Naked Economics: Undressing the Dismal Science pdfdrive com

Wealth of Nations: “It is not from the benevolence of the butcher, the brewer, or
the baker that we expect our dinner, but from their regard to their own interest.”
Bill Gates did not drop out of Harvard to join the Peace Corps; he dropped out to
found Microsoft, which made him one of the richest men on the planet and
launched the personal computer revolution in the process—making all of us
better off, too. Self-interest makes the world go around, a point that seems so
obvious as to be silly. Yet it is routinely ignored. The old slogan “From each
according to his abilities, to each according to his needs” made a wonderful folk
song; as an economic system, it has led to everything from inefficiency to mass
starvation. In any system that does not rely on markets, personal incentives are
usually divorced from productivity. Firms and workers are not rewarded for
innovation and hard work, nor are they punished for sloth and inefficiency.
How bad can it get? Economists reckon that by the time the Berlin Wall
crumbled, some East German car factories were actually destroying value.
Because the manufacturing process was so inefficient and the end product was
so shoddy, the plants were producing cars worth less than the inputs used to
make them. Basically, they took perfectly good steel and ruined it! These kinds
of inefficiencies can also exist in nominally capitalist countries where large
sectors of the economy are owned and operated by the state, such as India. By
1991, the Hindustan Fertilizer Corporation had been up and running for twelve
years.
3
Every day, twelve hundred employees reported to work with the avowed
goal of producing fertilizer. There was just one small complication: The plant
had never actually produced any salable fertilizer. None. Government
bureaucrats ran the plant using public funds; the machinery that was installed
never worked properly. Nevertheless, twelve hundred workers came to work
every day and the government continued to pay their salaries. The entire
enterprise was an industrial charade. It limped along because there was no
mechanism to force it to shut down. When government is bankrolling the
business, there is no need to produce something and then sell it for more than it
cost to make.
These examples seem funny in their own way, but they aren’t. Right now, the
North Korean economy is in such shambles that the country cannot feed itself,

---

nor does it produce anything valuable enough to trade to the outside world in
exchange for significant quantities of food. The nation is on the brink of famine,
according to diplomats, United Nations officials, and other observers. This mass
starvation would be a tragic repeat of the 1990s, when famine killed something
on the order of a million people and left 60 percent of North Korean children
malnourished. Journalists described starving people eating grass and scouring
railroad tracks for bits of coal or food that may have fallen from passing trains.
In the United States, there is a great deal of hand-wringing about two energy-
related issues: our dependence on foreign oil and the environmental impact of
CO
2
emissions. To economists, the fix for these interrelated issues is as close to
a no-brainer as we ever get: Make carbon-based energy more expensive. If it
costs more, we will use less—and therefore pollute less, too. I have powerful
childhood memories of my father, who has no great affection for the
environment but could squeeze a nickel out of a stone, stalking around the house
closing the closet doors and telling us that he was not paying to air-condition our
closets.
Meanwhile, American public education operates a lot more like North Korea
than Silicon Valley. I will not wade into the school voucher debate, but I will
discuss one striking phenomenon related to incentives in education that I have
written about for The Economist.
4
The pay of American teachers is not linked in
any way to performance; teachers’ unions have consistently opposed any kind of
merit pay. Instead, salaries in nearly every public school district in the country
are determined by a rigid formula based on experience and years of schooling,
factors that researchers have found to be generally unrelated to performance in
the classroom. This uniform pay scale creates a set of incentives that economists
refer to as adverse selection. Since the most talented teachers are also likely to
be good at other professions, they have a strong incentive to leave education for
jobs in which pay is more closely linked to productivity. For the least talented,
the incentives are just the opposite.
The theory is interesting; the data are amazing. When test scores are used as a
proxy for ability, the brightest individuals shun the teaching profession at every
juncture. The brightest students are the least likely to choose education as a
college major. Among students who do major in education, those with higher
test scores are less likely to become teachers. And among individuals who enter
teaching, those with the highest test scores are the most likely to leave the
profession early. None of this proves that America’s teachers are being paid
enough. Many of them are not, especially those gifted individuals who stay in
the profession because they love it. But the general problem remains: Any

