Incentivized stupidity

Two good things I’ve read this morning raise an under-appreciated point – that people can be incentivized to behave in ways that seem stupid.

First, there’s Tom Chivers’ review of Mervyn King’s and John Kay’s Radical Uncertainty. He says it is “completely terrifying” that they thought their book needed to be written, because economists and finance types shouldn’t need to be told that “models are not 100% precise representations of reality.”

Of course, he's right. Models are unreliable and the historic data that goes into them might not be a guide to the future – points well made by Richard Bookstaber in The End of Theory and by Nicola Gennaioli and Andrei Shleifer in A Crisis of Beliefs. But investment bankers have indeed made precisely this error, most famously when Goldman Sachs’ David Viniar sais that during the crisis “we were seeing things that were 25-standard deviation moves, several days in a row”.

It is trivially true that if you are regularly seeing 25 SD events, then you have horribly (pdf) mis-specified your model. So why did Mr Viniar do it?

Incentives, that’s why. Goldmans wanted to take big positions in mortgage derivatives, and persuading themselves that they were safe was the way to do this. Banks need precise measures of risk to set trading limits, liquidity positions and gearing. You can’t run a bank by saying “we don’t know” even if this is true. And banks’ bosses don’t pay their underlings fortunes to say they don’t know. You need at least an illusion of knowledge. And because profits are privatized whilst losses are socialized, bankers have an incentive to believe that risk is smaller than it is. Mr Viniar might have seemed stupid when he said that. But he’s richer than you or me.

My next example of motivated stupidity comes from Geoff Mulgan’s pessimistic assessment of whether Dominic Cummings really can improve the efficiency of government.

Geoff says:

The average tenure of many Ministerial roles is barely a year now. Since it takes a year for even a smart minister to learn how to do the job, the result is that most ministers, most of the time, are incompetent.

But Prime Ministers have incentives to do regular reshuffles. They need to remind ministers who’s boss, and they maintain party discipline in part by offering backbenchers the prospect of office. If a PM promised to go five years without a reshuffle, he’d lose authority.

Geoff continues:

Without buy in from the bottom the top down changes rarely stick, even in states with authoritarian powers far beyond what UK ministers could dream of…If there is no strategy for engaging hearts and minds the programme is almost certain to fail.

But again, there’s an incentives problem. People in power don’t have an incentive to give underlings a voice, even if doing so would make an organization more efficient. This is why we see so much heavy-handed top-down corporate management even though we know that worker democracy is often more efficient.

And Geoff adds:

One of the big vices of Westminster and Whitehall is their valuing of words over deeds.

Again, there are strong incentives for this to be the case. It’s much easier (especially for Tories) to manage the media by briefings, soundbites and press releases than it is to put in the hard graft of actually changing things.

What I’m describing here are specific examples of a general fact. Good government is (by definition) a common good, whereas maintaining power and prestige is a private one. Politics is therefore always in danger of delivering a tragedy of the commons*. 

What we have in both finance and politics is therefore incentivized stupidity - or at least the appearance of stupidity**. (And not just these occupations: journalism offers us other examples of this.)

A recent paper by Christine Exley and Judd Kessler give us experimental evidence for this. They show that when people had incentives to behave selfishly – for example in splitting cash between themselves and a charity – they often behaved apparently irrationally to give themselves more. They say:

Individuals make unambiguous decision errors — acting as if they suffer from cognitive limitations or behavioural biases — in order to make more selfish choices…Behaviour that could be attributed to a behavioural bias (such as anchoring…) might instead be indicative of self-serving motives.

I say all this as a corrective to a common error, particularly among Econ101ers. This is the belief that incentives are usually a good thing – that as Adam Smith said, “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.”

Yes, incentives can be powerful. But sometimes make us act against the public interest. Getting incentives right is not easy.   

* Of course, what Ostrom said of the tragedy of the commons is also true in politics: outright tragedies are often avoided thanks to unwritten rules and conventions. But these need shoring up. They cannot be taken for grant

** Whether such behaviour actually is stupid is questionable, given that it enhances the power and wealth of those engaging in it. 

Comments

[Ben Oldfield]

The old backstop to inexperienced ministers was the civil service but the Tories have stopped their pay rises. This has meant that the civil servants have to change jobs to get a pay rise. I have heard that any one who have not moved at least once a year they are considered a failure. So the government is run by amateurs which may explain the current problems.

