Tuesday, 14 June 2011

Incentives, belief in incentives, the left, the right and moral hazard

Several old political problems turn out to be based on the same underlying question. Here are some examples.

Should we tax the rich more? The "yes" argument says rich people need the money less (that is, poor people's utility from wealth is higher), and wealth partly arises from luck and therefore is a legitimate target for taxation. The "no" argument says that if people expect to be taxed when they're rich (and receive handouts when they're poor) they have less incentive to earn wealth, and therefore less wealth will be produced by society.

Should we pay higher unemployment benefits? The "yes" argument: people are unemployed through no fault of their own; their spending will support the economy; it's moral to share resources with the poor; if it happened to you, you'd want benefits too. The "no" argument: it gives people an incentive not to work; it requires confiscation of resources from hardworking people to pay those who are (for whatever reason) not working; we don't know whether people are unemployed only through bad luck or whether their behaviour and choices contributed to it.

Should Greece default on its debts? The "yes" argument says its people need the money more than international bond investors, and if a default is inevitable there's no point wasting cash now if the consequences are going to come anyway. The "no" argument says debts should be honoured, and that Greece won't be able to borrow in the future if it defaults now.

Should we target higher inflation? The "yes" argument says inflation is bad for rentiers (who live off past earnings) and good for people currently earning; therefore it increases GDP - and what's more, helps the poor, who need it more, at the expense of the rich. The "no" argument says not all rentiers are wealthy, and not all wage-earners are poor, so we might be hurting the wrong people; and more fundamentally, inflation reduces the incentives to invest and save money which will lead to bad results in the long run.

Should we treat people better in prison? The "yes" argument says it's humane to do so, and it results in better outcomes for prisoners once they're released, and less repeat offending. The "no" argument says that if we let people believe prison isn't so bad, the incentives to commit crime are distorted and there will eventually be more crime.

Should we bail out struggling banks (or General Motors, or the airlines back in the day when they needed it?) The "yes" argument says that if we don't, there will be economic chaos in the short term, a major recession, and lots of people thrown out of work. The "no" argument says if we do, banks will come to believe they will always be rescued, and will take more risks in the future; we must set an example so we are better off in the future.

In all of these debates, the "no" argument is essentially this: if we act expediently now, people will come to believe we will act expediently in the future. And this will reduce their incentive to earn money, stay in a job, lend to Greece, save money, act lawfully, or avoid excessive risks - all forms of "good behaviour". The "yes" people want us to do what's best right now; the "no" people want us to make a sacrifice now in the hope of creating the right incentives for a better future.

The "no" strategy is a risky one. In all cases it involves definite costs today. But will it create strong enough incentives to bring those promised benefits tomorrow? The answer depends on how people's beliefs are formed today, because those beliefs are what influence tomorrow's behaviour.

The "yes" strategy is also risky, because it cashes in benefits today without any certainty about the impact on tomorrow. At least we get some definite benefits today, but the long-term costs might be much greater.

We'd quite like to have it both ways: have people act as if the incentives for good behaviour are powerful and sharp, but when things go wrong, do what's convenient and somehow avoid changing anyone's future behaviour. I guess this dilemma will be familiar to parents who love their children and don't want to cause them pain, but believes punishment is sometimes necessary to help them know how to behave in future.

This lays open an unstated question underlying the old debate between economists and other behavioural scientists: "do people act purely according to incentives?" In fact, even if they do act according to the incentives they think they face, what beliefs do they have about those incentives? We don't know enough about how beliefs are formed to give a clear answer to this question. But the answer is critical. I would argue that many of our beliefs about those incentives are formed at an early age and are very hard to change by the mere application of evidence. Evidence clearly has some impact - we don't really know how much - but most psychological research shows that people put less weight on evidence than they statistically should. So maybe we can act for today with impunity, because people will mostly ignore the bailouts/taxes/whatever and the impact on tomorrow will be minimal? That feels a bit too easy.

You may have noticed that the "yes" position in all of the above cases is the left-wing or liberal choice; the "no" argument is the right-wing or conservative policy. The particular yes/no framing is simply a matter of how I have asked the question, but the underlying relationship is genuine: the left-wing position is about what's best for today, while the right-wing position is about setting the best example for tomorrow. That is an unusual characterisation of the political spectrum, but it fits with the traditional constituency-based descriptions of left versus right: rich people can more easily afford to defer gratification until tomorrow, so they're more likely to be right wing.

Or let's put it another way. The left believes that if people are going to behave well, they will do so regardless of (or with little regard to) material incentives. The right believes the incentives are really important. (You can see this same division in the debate over competition in the NHS, or privatisation and market discipline in general.) We might draw the conclusion that people project their own self-image onto everyone else - and therefore left-wingers believe they are not influenced by incentives, while right-wingers believe themselves to be guided only by incentives. But that's also too simplistic.

Yet another way to ask this question: Does moral hazard really exist? Do we behave badly when we have an incentive to do so? To some extent, sure. But how much? Crudely, the right believes there is a lot of moral hazard, the left thinks there is only a little. There have been a few experiments on this but I don't think they answer the question clearly. Maybe it is unknowable.

11 comments:

PunditusMaximus said...

This seems something of a forced dichotomy; it seems like you're leaving out some of the arguments for each side to create your desired result.

The "yes" argument for taxing the rich includes the idea that increasing inequality is bad for decisionmaking in the long-term. The "no" argument for taxing the rich includes the idea that the wealthy are the primary drivers of immediate job creation.

The "yes" argument for unemployment benefits includes the idea that consumption smoothing avoids weird decisions regarding saving in the long term, as well as job-match concerns. The "no" argument includes the idea that the unemployed should be spurred to look harder for jobs this very instant.