---

system that pays all teachers the same provides a strong incentive for the most
talented among them to look for work elsewhere.
Human beings are complex creatures who are going to do whatever it takes to
make themselves as well off as possible. Sometimes it is easy to predict how that
will unfold; sometimes it is enormously complex. Economists often speak of
“perverse incentives,” which are the inadvertent incentives that can be created
when we set out to do something completely different. In policy circles, this is
sometimes called the “law of unintended consequences.” Consider a well-
intentioned proposal to require that all infants and small children be restrained in
car seats while flying on commercial airlines. During the Clinton administration,
FAA administrator Jane Garvey told a safety conference that her agency was
committed to “ensuring that children are accorded the same level of safety in
aircraft as are adults.” James Hall, chairman of the National Transportation
Safety Board at the time, lamented that luggage had to be stowed for takeoff
while “the most precious cargo on that aircraft, infants and toddlers, were left
unrestrained.”
5
Garvey and Hall cited several cases in which infants might have
survived crashes had they been restrained. Thus, requiring car seats for children
on planes would prevent injuries and save lives.
Or would it? Using a car seat requires that a family buy an extra seat on the
plane, which dramatically increases the cost of flying. Airlines no longer offer
significant children’s discounts; a seat is a seat, and it is likely to cost at least
several hundred dollars. As a result, some families will choose to drive rather
than fly. Yet driving—even with a car seat—is dramatically more dangerous
than flying. As a result, requiring car seats on planes might result in more
injuries and deaths to children (and adults), not fewer.
Consider another example in which good intentions led to a bad outcome
because the incentives were not fully anticipated. Mexico City is one of the most
polluted cities in the world; the foul air trapped over the city by the surrounding
mountains and volcanoes has been described by the New York Times as “a
grayish-yellow pudding of pollutants.”
6
Beginning in 1989, the government
launched a program to fight this pollution, much of which is caused by auto and
truck emissions. A new law required that all cars stay off the streets one day a
week on a rotating basis (e.g., cars with certain license plate numbers could not
be driven on Tuesday). The logic of the plan was straightforward: Fewer cars on
the road would lead to less air pollution.
So what really happened? As would be expected, many people did not like the
inconvenience of having their driving days limited. They reacted in a way that
analysts might have predicted but did not. Families who could afford a second

---

car bought one, or simply kept their old car when buying a new one, so that they
would always have one car that could be driven on any given day. This proved to
be worse for emissions than no policy at all, since the proportion of old cars on
the road went up, and old cars are dirtier than new cars. The net effect of the
policy change was to put more polluting cars on the road, not fewer. Subsequent
studies found that overall gas consumption had increased and air quality did not
improve at all. The policy was later dropped in favor of a mandatory emissions
test.
7
Good policy uses incentives to some positive end. London has dealt with its
traffic congestion problems by applying the logic of the market: It raised the cost
of driving during the hours of peak demand. Beginning in 2003, the city of
London began charging a £5 ($8) congestion fee for all drivers entering an eight-
square-mile section of the central city between 7:00 a.m. and 6:30 p.m.
8
In 2005,
the congestion charge was raised to £8 ($13), and in 2007, the size of the zone
for which the fee must be paid was expanded. Drivers are responsible for paying
the charge by phone, Internet, or in selected retail shops. Video cameras were
installed in some 700 locations to scan license plates and match the data against
records of motorists who have paid the charge. Motorists caught driving in
central London without paying the fee are fined £80 ($130).
The plan was designed to take advantage of one of the most basic features of
markets: Raising prices reduces demand. Raising the cost of driving discourages
some drivers and improves the flow of traffic. Experts also predicted an increase
in the use of public transit, both because it is a cheap alternative to driving, but
also because buses would be able to move more quickly through central London.
(Faster trips lower the opportunity cost of taking public transit.) Within a month,
the results were striking. Traffic fell 20 percent (settling after several years at 15
percent lower). Average speed in the congestion zone doubled; bus delays were
cut in half; and the number of bus passengers climbed 14 percent. The only
unpleasant surprise was that the program had such a significant deterrent effect
on car traffic that revenues from the fee were lower than expected.
9
Retailers
have also complained that the fee discourages shoppers from visiting central
London.
Good policy uses incentives to channel behavior toward some desired
outcome. Bad policy either ignores incentives, or fails to anticipate how rational
individuals might change their behavior to avoid being penalized.
The wonder of the private sector, of course, is that incentives magically align

