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A stitch in time. We need smarter government, but less of it

Posted by on November 22, 2012 in Economic Theory, Executive Pay, Markets, Politics, Taxation | 0 comments

What is the connection between the content of Boris Johnson’s speech this week to the CBI, tax avoidance and evasion, executive pay, petty crime and plagiarism by students?  This is yet another one where economics can help us with the solution. Economists have long used the example of a factory which imposes costs on other people in the neighbourhood through the pollution it generates.  They refer to such costs as ‘externalities’.    These are costs external to the factory itself.

Thomas Schelling, a Nobel Prize winner like blockbuster author Daniel Kahneman, extended the concept to the social domain forty years ago in his enigmatic paper ‘Hockey Helmets, Concealed Weapons and Daylight Saving Time: Binary Choice with Externalities’.  The idea here is that the eventual impact of a social choice by an individual can be magnified many fold.  The behaviour, whether it is good or bad, may be copied by his or her peers, and so generates social externalities.

Two Italian economists, Claudio Lucifora and Marco Tonello at Milan, have just published a detailed study, replete with heavy duty maths, on cheating in exams, something which is now widespread in many European countries, including the UK.  They find, perhaps not surprisingly, that the more people do it, the more likely it is that yet more will follow their example.  The effects feedback on each other, and a small snowball can turn into an avalanche.

The authors trace the origins of the current wave of plagiarism and cheating right back to the school classroom, to things which by themselves seem pretty innocuous, such as teachers tolerating minor instances of homework copying.  The same thing takes place with the ‘broken window’ effect on petty crime.  Most crime takes place in poor neighbourhoods, which tend to be a bit run down.  But rigorous enforcement of standards, such as mending broken windows quickly, can have a big impact not just on the ambience but on the values of a local estate.

The executive pay boom began back in the 1980s, with a few examples such as the hapless Cedric Brown, Chief Executive of the newly privatised British Gas, who increased his pay to the then outrageous level of £400,000 a year.  Despite public opprobrium, he got away with it and other executives saw that he had.  The Mayor called for companies to show more socially responsible behaviour.  But we are by now a very long way down the track where virtually the only focus of the corporate ethos is to maximise shareholder value and executive rewards.

Once the genie is out of the bottle, it is very difficult to put back in.  The instinct of government is to want to do more, to spend more money, to regulate more.  We don’t need more government.  We need smarter government, using the waves of information on the web and modern tools of analysis to identify potentially harmful trends at an early stage.  Fixing the broken window does not need armies of bureaucrats.  It just needs to be done early enough.

As published in City Am on Wednesday 21st November 2012






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