Can we live by incentives?

After reading my 156 – Between markets and regulation a young friend of mine has argued “I believe in incentives”. Leaving aside the matter of “belief”, let’s look closer at what thw “incentives” theory is saying.

“Incentive” is shorthand for money signal. Profits will be an incentive to act; losses are incentives no desist. By closely tracking money signals – as provided by the markets – I can orient my action successfully. I’ll be better off for adjusting to incentives. If everyone is doing his/her best, just deserts are secured, and we end up automatically living in the “best of possible worlds”, under the benign gaze of Dr. Pangloss.

Money plays the role of “meta-value” or “frozen desire”[1]: All the infinite diversity of the material world can be compressed into “money” without loss of information and then injected in the markets, which mediate transactions between humans through money incentives. All my wishes and aspirations somehow emerge anew and unblemished. Money makes the material world fungible.

Money’s pendant in the spiritual world is the “meta-value” of “freedom”. Freedom is personal just as wealth is. The state’s only role then is to secure these two “meta-values” – personal freedom and personal property – against brute violence.

This is the idea behind “incentives” – simple (I’d even say self-evident), coherent, and self-fulfilling – we only have to do our best[2] and everything will be for the best in the end. And if it’s not the best, then it is not the end.

So much for theory. What’s the fit with reality?

Prices follow endowments, not wants

Economic theory links prices to endowments (wealth, income, skills, etc.). Those who have (or have earned) can bid for goods, those who don’t, sit out the bidding. Prices truly reflect wants if and only if we assume that endowments have been distributed fairly. By the look of it, contingent history, not human wants, dominates the markets.

Asymmetries in information

A former professor of mine won a “Nobel Prize” in economics for discussing second-hand car markets – the “market for lemons”. The side in the transaction which knows less than the other is quickly at terminal disadvantage: he unwittingly buys a “lemon” (it happened to me as I was sitting at Prof. AKERLOF’s feet during the heavy and heady years at Berkeley: the jalopy soon conked out). It does not take much asymmetry to skew the result, economic analysis shows: buyers beware

Market failures

In the material world actions have many consequences. Markets, however, only recognize transactions – exchanges of legal rights. Only consequences that have been endowed with legal status matter – what is left out is ignored. I buy and sell “property” rights only because the state has established and protects them. No legal right – no money transaction (it does not matter so much who originally owns the right as the fact that it is established and recognized by the market). If there is no “right” to clean air there is no “incentive” for a plant to stop a plant polluting. We have spent the last fifty years painfully and painstakingly retrofitting markets with these rights/obligations so as better to bring into congruence the material and the legal world. This is a never-ending process of discovering what is hidden behind the veil of money.

Discontinuities and singularities

In 156 I’d mentioned the fact that no system of incentives yields 100% compliance: if everyone has to drive on the same side of the road, the incentive to get the last contrarian to comply would be infinite – he can hold everyone else up for ransom. Only a regulation and an appropriate disincentive (fine and/or jail) will do. Every time the find ourselves confronted with such discontinuities and singularities (where prices would either be 0 or infinite) the system breaks down.

Trust – the ghost in the machine

Economists will agree – trust is what makes the economy go round. Trust is the “general” that undergirds the “particulars” of a contract – rules so self-evident that it need not even be mentioned (but silently in the handshake after the contract has been signed). Trust is our willingness to abide voluntarily by intentions as well as the letter of contracts. Linguists would argue that the written word is “dead” and the spoken is “alive” – they’d refer to the shared yet silent culture shared among contracting parties. Trust is what makes a contract come alive.

If the latest crisis has taught us anything it is that the principal cannot count on incentives alone in making the agent trustworthy. In fact not even self-interest of the agent will achieve this. Why? It is in any case most difficult to align the interests of principal and agent, i.e. to give him the incentives to do the “right thing”. While the incentive is clear, the “right thing” is vague, circumstantial, and discretionary. Particularly when asymmetries of information exist, the agent’s readiness to deviate from the spirit of his mandate is about foreordained.

Everything is in everything

Markets are totally interconnected – for they collapse into “money” as transactions take place. The very interconnectedness causes errors to spread like wildfire through markets. One “market imperfection” fatally pollutes the whole well.

Theory of second best

It stands to reason: if I need to jump across a deep ravine to save myself from a lion, it does not help that I jump only half as far. This, is in essence is the theory of second best, which was mathematically developed in the 1950s. There is no leisurely and inevitable upward path from the valley of messy reality to the highest peaks of perfection. Reality is not an approximation of the ideal. Reality is something essentially different and the ideal is a false friend. Plato, eat your heart out: “Striving” for an ideal is no good guide in mastering reality!

I have sketched a few objections to the idea that “incentives” are the markets’ gift to mankind. These arguments are all endogenous to the very theory which undergirds the claims to the reputed perfection of “incentives” – they are standard fare in economics courses. This is not a radical critique… just a child’s (or childish) observation that the Emperor may have no clothes.

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