---

themselves in a way that makes everyone better off. Right? Well, not exactly.
From top to bottom, corporate America is a cesspool of competing and
misaligned incentives. Have you ever seen some variation of the sign near the
cash register at a fast-food restaurant that says, “Your meal is free if you don’t
get a receipt. Please see a manager”? Does Burger King have a passionate
interest in providing a receipt so that your family bookkeeping will be complete?
Of course not. Burger King does not want its employees stealing. And the only
way employees can steal without getting caught is by performing transactions
without recording them on the cash register—selling you a burger and fries
without issuing a receipt and then pocketing the cash. This is what economists
call a principal-agent problem. The principal (Burger King) employs an agent
(the cashier) who has an incentive to do a lot of things that are not necessarily in
the best interest of the firm. Burger King can either spend a lot of time and
money monitoring its employees for theft, or it can provide an incentive for you
to do it for them. That little sign by the cash register is an ingenious management
tool.
Principal-agent problems are as much a problem at the top of corporate
America as they are at the bottom, in large part because the agents who run
America’s large corporations (CEOs and other top executives) are not
necessarily the principals who own those companies (the shareholders). I own
shares in Starbucks, but I don’t even know the CEO’s name. How can I be sure
that he (she?) is acting in my best interest? Indeed, there is ample evidence to
suggest that corporate managers are no different from Burger King cashiers—
they have some incentives that are not always in the best interest of the firm.
They may steal from the cash register figuratively by showering themselves with
private jets and country club memberships. Or they may make strategic decisions
from which they benefit but shareholders do not. For example, a shocking two-
thirds of all corporate mergers do not add value to the merged firms and a third
of them leave shareholders worse off. Why would very smart CEOs engage so
often in behavior that seems to make little financial sense?
One partial answer, economists have argued, is that CEOs benefit from
mergers even when shareholders are left with losses. A CEO draws a lot of
attention to himself by engineering a complex corporate transaction. He is left
running a bigger company, which is almost always more prestigious, even if the
new entity is less profitable than the merged companies were when they were on
their own. Big companies have big offices, big salaries, and big airplanes. On the
other hand, some mergers and takeovers make perfect strategic sense. As an
uninformed shareholder with a large financial stake in the company, how do I
tell the difference? If I don’t even know the name of the CEO of Starbucks, how

---

can I be sure that she (he?) is not spending the bulk of her day chasing attractive
secretaries around her office? Hell, this is harder than being a manager at Burger
King.
For a time, clever economists believed that stock options were the answer.
They were supposed to be the CEO equivalent of the sign near the cash register
asking if you received your receipt. Most American CEOs and other important
executives receive a large share of their compensation in the form of stock
options. These options enable the recipient to purchase the company’s stock in
the future at some predetermined price, say $10. If the company is highly
profitable and the stock does well, climbing to say $57, then those stock options
are very valuable. (It is good to be able to buy something for $10 when it is
selling on the open market for $57.) On the other hand, if the company’s stock
falls to $7, the options are worthless. There is no point in buying something for
$10 when you can buy it on the open market for $3 less. The point of this
compensation scheme is to align the incentives of the CEO with the interests of
the shareholders. If the share price goes up, the CEO gets rich—but the
shareholders do well, too.
It turns out that wily CEOs can find ways to abuse the options game (just as
cashiers can find new ways to steal from the register). Before the first edition of
this book came out, I asked Paul Volcker, former chairman of the Federal
Reserve, to give it a read since he had been a professor of mine. Volcker read the
book. He liked the book. But he said that I should not have written admiringly
about stock options as a tool for aligning the interests of shareholders and
management because they are “an instrument of the devil.”
Paul Volcker was right. I was wrong. The potential problem with options is
that executives can do things to goose the firm’s stock in the short run that are
bad or disastrous for the company in the long run—after the CEO has sold tens
of thousands of options for an astronomical profit. Michael Jensen, a Harvard
Business School professor who has spent his career on issues related to
management incentives, is even harsher than Paul Volcker. He describes options
as “managerial heroin,” because they create an incentive for managers to seek
short-term highs while doing enormous long-term damage.
10
Studies have found
that companies with large options grants are more likely to engage in accounting
fraud and more likely to default on their debt.
11
Meanwhile, CEOs (with or without options) have their own monitoring
headaches. Investment banks like Lehman Brothers and Bear Stearns were
literally destroyed by employees who took huge risks at the firm’s expense. This
is a crucial link in the chain of causality for the financial crisis; Wall Street is

---

where a bad problem became disastrous. Banks across the country could afford
to feed the real estate bubble with reckless loans because they could quickly
bundle these loans together, or “securitize” them, and sell them off to investors.
(A bank takes your mortgage, bundles it together with my mortgage and lots of
others, and then sells the package off to some party willing to pay cash now in
exchange for a future stream of income—our monthly mortgage payments.) This
is not inherently a bad thing when done responsibly; the bank gets its capital
back right away, which can then be used to make new loans. However, if you
take the word “responsibly” out of that sentence, it does become a bad thing.
Simon Johnson, former chief economist for the International Monetary Fund,
wrote an excellent postmortem of the financial crisis for The Atlantic in 2009.
He notes, “Major commercial and investment banks—and the hedge funds that
ran alongside them—were the big beneficiaries of the twin housing and equity-
market bubbles of this decade, their profits fed by an ever-increasing volume of
transactions founded on a relatively small base of actual physical assets. Each
time a loan was sold, packaged, securitized, and resold, banks took their
transaction fees, and the hedge funds buying those securities reaped ever-larger
fees as their holdings grew.”
12
Each transaction carries some embedded risk. The problem is that the bankers
making huge commissions on the buying and selling of what would later become
known as “toxic assets” do not bear the full risk of those products; their firms do.
Heads they win, tails the firm loses. In the case of Lehman Brothers, that’s a
pretty accurate description of what happened. Yes, the Lehman employees lost
their jobs, but those most responsible for the collapse of the firm don’t have to
give back the huge bonuses they made in the good years.
One other culpable party deserves mention, and again misaligned incentives
was a key problem. The credit rating agencies—Standard & Poor’s, Moody’s,
and others—are supposed to be the independent authorities that evaluate the risk
of these newfangled products. Many of the “toxic assets” now at the heart of the
financial meltdown were given stellar credit ratings. Part of this was pure
incompetence. It didn’t help, however, that the credit rating agencies are paid by
the firms selling the bonds or securities being rated. That’s a little like a used car
salesman paying an appraiser to stand around the lot and provide helpful advice
to customers. “Hey Bob, why don’t you come over here and tell the customer
whether he is getting a good deal or not.” How useful do you think that would
be?
These corporate incentive problems remain unresolved as far as I can tell,
both for senior executives in public companies and for other employees taking
risks with their firm’s capital. There is a fundamental tension that is tough to

