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Beware the dysfunctional consequences of imposing misguided incentive systems

Beware the dysfunctional consequences of imposing misguided incentive systems

Following the disclosure of salaries at the BBC, it has hardly seemed possible to open a newspaper or switch on the television without being bombarded by stories about pay.

By pure coincidence, an academic paper entitled “Pay for Performance and Beyond” has just appeared. So what, you might ask? Except that it is one of the 2016 Nobel Prize lectures, by Bengt Holmstrom, a professor at MIT.

Holmstrom’s work began in the 1970s on the so-called principal-agent problem. This is of great practical importance. For example, how should the owners of companies (the “principals”, in economic jargon) design contracts so that the interests of the directors (the “agents”) are aligned as closely as possible with the interests of the shareholders?

Many aspects of economics have a lot of influence on policy making. But this is not yet one of them. We have only to think of the behaviour of many bankers in the run up to the financial crisis. Stupendous bonuses were paid out to the employees, and, in examples such as Lehman Brothers, the owners lost almost everything.

It is not just at the top levels that scandals occur. Towards the end of last year, Wells Fargo had to pay $185m in penalties. Holmstrom cites this prominently in his lecture. The performance of branch managers was monitored daily. They discovered that one way of doing well was to open shell accounts for existing customers. These were accounts which the customers themselves did not know about, but they counted towards the managers’ bonuses.

A culture of pressure to perform against measured criteria can lead to problems even when the organisations involved are not strongly driven by money.

The education system in the UK has many examples. But the one given by Holmstrom is even more dramatic. The No Child Left Behind Act of 2001 in the US was very well intentioned. But the test-based incentives eventually led, around a decade later, to teachers in Atlanta being convicted of racketeering and serving jail sentences for fixing exam results.

Holmstrom is in many ways a very conventional economist – his Nobel lecture rapidly becomes full of dense mathematics. He believes that, given the right information and incentives, people will make rational decisions.

This is why his conclusion is so startling.

He writes: “one of the main lessons from working on incentive problems for 25 years is that, within firms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the firm are generally misguided”.

The whole trend in recent years has been to bring even more market-type systems inside companies, from bonuses for meeting potentially counter-productive targets, to devolving budget authority away from the discretion of mangers and handing it to specialised departments.

Holmstrom’s conclusion implies the need for a pretty radical rethink of the way incentives are structured, in both the public and private sectors.

As published in City AM Wednesday 26th July 2017

Image: Lehman Brothers Headquarters by Sachab is licensed under CC by 2.0
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What climate warrior Twisleton-Wykeham-Fiennes teaches us about punishment

What climate warrior Twisleton-Wykeham-Fiennes teaches us about punishment

Natalie Twisleton-Wykeham-Fiennes: don’t you just love her? One of the Black Lives Matter campaigners, our Nat caused chaos by occupying the runway at London City Airport, on the grounds that climate change is racist.

She and eight others, including a former member of the Oxford University Croquet Club, were sentenced by the courts last week. For many, their punishments were derisory: token fines and suspended prison sentences.

Would harsher treatment deter future protests like this and the one which disrupted Heathrow last month? Anecdotal evidence suggests it would.

In the town where I grew up, nestling in the foothills of the Pennines, the police would often drive miscreant youths late at night to remote hamlets up on the moors and make them walk home. It helped if it was raining, which it usually was. The more recalcitrant were likely to discover that the damp made the steps of the local police station unusually slippery. Compared to today, crime was low.

But this is mere causal empiricism, and there is a vast academic literature on whether or not harsher punishments deter crime. As a broad approximation, criminologists themselves tend to be sceptical about the impact of punishment as a deterrent.

A few years ago, I was at a seminar on the topic in which a criminology professor at Middlesex University asserted, without a trace of irony, that crime was caused by capitalism. In contrast, economists, who believe that agents respond to incentives, often claim that deterrence works.