[Jim]

"What I’m describing here are specific examples of a general fact. Good government is (by definition) a common good, whereas maintaining power and prestige is a private one. Politics is therefore always in danger of delivering a tragedy of the commons*. "

Its almost as if the less power the State has over its citizens the better.........

[jim2]

I doubt making government a few % more efficient will make much difference. A bit like making a buggy whip factory more efficient.

The real problem is a lack of animal spirits. If we look around tech is soooo boring. No transgalactic transporters or time machines, only shinier mobile phones and tellys. Then there are only so many ways you can package insurance and mortgages, the only advance is how to do it cheaper - aka with fewer people.

The real problem is finding new things to do and everyone else is in the same boat. Even the old competitive advantage of nations has eroded away - ask the Swiss watchmakers. Anything can be done anywhere.

Now UK governments are notoriously useless at picking winners and notoriously short-term investors and notoriously mean-minded when it comes to investing in its people. In this situation we have a couple of options - work cheap or invest in skills.

But what do we mean by invest in skills? How do the middle classes train their kids for the better jobs? Answer start early, take them on ski holidays, to the theatre, galleries, footy, dance classes and hire tutors to get into good schools and keep them away from street fights. That is how you get new creative industries, But that is also where the split between those who become politicians and those who become the doers and creators comes in. So work cheap it is for people like you, but not us.

The question is how do the British train their politicians and how does everyone else, is there a difference?

[Blissex]

Really amazed that our blogger seems for one post has left aside his wykehamism where politics is a discussion of principles among gentlemen, where the greater good is prevented only by mistakes caused by cognitive biases or lack of knowledge, and acknowledges that they are often caused by very rational and unbiased and well informed material interests.

[Blissex]

«The old backstop to inexperienced ministers was the civil service but the Tories have stopped their pay rises.»

Perhaps, or perhaps the cut of the budgets of several departments by 30-40% over 10 years has been quite devastating. Or viceversa "liberating": cutting the budget for the tax inspectorate by 40% saved rich taxpayers a lot of money.

Also, typically Conservative governments regard the civil service as a socialist conspiracy, and therefore a political opponent of common-sense apolitical policy, which for them is thatcherism.

[Robert Mitchell]

Goldman Sachs hedged and profited from 25-sigma events. They bought Credit default swaps. The only uncertainty was whether the Fed would bail out AIG so the CDS would get paid. When former GS executives run the Treasury and Fed, how uncertain was a Fed backstop really?

[derrida derider]

What Robert Mitchell said - they cursed their own stupidity all the way to the bank (or Bahamas based hedge fund, as the case may be).

I think all you are saying is that arrogance and overconfidence pays (which indeed all the labour market research confirms) so arrogance and overconfidence is what we get, even in technical fields. How long O Lord must the wicked prosper?

[Blissex]

«I think all you are saying is that arrogance and overconfidence pays»

On a small scale yes, but the examples our blogger and "Robert Mitchell" make are actually self-dealing by a clique of privileged insiders. That is not stupidity.

Consider the AIG case: the AIG traders who sold the CDSes that bankrupted AIG made a *lot* of money in commissions, and so did the executives with bonuses. At some point finance made 40% of the profits of all USA quoted companies (and a large chunk of those go into executive bonuses), almost all of them the result of ridiculously low depreciation of risk, which I reckon was entirely deliberate, as the constant pressure by the finance sector to reduce capital ratios (which has resulted in most of them trading with negative capital for decades).

The movie "The big short" ends with the narrator, the derivative salesman who pushed the shorters to buy CDSes by telling them they would pay out big, receiving a very large cheque in commissions.
That is not "arrogance and overconfidence".

[Robert S Mitchelk]

When that same salesman said to trust his math because his quant's name was Yang, that was pretty arrogant and overconfident. Banks today are doing the same thing; recently Nomura's McGellicott (his newsletters get quoted a lot by fintwit) recently said "we sell vol, knowing we're backstopped." Volatility is the new CDS and we'll see if the Fed doesn't suppress this recent volatility spike soon ...

[Jim]

Surely evolution has designed us human beings to value arrogance and overconfidence? The mammoth only got slain by someone who said 'We can do that!', tried and succeeded (even if others failed), not someone who said 'Ooh thats a bit hard, and difficult, lets not try!'. The former ate, the latter starved, and our genes come from the former.

[Robert Mitchell]

Jains have been vegetarian since before recorded history. Jains learned that arrogance and overconfidence obstruct knowledge. I don't want to live in ignorance no matter how confident I might feel. I hope arrogant and overconfident humanity goes extinct. I'd go first if you liberalized suicide markets ...