---

resolve. On the one hand, firms need to reward innovation, risk, insight, hard
work, and so on. These are good things for the firm, and employees who do them
well should be paid handsomely—even astronomically in some cases. On the
other hand, the employees doing fancy things (like designing new financial
products) will always have more information about what they are really up to
than their superiors will; and their superiors will have more information than the
shareholders. The challenge is to reward good outcomes without creating
incentives for employees to game the system in ways that damage the company
in the long run.
One need not be a corporate titan to deal with principal-agent problems. There
are plenty of situations in which we must hire someone whose incentives are
similar but not identical to our own—and the distinction between “similar” and
“identical” can make all the difference. Take real estate agents, a particular breed
of scoundrel who purport to have your best interest at stake but may not,
regardless of whether you are buying or selling a property. Let’s look at the buy
side first. The agent graciously shows you lots of houses and eventually you find
one that is just right. So far, so good. Now it is time to bargain with the seller
over the purchase price, often with your agent as your chief adviser. Yet your
real estate agent will be paid a percentage of the eventual purchase price. The
more you are willing to pay, the more your agent makes and the less time the
whole process will take.
There are problems on the sell side, too, though they are more subtle. The
better price you get for your house, the more money your agent will make. That
is a good thing. But the incentives are still not perfectly aligned. Suppose you are
selling a house in the $300,000 range. Your agent can list the house for $280,000
and sell it in about twenty minutes. Or she could list it for $320,000 and wait for
a buyer who really loves the place. The benefit to you of pricing the house high
is huge: $40,000. Your real estate agent may see things differently. Listing high
would mean many weeks of showing the house, holding open houses, and
baking cookies to make the place smell good. Lots of work, in other words.
Assuming a 3 percent commission, your agent can make $8,400 for doing
virtually nothing or $9,600 for doing many weeks of work. Which would you
choose? On the buy side or the sell side, your agent’s most powerful incentive is
to get a deal done, whether it is at a price favorable to you or not.
Economics teaches us how to get the incentives right. As Gordon Gekko told us

---

in the movie Wall Street, greed is good, so make sure that you have it working
on your side. Yet Mr. Gekko was not entirely correct. Greed can be bad—even
for people who are entirely selfish. Indeed, some of the most interesting
problems in economics involve situations in which rational individuals acting in
their own best interest do things that make themselves worse off. Yet their
behavior is entirely logical.
The classic example is the prisoner’s dilemma, a somewhat contrived but
highly powerful model of human behavior. The basic idea is that two men have
been arrested on suspicion of murder. They are immediately separated so that
they can be interrogated without communicating with one another. The case
against them is not terribly strong, and the police are looking for a confession.
Indeed, the authorities are willing to offer a deal if one of the men rats out the
other as the trigger man.
If neither man confesses, the police will charge them both with illegal
possession of a weapon, which carries a five-year jail sentence. If both of them
confess, then each will receive a twenty-five-year murder sentence. If one man
rats out the other, then the snitch will receive a light three-year sentence as an
accomplice and his partner will get life in prison. What happens?
The men are best off collectively if they keep their mouths shut. But that’s not
what they do. Each of them starts thinking. Prisoner A figures that if his partner
keeps his mouth shut, then he can get the light three-year sentence by ratting him
out. Then it dawns on him: His partner is almost certainly thinking the same
thing—in which case he had better confess to avoid having the whole crime
pinned on himself. Indeed, his best strategy is to confess regardless of what his
partner does: It either gets him the three-year sentence (if his partner stays quiet)
or saves him from getting life in prison (if his partner talks).
Of course, Prisoner B has the same incentives. They both confess, and they
both get twenty-five years in prison when they might have served only five. Yet
neither prisoner has done anything irrational.
The amazing thing about this model is that it offers great insight into real-
world situations in which unfettered self-interest leads to poor outcomes. It is