Economists base their conclusions not just on theory, but on statistical analysis of detailed databases. Even so, the results might not be straightforward to interpret. For example, if prison sentences are increased and we see a fall in crime, is this because potential criminals are deterred, or because prolific criminals are in jail and can’t commit crimes?

Francesco Drago and colleagues published an influential paper in the Journal of Political Economy in 2009. They exploited the natural experiment provided by the Collective Clemency Bill passed by the Italian Parliament in July 2006. This provided for an immediate reduction of three years in the sentences of existing inmates, and as a result 22,000 of them were released. But if they re-offended, they had to serve all the suspended time, plus whatever extra they were given.

The study showed decisively that an additional month in expected sentence reduced the propensity to re-commit a crime by 1.24 per cent. Steve Levitt, in his bestseller Freakonomics, described similar results obtained by smart analysis of American data.

Perhaps the way forward is to experiment with another fundamental concept in economics, that of externalities. Twisleton-Wykeham-Fiennes believes that flying, while convenient for the individual, imposes costs on others through its negative impact on the climate. Other people bear these costs, which are external to the benefits to the person flying.

The airport protests inconvenienced many others. So the fines should be in proportion to the external costs created by the crime. The assets of the well-heeled protestors would vanish in a trice. Anyone for this natural experiment? Future Twisleton-Wykeham-Fienneses might prefer croquet instead.

Paul Ormerod

As Published in CITY AM on Wednesday 21st September 2016

Image: Croquet by Aren’tYouAlex-Spencer? as licensed under CC BY 2.0

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There’s a smart case for diversity – but it’s not the one you think.

There’s a smart case for diversity – but it’s not the one you think.

Andy Haldane, chief economist at the Bank of England, hit the headlines last week with his confession that even he could not understand much of the material which pension providers give to customers. Less noticed, however, was a speech he gave the previous week at a dinner organised in aid of Children in Need on the fashionable theme of diversity.

The concept is dear to the heart of the liberal elite. Company boards, public institutions, all must embrace it without question. Each must have its “appropriate” quota of under-represented groups – every group, in fact, except white working class men. Mass immigration and open borders should be welcomed on the grounds that this makes society more diverse, which is unequivocally a Good Thing.

Haldane, one of the most original economists around, puts forward an altogether smarter set of arguments for diversity. A very deep seated human instinct is to be very wary of anything which is different. For much of our history, we have lived in small hunter-gatherer communities of 100 people or less. Groups of this size were very vulnerable to events which could make them extinct. The principal threats were conflict and disease, and the principal bearers of these were strangers. So it can be very sensible to prefer people who are similar to you and to distrust the unknown. As Haldane points out, this is “ecologically rational” behaviour.

But decisions which are rational for the individual can have consequences which are, collectively, bad. It is perfectly rational for everyone to head to the exits if the fire alarm sounds in the theatre. But the collective consequences are potentially catastrophic.

Haldane notes that economists call this an externality problem. He argues that a certain amount of diversity can generate positive externalities for society and the economy as a whole. Taking a very broad sweep of history, he cites Ancient Greece, medieval Italian cities and the London of Elizabeth I as examples of cosmopolitan, diverse cultures in which creativity flourished. Shakespeare was very much the product of that latter era, when England was opening up the world. And diversity, Haldane argues, in addition offers protection against the dangers of “group think”.

Some of his other examples are less convincing. He cites the results of the Harvard economist Alberto Alesina that a 1 per cent increase in the population arising from skilled immigrants raises long-run output by 2 per cent.  But the point here is surely that they are skilled rather than that they are immigrants. And, incredibly, Haldane gives the Monetary Policy Committee as an example of successful diversity.

Cultivating creativity requires what Haldane calls cognitive diversity, which may not be related at all to ethnic or gender diversity. Cambridge in the middle of last century consisted almost entirely of white, upper class men. Yet Keynes in economics, Wittgenstein in philosophy and, most important of all, Crick in biology generated world-changing ideas.

