steps that would help as well, like requiring a functioning prototype and capping terms to seven or fourteen years depending on category.

He next turns his sights on to a prize system for innovation. His proposed policies are well-intentioned but naïve. He proposes that the government fund sizeable prizes (to the tune of millions or billions of dollars per prize) with specific goals—not methods—in mind. This should work in theory, but the fundamental problem with this method is that it fails to discern how the government would go about setting the most economic goals and prizes. This process could become highly politicized, as anything involving billions of federal dollars tends to. However, venture capitalists and innovation firms should take note of this recommendation and implement it.

Tabarrok closes his short book by looking briefly at education—both public and post-secondary. Regarding the former, he recommends reform. Why this is preferable to privatization is unstated, but perhaps that is beyond the scope of the book. One curious thing about is argument is how he claims that there is a correlation between high school graduation rates and GDP growth. While statistical analysis bears this out, it is worth noting that there is no proven causal relationship between the two. It could be that GDP growth causes increases in the rate of High School graduation as families become wealthier, and better able to secure leisure time for their children, thus reducing teenagers’ need to work.

It is worth pointing out, though, that public education in the US is crap, and is entirely too test-driven, thanks in large part to No Child Left Behind. Tabarrok doesn’t dwell much on this, which seems to be a bit of an oversight.Finally, Tabarrok turns his sights on to college education, noting that there is undoubtedly a college bubble and that there should thus be fewer college students. Government reform is recommended, since that is a source of the current malinvestment. Better education as to the benefits of a post-secondary education is also recommended, though this seems largely fruitless.

In all, this short book is a rather thought-provoking read. Readers are not likely to agree with all the answers, but the questions are worth mulling over. In fact, the questions the book asks make it worth the purchase. There is a lot to consider and debate, thanks to this book, and the answers Tabarrok provides are considerably less hackneyed than what has been heretofore seen. As such, the book is a recommended read.

Eliminate the Complexity

That’s my recommendation for the corporate tax:

Those advocating a cut in the corporate tax rate today generally ignore the tax on dividends, as well as many other provisions of United States and foreign tax law that may reduce the effective tax rate well below the statutory rate.

A recent study found that only 25 percent of the largest American corporations pay anywhere close to the statutory corporate tax rate of 35 percent on their earnings, while 40 percent pay less than half that rate.

Indeed, General Electric, the nation’s largest corporation, paid no federal corporate taxes in the United States in 2010, according to a report in The New York Times.

The sheer diversity of effective tax rates binding corporations—even though there is only supposed to one rate—suggests that the corporate tax rate is being used as a political tool. This perception is certainly encouraged by GE facing an effective rate of zero. If, as the current evidence suggests, the corporate tax rate is used as a political tool for punishing and rewarding certain corporations, then perhaps abolishing the corporate tax rate would be a good step.

While abolishing the corporate tax would not lead to massive economic growth, it would certainly be a step in the right direction. In the first place, corporations could actually focus on producing things instead of playing pointless political games. Furthermore, government costs could be slightly reduced—the natural result of reduced compliance requirements and the corresponding enforcement costs.

While corporate taxes do not apply to the vast majority of businesses, nor do they account for anything but a minor amount of tax revenue. However, this is no reason to accept an incredibly stupid, highly politicized tax system.

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When talking heads converge

The public finance wonk in me just loves this.  Just passing on what the CP had a few days ago actually.  Seems that even though everyone was talking about how important the film industry tax credit in Pennsylvania was to luring the mega Batman production to town, it seems that the producers did not even apply for the credit at all.

Note the UK’s Daily Mail has a piece just out all about the job impact of the Batman filming in Pittsburgh. They got the memo though, no mention of the film credit at least in that piece.  Note also the mention of Bloomfield’s own Paul Lumber.  The Home Depot PR department lost that one.

and just a random stray neuron… When everyone was getting excited last week about the Batman spotlight in the sky, I wondered if anyone ever tried anything similar with the old Zeiss projector?

A False Analogy

Robin Hanson makes a predictable mistake:

Similarly, the kinds of innovation activities and intellectual property rights that make sense depend on available institutions and technologies. I’m happy to admit that today intellectual property (IP) is not obviously a good idea. Such property can create large “anti-commons” transaction and enforcement costs that greatly raise the cost of combining old ideas into valuable new ideas. Such costs often outweigh the social benefits of the incentives to create IP, in order to sell it. Today, it is often better to rely on other social incentives to innovate, incentives that don’t require such expensive support.

But if true, this is a sad fact about our limited abilities, not a fundamental natural law or right. You have no fundamental right to enjoy the innovations produced by others without compensating them. You owe them, at least your gratitude. Yes for now it may be best to let you take innovations freely without paying, since the alternative seems too expensive. But you have no right to expect that situation to last forever, any more than ranchers had a right to expect they could forever let their animals trample nearby farms.

The problem with Hanson’s comparison of IP rights to real property rights is that intellectual production is not tangible whereas real property is, and one can adapt another’s idea without in any way diminishing its usage by its originator. As Jefferson aptly observed centuries ago, as it is possible to use another’s candle to light one’s own without diminishing the other’s flame, so too can one use another’s idea as one’s own without diminishing the other’s usage of their idea. Taking another person’s ideas and using them does not any way prevent him from using his own ideas in whatever way he sees fit. Since using another’s ideas does not trample upon his rights, it is absurd to compare this to cows trampling a neighbor’s fields. Using an idea is not inherently deprivatory in the way that using property is, and so the comparison is false.
At any rate, since ideas are not tangible, there is no conceivable limit to their spread save for demand. Basically, demand, not supply, is the limiting factor for the production of any given idea and, as such, there is no need for prices or any other limitation of ideas. Prices indicate scarcity relative to demand, and attempting to attach prices to ideas is essentially an attempt to attach scarcity to ideas. Since there are an infinite number of ideas and production costs of ideas are close to nil (or at least so close to infinity and nil respectively that the upper bound makes a price schedule impossible), the only effect that bringing costs to ideas would be to limit something that is naturally unlimited.
Also, note that Hanson’s claims that “you have no fundamental right to enjoy the innovations produced by others without compensating them” and “you owe them, at least your gratitude” are both spurious. The first is false, but only because of how he qualifies it. He is correct in saying that no one has the right to enjoy the innovations of others. No one has the right to anything save for life, liberty, the pursuit of property, and any derivatives thereof. But it does not stand to reason that anyone deserves to be paid for what they produce, whether it be an idea or a physical object. Quite simply, no one has a right to an income of any sort. If you wish to be paid, convince consumers that you deserve it, whether it be on the technical merits of your product or whether it be on the ease of purchase relative to the cost of piracy. In keeping with this, if one does not have a right to income for producing something, then one certainly does not deserve gratitude either. Again, if a producer wants something from consumers, he must make or do something that causes consumers to respond favorably.
As can be seen, Hanson’s argument is riddled with plenty of intellectual errors, leading to erroneous conclusions. He would do well to simply acknowledge that IP is a myth, and that no one is inherently deserving of anything just because they happened to produce something.