The potential for incentives to create bad behaviour has been much discussed in the wake of the GFC while the Financial Services Royal Commission in Australia has provided a fresh set of examples of bankers behaving badly. It is tempting of course to conclude that bankers are just morally corrupt but, for anyone who wants to dig deeper, this book offers an interesting perspective on the role of incentives in the economy.
What I found especially interesting is Bowles account of the history of how the idea that good institutions and a free market based economy could “harness self interest to the public good” has come to dominate so much of current economic and public policy. Building on this foundation, the book examines the ways in which incentives designed around the premise that people are solely motivated by self interest can often be counter-productive; either by crowding out desirable behaviour or by prompting people to behave in ways that are the direct opposite of what was intended.
Many parts of this story are familiar but it was interesting to see how Bowles charted the development of the idea over many centuries and individual contributors. People will no doubt be familiar with Adam Smith’s “Invisible Hand” but Bowles also introduces other thinkers who contributed to this conceptual framework, Machiavelli and David Hume in particular. The idea is neatly captured in this quote from Hume’s Essays: Moral, Political and Literary (1742) in which he recommended the following maxim
“In contriving any system of government … every man ought to be supposed to be a knave and to have no other end … than private interest. By this interest we must govern him, and, by means of it, make him notwithstanding his insatiable avarice and ambition, cooperate to public good” .
Bowles makes clear that this did not mean that people are in fact solely motivated by self-interest (i.e “knaves”), simply that civic virtue (i.e. creating good people) by itself was not a robust platform for achieving good outcomes. The pursuit of self interest, in contrast, came to be seen as a benign activity that could be harnessed for a higher purpose.
The idea of embracing self-interest is of course anathema to many people but its intellectual appeal is I think obvious. Australian readers at this point might be reminded of Jack Lang’s maxim “In the race of life, always back self-interest; at least you know it’s trying“. Gordon Gekko’s embrace of the principle that “Greed is good” is the modern expression of this intellectual tradition.
Harnessing self-interest for the common good
Political philosophers had for centuries focused on the question of how to promote civic virtue but their attention turned to finding laws and other public policies that would allow people to pursue their personal objectives, while also inducing them to take account of the effects of their actions on others. The conceptual foundations laid down by David Hume and Adam Smith were progressively built on with competition and well defined property rights coming to be seen as important parts of the solution.
“Good institutions displaced good citizens as the sine qua non of good government. In the economy, prices would do the work of morals”
“Markets thus achieved a kind of moral extraterritoriality … and so avarice, repackaged as self-interest, was tamed, transformed from a moral failing to just another kind of motive”
Free market determined prices were at the heart of the system that allowed the Invisible Hand to work its magic but economists recognised that competition alone was not sufficient for market prices to capture everything that mattered. For the market to arrive at the right (or most complete) price, it was also necessary that economic interactions be governed by “complete contracts” (i.e. contracts that specify the rights and duties of the buyer and seller in all future states of the world).
This is obviously an unrealistic assumption. Apart from the difficulty of imagining all future states of the world, not everything of value can be priced. But all was not lost. Bowles introduces Alfred Marshall and Arthur Pigou who identified, in principle, how a system of taxes and subsidies could be devised that compensated economic actors for benefits their actions conferred on others and made them liable for costs they imposed on others.
These taxes and subsidies are of course not always successful and Bowles offers a taxonomy of reasons why this is so. Incentives can work but not, according to Bowles, if they simplistically assume that the target of the incentive cares only about his or her material gain. To be effective, incentives must account for the fact that people are much more complex, social and moral than is strictly rational from an economic perspective. Bowles devotes a lot of the book to the problem with incentives (both positive and negative, including taxes, fines, subsidies, bonuses etc) which he categorises under three headings:
- “Bad News“; incentives send a signal and the tendency is for people to read things into incentives which may not have been intended but prompt them to respond negatively (e.g. does this incentive signal that the other party believes I am not trustworthy or lazy)
- “Moral Disengagement”; the incentive may create a context in which the subject can distance themselves from the moral consequences of how they respond
- “Control Aversion”; an incentive that compromises a subject’s sense of autonomy or pride in the task may reduce their intrinsic motivation to perform the task well
Having noted the ways that incentives can have adverse impacts on behaviour, Bowles notes that civic minded values continue to be an important feature of market based economies and examines why this might be.
“If incentives sometimes crowd out ethical reasoning, the desire to help others, and intrinsic motivations, and if leading thinkers celebrate markets as a morality-free zone, it seems just a short step to Karl Marx’s broadside condemnation of capitalist culture”
One answer is that trading in markets encourages people to trust strangers and that the benefits of trading over time teach people that trust is a valuable commodity (the so called “doux commerce” theory).
While admitting his answer is speculative, Bowles rejects “doux commerce” as the whole answer. He argues that the institutions (property rights, rule of law, etc) developed by liberal societies to protect citizens from worst-case outcomes such as personal injury, loss of property, and other calamities make the consequences of mistakenly trusting a defector much less dire. As a result, the rule of law lowers the bar for how much you would have to know about your partner before trusting him or her, thereby promoting the spread of trusting expectations and hence of trusting behavior in a population.
The “institutional structure” theory is interesting but there is still much in the book worth considering even if you don’t buy his explanation. I have some more detailed notes on the book here.