Haldane’s speech is a powerful counterweight to the tick-box mentality which currently dominates the thinking on diversity in policy circles.

Paul Ormerod

As published in City AM on Wednesday 24th May 

Image: All the colours by Garry Knight licensed under CC by 2.0

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Do markets solve the problem of discrimination?

Do markets solve the problem of discrimination?

The Prime Minister recently announced that the civil service will now introduce name-blind recruitment.  When people apply for public sector jobs, their name will not appear on the documents sent to the appointment panel.  Major companies such as HSBC, KPMG, the BBC and the NHS are following suit.  Economists have produced a substantial body of evidence which shows that some employers discriminate on the basis of the names of the applicants.

The classic paper was written as long ago as 2003 by two academics at the National Bureau of Economic Research.  The title is “Are Emily and Greg more employable than Lakisha and Jamal? A field experiment on labor market discrimination”.  The article does what it says on the tin. The answer to the question is ‘yes’.  People with names which sound white have a better chance of getting a job than those with names which are obviously black or Muslim. The results have since been replicated in numerous studies.

Perhaps David Cameron’s measures do not go far enough.  The ethnic origin of an applicant will, after all, be immediately apparent at the interview.  The job seekers should really enter the building covered by a security blanket, sit behind screens, and have their voices distorted by computer so they all sound like Stephen Hawking.

More seriously, the question of discrimination was discussed at length by Milton Friedman in his great book ‘Capitalism and Freedom’.  He pointed out that capitalism was by far the most successful form of social and economic organisation for reducing discrimination.  We can readily contrast the situation in, say, the UK or Germany with that of the treatment of so-called ‘enemies of the people’ and their families under socialism in the former Soviet Union and China, and the widespread gender, sexual and religious intolerance found in many Muslim countries.

Friedman’s argument was essentially that a market economy separates economic efficiency from irrelevant characteristics of the product or service being offered.  So when you buy a shirt, for example, you are not interested in the colour or creed of the person who made it, just in whether it is a nice shirt at the right price.

So far, so good.  But Friedman went on to much weaker ground by arguing that the very concept of discrimination did not make sense in a market economy.  In particular, employers who discriminated would be making less efficient choices and so would eventually be forced out of business by non-discriminators.

This makes logical sense.  But there is the question of the additional costs a company might incur in conducting a more extensive search process.  These have to be balanced against the potential loss of efficiency, which might be quite small.  A more fundamental point is that markets for goods and services do not usually expose inefficiencies swiftly.  Substantial differences in productivity between firms in the same industry can persist for years.

Markets are indeed much more colour, creed and gender blind than any other form of economic structure.  But they are not completely perfect, and David Cameron’s initiative is to be welcomed.

As published in City AM on Wednesday 4th November 2015

Image: London by Olivier Bacquet licensed under CC BY 2.0

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FIFA, corruption and economic growth

FIFA, corruption and economic growth

The FIFA arrests have dominated both front and sports pages. We must await the outcomes of the trials before pronouncing on individuals.  But amongst soccer fans, the organisation is a byword for sleaze and corruption. England spent £21 million on the campaign to secure the 2018 World Cup. The height of our attempts to influence the delegates seems to have been the offer of a free breakfast with Prince William in Zurich. Little wonder that we only obtained one vote in addition to our own.

Economics has a great deal to say about corruption. Does it, for example, tend to increase or reduce the level of GDP per head in a country? The answer might seem obvious, but economic theorists are nothing if not imaginative. For example, in almost a caricature of rational choice theory, it has been argued that allowing government employees to solicit bribes provides them with an incentive to work harder. To be fair, however, the overwhelming consensus is that corruption is bad for the economy.

A key figure in the debate is Paolo Mauro, for over 20 years a senior economist at the IMF, and now a fellow of the Petersen Institute in Washington DC. His 1995 article in the Quarterly Journal of Economics has become the classic empirical investigation of the impacts of both bureaucracy and corruption on growth. He constructed a detailed data base across 67 countries, summarised in a bureaucratic efficiency index. This combined data on red tape, the independence of the judiciary, and corruption.

