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Incentives for smart action

Incentives for smart action
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First Published: Mon, Jul 12 2010. 09 27 PM IST
Updated: Mon, Jul 12 2010. 09 27 PM IST
Recently, I came across two interesting news items that made the case for doing nothing as the best of all options available in the given situation. The first dealt with the oil spill in the Gulf of Mexico. Some academics have said that doing nothing might have kept the oil spill confined to the sea waters. Prima facie, that sounds plausible. This observation prompted one of my friends to send a link to another study. In football matches, confronted with a penalty stroke, goalkeepers dive either to the left or to the right. Researchers have found that their odds of stopping the shot were better if they stood still in the middle instead of lurching in either direction.
Hence, being active is not always the best thing. However, in both cases, it is clear that decision makers were influenced by perceptions of what others might think of them, rather than what would be best for the situation. Reputation and image mattered more than a rational approach. For behavioural scientists, this should come as no surprise. They know that people react to non-economic incentives. That is why the indifference displayed by economists to such considerations makes both their analyses and recommendations incomplete and even wrong. What is worse, they refuse to recognize the limitations of their work, given their inability or unwillingness to incorporate “irrational” elements into their model. Humility is a missing behavioural trait in economists.
The first thought that comes to mind on reading such stories is how to make sure that the goals that people—politicians and bureaucrats, for instance— pursue are aligned with what they ought to be pursuing. Traditional economists would only think of economic incentives. For example, if income-tax officials take bribes, then incentivize them for better tax collection. Unfortunately, this results in bogus claims and harassment. In contrast, applying a non-economic (dis)incentive worked in the case of loan defaulters. Publishing their names on the website of the central bank embarrassed many that they came to an agreement on settling their debt.
Corruption, transparency, ease of doing business, human development and competitiveness indices are steps in this direction. They are about motivating governments through recognition (a non-economic incentive) of achievements and failures. But in developing countries that is not often enough. Social service organizations, think tanks and newspapers need to extend these indicators to individual ministers and bureaucrats.
Public perception indices—of the dedication and commitment and extent of corruption practised by Central and state ministers, chief ministers and bureaucrats—can be created. Universities can stop awarding doctorates to those who are rated poorly. Newspapers and television agencies can boycott them. Cultural organizations could stop inviting them to preside over functions. As a second step, transparent and fully accounted-for economic rewards can then be bestowed on “clean” and “honest” officials as perceived by the public. This is both urgent and important in our country since there is very little personal or systemic accountability at all levels of the government. Bare Talk hopes that it has kicked off the project with this column.
The second thought that we grapple with is the trade-off between action and inaction when confronted with situations described earlier. It is hard to ignore the urge to act. As noted in Bare Talk on 6 July, the tendency towards activism is high in the US. They are restless. That is why the President was busy looking for asses to kick for the oil spill. But activism has its downside. Monetary policy activism since the 1990s for every stock market downturn has finally resulted in a debt burden in the US that might take a generation to be brought under control.
Left-liberals might be alarmed, for they might see in this criticism of activism the seeds of a hands-off approach that many economic conservatives in the US favour. Bare Talk would like to dispel such fears. This is not a veiled attempt to propose a doctrinaire laissez-faire attitude. The key is not to eschew action, but to pursue intelligent action.
In a major crisis, the important thing that needs to be restored is confidence, and confidence is restored by visible leadership—leadership that bestows primacy to long-term and broader social good rather than short-term and narrower political and personal goals. That is why it was disappointing not to find in the latest VoxEU e-book on Completing the Eurozone Rescue (June 2010) any reference to this aspect as a key component of policy measures that are needed in the euro zone. The book correctly identifies the role of self-fulfilling expectations in financial markets. While we may be never certain about what and how expectations are formed, we know that leadership influences them for better or for worse. But more than at any time in recent history, this quality appears as rare in practice as it is obvious in theory.
Unfortunately, there is a limit to what incentives can achieve—economic or non-economic. Good leadership is beyond their reach.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at baretalk@livemint.com
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First Published: Mon, Jul 12 2010. 09 27 PM IST