The "yes" argument for Greece includes the idea that we're all worse off if the people actually responsible for Greece's problems -- bankers and the financial community -- remain unpunished. The "no" argument includes the idea that a Greek default would trigger an immediate financial collapse.

You can find similar aspects for the rest of the arguments, with the exception of the bank bailout one. The bank bailout position is neither liberal nor conservative -- you can find people arguing both directions on both sides. That one's outside the liberal/conservative split. This is because it's an elite/middle split, and there are elites and middles in both camps.

I'm sorry, but I don't buy the condescending "conservatism is for grownups" baseline thesis. If what you are saying were true, then we'd see poor liberal areas doomed by their policy choices in the long term, and rich conservative areas vindicated by their successful efforts. In fact, we see the precise opposite. The conflict isn't between now and later. It's between liberals and conservatives, both of whom have visions for now and visions for later.

Leigh Caldwell said...

Thanks for the comment.

I didn't mean to imply "conservatives are grownups, liberals are not". The distinction isn't just between whether we act purely for now, or for later. It's specifically a difference in how people think about shaping future incentives.

Indeed, the yes/no distinctions I've picked are not clear-cut divisions between left and right. You give some good counterexamples. But I think the broad arguments on each of these issues do roughly fit a left-right distinction, and the preponderance of opinion about how current actions shape future incentives is in the direction I've suggested.

PunditusMaximus said...

I definitely agree that people think differently about incentives, but I don't think it's a now/later thing.

In general, liberals believe that the vast majority of ordinary people can be fairly easily coaxed to do more or less the right thing, and conservatives believe that they can really only be punished into it.

So liberals believe in no-fault divorce, because they believe that families will re-form, with some other incentives elsewhere. Conservatives believe people need to be coerced into maintaining stable households. Both sides believe that there should be reasonably stable households, now and later. It's about what kinds of incentives they view as effective.

PunditusMaximus said...

Amusingly, this dichotomy seems to be reversed with regard to the wealthy and powerful -- liberals tend to view them as the folks who need the most oversight, while conservatives view them as the people who need the least. But, again, both are thinking of now and in the future.

Leigh Caldwell said...

yes, I agree with those points (pretty much). Maybe my point is a bit narrower than I originally thought: it is simply about differing belief in the strength of moral hazard effects.

Nicki said...

Reading this post and PunditusMaximus' comments, I thought of these two articles I recently read (among other things):

Study finds left-wing brain, right-wing brain

Study: Conservatives have larger ‘fear center’ in brain

I'd be interested to know what both of you think.

norm said...

The Greek bonds are a perfect example of Moral Hazard. They were priced way below their level of risk and any idiot who bought them needs a good haircut. The Germans are out of their minds trying to stop a Greek default and are risking way more damage to their own tax payers by bailing out a boat that is sitting on the bottom of the river bed. Risk has a price. This mess we are digging out of is based on our lack of respect for the price of risk-now, right or left, I have no idea but the barber is in.

Anonymous said...

And I think there is a major difference in the Yes/No camp here. The Yes pretty much do it using other people's money.
Steven

Anonymous said...

I guess that many would say that I am rich. I was a council house kid and an 11+ failure. I left school in 1955 with one 'O' level (maths which the headmaster said I didn't deserve).

I then did one year Telecomms - should have been 3 evenings/week but excused maths with 'O' level - failed 'cos I forgot to turn up for the maths exam.

Then did 5 years one afternoon + evening Radio + TV servicing(worked in a shop so half day at college was instead of half day off). Passed final exams.

Then did 5 years ONC and HNC 3 evenings/week - one year was 4 evenings 'cos I found 1st year HNC maths difficult so went to another college to do the same subject again (that is, the same maths unit on 2 evenings/week).

Then did 2 years evenings for endorsements for Institute membership MIERE (later MIEE) and CEng.

I bought our house and have done many projects outside of working hours. I built a VDU when they were £2,000 which was not far off my annual salary at that time - I sold it as a design project but it could have been £900 of rubbish if I couldn't get it to work.

I built two houses with a lot of my own labour for the unskilled work - and a bungalow where I did the vast majority of the work (I did a 5-week one evening/week 'build-a-garden-wall' course then built a bungalow - and I did all the brickwork. The bungalow took two years.

Some would say that I have been mean - I prefer the word 'careful'. We have always lived within our income - camping holidays when the kids were young.

The only new vehicle I have bought was a mini-van £387-10 shillings and ran it for 18 years - a car would have been £60 more with purchase tax.

I have saved when I could and bought my first share nearly 50 years ago.

I know that the state will get a fairly big lump when I drop off the end of this conveyor belt of life - should I be taxed now for the careful management of my finances over the years?

And what will the state do with the money - generous pensions for civil servants, teachers, police officers, firemen?

Or will they send my tax to Greece to help their finances?

The London Fire Service spend more money on pensions than they do for salaries of those currently working.

I know a deputy chief constable - salary well over £100,000. If the last promotion brought a £10,000/year increase then they will pay another £1,100/year in pension contributions - £3,300 if they then retire after 3 years. The pension will be about 2/3 final salary so another £2,200/year for the last promotion.

If they then live 30 years - a reasonable probability - then the extra pension is £66,000 - not bad for an extra £3,300 contribution towards the cost of their pension. And should I be taxed to pay that?

I know that youngsters today are getting a raw deal with university tuition fees and expensive housing but will my taxes be used to help them or will it go to those who are already doing well out of the system? I expect to help my grandchildren get onto the housing ladder in the near future.

I have always paid taxes due, and I could consider moving to Gibralter if I thought that the state was being too gready.

Apologies for the ramble, but I think that it is important to recognise that some are well off from their own efforts and restraint in their spending - we weren't born into wealth.

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