Tag: Trust

Recently read – “The Moral Economy: Why Good Incentives Are No Substitute For Good Citizens” by Samuel Bowles

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:

  1. “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)
  2. “Moral Disengagement”; the incentive may create a context in which the subject can distance themselves from the moral consequences of how they respond
  3. “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.

“The End of Alchemy” by Mervyn King

Anyone interested in the conceptual foundations of money and banking will I think find this book interesting. King argues that the significant enhancements to capital and liquidity requirements implemented since the GFC are not sufficient because of what he deems to be fundamental design flaws in the modern system of money and banking.

King is concerned with the process by which bank lending creates money in the form of bank deposits and with the process of maturity transformation in banking under which long term, illiquid assets are funded to varying degrees by short term liabilities including deposits. King applies the term “alchemy” to these processes to convey the sense that the value created is not real on a risk adjusted basis.

He concedes that there will be a price to pay in foregoing the “efficiency benefits of financial intermediation” but argues that these benefits come at the cost of a system that:

  • is inherently prone to banking crises because, even post Basel III, it is supported by too little equity and too little liquidity, and
  • can only be sustained in the long run by the willingness of the official sector to provide Lender of Last Resort liquidity support.

King’s radical solution is that all deposits must be 100% backed by liquid reserves which would be limited to safe assets such as government securities or reserves held with the central bank. King argues that this removes the risk/incentive for bank runs and for those with an interest in Economic History he acknowledges that this idea originated with “many of the most distinguished economists of the first half the twentieth century” who proposed an end to fractional reserve banking under a proposal that was known as the “Chicago Plan”. Since deposits are backed by safe assets, it follows that all other assets (i.e. loans to the private sector) must be financed by equity or long term debt

The intended result is to separate

  • safe, liquid “narrow” banks issuing deposits and carrying out payment services
  • from risky, illiquid “wide” banks performing all other activities.

At this point, King notes that the government could in theory simply stand back and allow the risk of unexpected events to impact the value of the equity and liabilities of the banks but he does not advocate this. This is partly because volatility of this nature can undermine consumer confidence but also because banks may be forced to reduce their lending in ways that have a negative impact on economic activity. So some form of central bank liquidity support remains necessary.

King’s proposed approach to central bank liquidity support is what he colloquially refers to as a “pawnbroker for all seasons” under which the  central bank agrees up front how much it will lend each bank against the collateral the bank can offer;

King argues that

“almost all existing prudential capital and liquidity regulation, other than a limit on leverage, could be replaced by this one simple rule”.

which “… would act as a form of mandatory insurance so that in the event of a crisis a central bank would be free to lend on terms already agreed and without the necessity of a penalty rate on its loans. The penalty, or price of the insurance, would be encapsulated by the haircuts required by the central bank on different forms of collateral”

leaving banks “… free to decide on the composition of their assets and liabilities… all subject to the constraint that alchemy in the private sector is eliminated”

Underpinning King’s thesis are four concepts that appear repeatedly

  • Disequilibrium; King explores ways in which economic disequilibrium repeatedly builds up followed by disruptive change as the economy rebalances
  • Radical uncertainty; this is the term he applies to Knight’s concept of uncertainty as distinct from risk. He uses this to argue that any risk based approach to capital adequacy is not built on sound foundations because it will not capture the uncertain dimension of unexpected loss that we should be really concerned with
  • The “prisoner’s dilemma” to illustrate the difficulty of achieving the best outcome when there are obstacles to cooperation
  • Trust; he sees trust as the key ingredient that makes a market economy work but also highlights how fragile that trust can be.

My thoughts on King’s observations and arguments

Given that King headed the Bank of England during the GFC, and was directly involved in the revised capital and liquidity rules (Basel III) that were created in response, his opinions should be taken seriously. It is particularly interesting that, notwithstanding his role in the creation of Basel III, he argues that a much more radical solution is required.

I think King is right in pointing out that the banking system ultimately relies on trust and that this reliance in part explains why the system is fragile. Trust can and does disappear, sometimes for valid reasons but sometimes because fear simply takes over even when there is no real foundation for doubting the solvency of the banking system. I think he is also correct in pointing out that a banking system based on maturity transformation is inherently illiquid and the only way to achieve 100% certainty of liquidity is to have one class of safe, liquid “narrow” banks issuing deposits and another class of risky, illiquid institution he labels “wide” banks providing funding on a maturity match funded basis. This second class of funding institution would arguably not be a bank if we reserve that term for institutions which have the right to issue “bank deposits”.

King’s explanation of the way bank lending under the fractional reserve banking system creates money covers a very important aspect of how the modern banking and finance system operates. This is a bit technical but I think it is worth understanding because of the way it underpins and shapes so much of the operation of the economy. In particular, it challenges the conventional thinking that banks simply mobilise deposits. King explains how banks do more than just mobilise a fixed pool of deposits, the process of lending in fact creates new deposits which add to the money supply. For those interested in understanding this in more depth, the Bank of England published a short article in its Quarterly Bulletin (Q1 2014) that you can find at the following link

He is also correct, I think, in highlighting the limits of what risk based capital can achieve in the face of “radical uncertainty” but I don’t buy his proposal that the leverage ratio is the solution. He claims that his “pawnbroker for all seasons” approach is different from the standardised approach to capital adequacy but I must confess I can’t see that the approaches are that different. So even if you accept his argument that internal models are not a sound basis for regulatory capital, I would still argue that a revised and well calibrated standardised approach will always be better than a leverage ratio.

King’s treatment of the “Prisoner’s Dilemma” in money and banking is particularly interesting because it sets out a conceptual rationale for why markets will not always produce optimal outcomes when there are obstacles to cooperation. This brings to mind Chuck Prince’s infamous statement about being forced to “keep dancing while the music is playing” and offers a rationale for the role of regulation in helping institutions avoid situations in which competition impedes the ability of institutions to avoid taking excessive risk. This challenges the view that market discipline would be sufficient to keep risk taking in check. It also offers a different perspective on the role of competition in banking which is sometimes seen by economists as a panacea for all ills.

I have also attached a link to a review of King’s book by Paul Krugman