Capitalism's bad incentives

Martin Wolf writes that successful leftism “must recognise the crucial role of incentives in shaping human behaviour.” This is correct. I’m not sure, though, that it is a big argument against Corbynism. This is because actually-existing capitalism itself contains many dysfunctional incentives – ones that constrain innovation and encourage rent-seeking - and Corbynism offer the hope of reducing some of these.

One such bad incentive is that high inequality gives the rich stronger incentives to protect their privilege by investing in methods which keep or increase their share of the economic pie without much increasing it. Sam Bowles and Arjun Jaydev show that unequal countries employ more “guard labour” – policemen, security guards, supervisors and so – than egalitarian ones. They say:

A significant portion of an economy‘s productive potential may be devoted to the exercise of power and to the perpetuation of social relationships of domination and subordination.

A similar thing applies to innovation. Capitalists have incentives to invest in power-biased technical change – devices such as CCTV, Worksnaps or tachographs that help bosses monitor workers. Such technologies reduce the need for efficiency wages and so boost profits. But it’s not clear they are good for aggregate output.

Also, capitalists have incentives to stifle competition and to lobby for protection. Bank subsidies, corporate welfare such as some PFI contracts and intellectual property laws that stifle innovation are the result.

There’s another class of bad incentives under capitalism – those that arise because of imperfect monitoring of CEOs by outside shareholders or of underlings by bosses.

The former case can lead bosses to divert (pdf) their efforts to tasks that shareholders can easily monitor – such as cutting costs or manipulating short-term earnings numbers – whilst neglecting perhaps more important tasks such as promoting good corporate culture. This can lead to widespread criminality: Luigi Zingales and colleagues estimate that around one-in-seven companies engage in fraud.

It can also lead to the accumulation of cash piles and under-investments or to bad investments (RBS’s takeover of ABN Amro destroyed billions of pounds of wealth) as bosses aren’t properly monitored by shareholders.

Within the corporation, imperfect monitoring can cause bosses to hire underlings who resemble themselves, which generates groupthink and the Dilbert phenomenon (pdf).

Agency failure also allows a few lucky mediocrities to get big money, thus entrenching inequality. As Marko Tervio has shown, what’s scarce in many industries is not so much talent as proven talent. Employers would rather stick with known quantities who are just good enough rather than take a risk on unproven but potentially brilliant people. The upshot is mediocre management and stagnant organizations.

And all this is before we come to the financial sector. Here, Anat Admati has shown that implicit subsidies, shareholders’ desire for a high return on capital and the favourable tax treatment of debt finance have encourage excess leverage. She says (pdf):

In banking, the public interest in safety conflicts with the incentives of people within the industry. Protecting the public requires effective regulations because market forces fail to do so.

Bjorn-Christopher Witte offers a variant of this. He shows that fund managers are sometimes incentivized to be lucky risk-seekers rather than genuinely skilled. He says: “Intense competitive pressure generates risk-seeking behavior and diminishes the predominance of the most skilled.” For example, in the tech bubble of the late 90s managers who thought boo.com was a great stock attracted fund flows and big bonuses whilst knowledgeable ones like Tony Dye lost their jobs.

Now, I’m not saying that these bad incentives will bring down capitalism or that they are all eliminable: there is a great deal of ruin in a nation. They do, however, raise an important possibility – that there is abundant room for a leftist government to consider alternative governance structures that reduce agency problems and produce better incentives. As John McDonnell notes, such structures might (pdf) well include more cooperatives, as these give control to workers who have both skin in the game and local knowledge of particular working practices.

We shouldn’t generalize about the precise form such coops will take, as they’ll vary from firm to firm. Whether incentives work well or not is a matter of precise market microstructure, not windy talk. In this sense, socialism is an exercise in applied transactions economics.

Martin is sniffy about Corbyn’s promise to “transform Britain by genuinely putting power in the hands of the people”, but I’m not sure he should be. Such a transformation might be a way of improving the incentives which he rightly believes are so important.   

Comments

[Peter K.]

"Nor can one possibly forget the shock of the financial crisis or the stagnation in productivity that followed it."

Apparently Wolf can.

"Last, it must understand that the private sector, foreign as well as domestic, must play a leading role in the economy."

Yes the private sector did such a wonderful job with the epic housing bubble and financial crisis.

There are also incentives for the corporate media to lie about capitalism and warp the culture.

[Acarraro]

This is all reasonable, but how would it be different in a nationalized industry? Don't agency problems apply to managers of publicly owned businesses?

Cooperatives are actually legal: they are just not very popular.

I think one could make the case that the financial system (as well as any government) really exists to trick people into taking risks they don't want to take but that we have to take to have a wealthy society. Pretending houses are safe assets gives us more houses overall...

[Badiou]

Cooperatives, especially in agriculture, were and are quite popular in Portugal after the 74 revolution and the cooperative sector is recognized in the constitution as a pillar to our "construction of socialism" although these were little more than voie words written in the revolutionary fervor, as seen nowadays. Anyway the problems that arised from the cooperative sector here would be enough for a dozen of pessimistic posts of yours. Maybe also in Venezuela you will find a newer hub of exciting examples of cooperatives? People can form cooperative everywhere in the world but we somehow we don't. I would really like to dig further, if you could provide links to successful cases it would be good to provide when you make a case for it.

[JB]

I enjoy this blog very much. Would appreciate, if you have time, some suggested reading that you think is worthwhile.

[Luis Enrique]

How does Corbyn plan to put power in the hands of the people?

[gastro george]

"Cooperatives are actually legal: they are just not very popular."

There are enormous financial barriers that prevent cooperatives being successful, but also true for a lot of SMEs.