Mauro divided his sample into six different groups, depending upon the level of his index. There is a very strong correlation between membership of these groups, and whether or not a country has actively supported Sepp Blatter in FIFA. The African countries, for example, are almost all in the bottom two groups in terms of efficiency, and the top two are made up of Western Europe, America, Canada, Singapore and Japan.

The negative impact of corruption on growth is strong. The results of Mauro’s sophisticated statistical analysis are not straightforward to present. But, as an example, if Nigeria could somehow move from the most corrupt of his six groups to the third most corrupt, its economic growth rate would improve by as much as 1 per cent a year. If the country had done this over the whole period of its independence from the 1960s, income per head would be 65 per cent higher than it is now.

The problem of course is that a culture of bribery and corruption is self-reinforcing. In a corrupt society, it is in the collective interest to move to a much lower level of corruption. But it is not really in any individual’s interest to try and do so. If you take bribes, you will lose them. And if you expose bribes you will be ostracised, maybe even killed. This clash between the collective and the individual interest means that markets cannot solve the problem. I rarely praise the bureaucrats of the OECD in Paris, but their anti-bribery campaigns deserve support.

As published in City AM on Wednesday 3rd June 2015

Image: soccer_ball_2019 by Paul Sleet under license CC BY 2.0

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Popular culture is the driving force of inequality

Popular culture is the driving force of inequality

The Oscars have come and gone for another year. Winning an Oscar is very often the basis for either making a fortune, or turning an existing one into mega riches. Jack Nicholson has an estimated worth of over $400 million, and stars like Tom Hanks and Robert de Niro are not far behind.

Even winners who lack the instant recognition of these stars do not do too badly. Cuba Gooding Jnr has recently starred in the American civil rights film Selma. But after his 1996 Oscar for a supporting role in Jerry Maguire, he became notorious amongst film buffs for appearing in movies which were panned by critics and which tanked commercially. This has not stopped his wealth rising to an estimated $40 million.

The Premier League has provided us with another example of success apparently reinforcing success. Its recent TV deal with Sky and BT Sports is worth over £5 billion. Along with investment banking, soccer is one of the few industries which practices socialism, with almost all the income of the companies eventually ending up in the hands of what we might call the workers. The year immediately prior to the financial crisis, 2007, still represents a high point in the annual earnings of many people. But the average salary of a Premier League player has risen over this period from some £750,000 to almost £2.5 million.

At one level, films and football seem to provide ammunition for the sub-Marxist arguments of people like Thomas Piketty, arguing that capitalism inevitably leads to greater inequality. The rich simply get richer. This conveniently ignores the fact that over the fifty years between around 1920 and 1970, there was a massive movement towards great equality in the West, in both income and wealth.

During the second half of the 20th century, a profound difference in communications technology opened up between the world as it is now and all previous human history. Television by the 1960s had become more or less ubiquitous in the West. Vast numbers of people could access the same visual information at the same time. The internet has of course enormously increased the connectivity of virtually the whole world.

These advances in technology have altered the way in which people respond to information. The importance of social networks in influencing the choices made by individuals has risen sharply. The economic model of choice in which rational individuals carefully sift all the available information is no longer even feasible in many situations. Almost all click throughs on Google searches, for example, are on the first three sites which come up. It is simply not possible to work through the thousands, or even millions, of sites which are offered.

This means that self-reinforcing processes are set up. Things which become popular become even more popular, simply because they are popular. And because of communications technology, we know what is popular. In popular culture, a rapidly growing sector of the economy embracing both films and soccer, high levels of inequality of income are inevitable

As Published in City AM on Wednesday 25th February 2015

Image: Academy Award Winner by Davidlohr Bueso licensed under CC BY 2.0

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