Nudging the state toward better behavior

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The Obama Administration is very impressed by the findings of behavioral economics and its proposed government policies designed to nudge private individuals toward “better" behavior like increased savings for retirement, stopping smoking, controlling weight, and so forth.

We are also told that Peter Orszag, the federal budget director no less, uses a “behavioral" method to get himself to prepare for running marathons so as to overcome his own lack of sufficient willpower. He has somehow arranged things so that if he does not meet his running goals he will automatically donate money to a charity he doesn’t like.

Orszag, as a private citizen, may do what he likes. Perhaps he should write a book of self-help advice.

What I should like to see, however, is the Obama Team come up with nudge-style techniques to make the government engage in better behavior. Whatever mess people make or do not make of their own lives is a matter of some concern to people with strong fellow-feelings. But what government does affects us all, in my view usually for the worse. It affects even those who lead exemplary lives by creating economic difficulties, by engaging in unjustified wars, and by abridging our liberties – just to name a few examples.

Today the United States government is implementing enormous fiscal stimulus and the Federal Reserve has engaged in the unprecedented creation of money. Some economists, including me, have questioned the wisdom of all this. Nevertheless, even among those who support these policies, there is general agreement that they must be reversed once economic recovery is underway.

We are to suppose that, unlike Peter Orszag, those with the power to control these matters will have the (political) willpower to carry through with the less popular side of counter-cyclical policy. Why should we simply suppose this?

If the Obama Team has such confidence in behavioral techniques, they should apply them to this very important case of potential bad behavior: the possible (probable?) failure to implement the contractionary part of the stimulus cycle.

Congress should pass a law right now specifying that when the rate of growth in the U.S. gross domestic product becomes 1% or greater for two consecutive quarters that a certain overall percentage reduction in government spending take place. The law should further require that if Congress does not pass the enabling legislation at the appropriate time later, then 25% of the salaries of all members of Congress will automatically go to a group of organizations that will promote reductions in government spending. This could be arranged to occur automatically through the members’ respective banks. (A similar nudge might be arranged for the Board of Governors of the Federal Reserve System but that would be more difficult because of the supposed independence of the central bank.)

It is true that members of Congress could undo the nudge at the time – just as, I suppose, Peter Orszag could reverse his charity commitment. But then, having taken this extraordinary step, they would have to admit publicly their failure or rationalize it away – costly options.

This is just one possible implementation of the nudge-technique to create better government behavior. Perhaps others, like Cass Sunstein (the nominee for regulatory czar and coauthor of Nudge,) can come up with better ones.

Guest author Dr Mario J. Rizzo is associate professor of economics and co-director of the Austrian Economics Program at New York University. He blogs regularly here.

Bad money

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Money is not the root of all evil, but it is at the root of economic malaise and this economic crisis.

In the years preceding the subprime crisis, money acted a super stimulant. In many countries, bubbles began to form, and as the system inflated things felt so good. Protected by incompetent and impotent regulation, government directives further stimulated subprime lending and encouraged risky practices. Many investors, imperfect as they are, were duped by it all - the booming house prices and the strong credit ratings, and used every trick in the book to gear themselves and multiply nominal gains on the way up. But as the bubble beneath did not lead to a sound expansion of production, what came next was inevitable. As Mises noted in Human Action, “Credit boom is built on the sands of banknotes and deposits. It must collapse."

The evil of bad money is doomed to return unless we learn the lessons of history. Directed government stimulus plans increasing the quantity of money, and excessively cheap money with interest rates held down too low for too long, both lead to the same conclusion.

When inflation backed fiscal stimulus is implemented and noticed, the inflationary results act as a stealth tax by the government as our money falls in value. When monetary growth is better hidden, it drives many into a state of economic irrationality which one day terminates abruptly.

Monetary stimulus may help in the short run, when looking to relieve the nation of economic malaises such as unemployment, and searching for political boost but over time consistently bad money will cause greater woe: mal investment, bubbles, inflation, and crisis.

A more conservative policy goes some of the way to improving the quality of our money, but actually achieving sound money is a much more difficult task.

Good money

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Much harder than seeing the flaws of bad money is deciding exactly how to get good money.

If price level targeting is to remain, it must be much more conservative and consistent in nature, ensuring genuine price stability and an equilibrium between the supply and demand of money.

Perhaps a Friedman type monetary rule under which the money supply is increased at a constant rate regardless of changing conditions is the way forward.

A more Austrian line to follow would be a return to a standard, most likely gold. This has the advantage of limiting the scope for official bodies to inflate the money supply. Unfortunately, even if one were able to reinstate such a standard, and ensure it was maintained for some time, governments wouldn’t necessarily play by the rules.

Governments would be unwilling to follow constant rules and in times of economic woes might abandon restraint especially to avoid short term pain.

The most revolutionary approach and in theoretical terms attractive, is that there need not be "a single producer of the medium of exchange (Friedman & Schwartz) echoing Hayek‚s thoughts in the Denationalisation of Money. Good money can only be achieved if the issuer is truly forced to preserve its value. The problem is that there is no clear precedent for sound, privately run, inconvertible money. Perhaps, we will never get good money with a government monopoly, but these are uncharted and rocky waters.

Enlightenment from Adam Smith

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Donald J. Boudreaux over at Cafe Hayek writes an interesting letter to The Times.

Blog Review 930

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How do you make people care for each other when they don't care for each other? Use markets of course!

A message for all those who would limit bankers' pay. It's not as easy to do as you might think.

This week's updates from the fake charities.

One of the problems with group and identity politics (based upon skin colour, sexuality and the like) is that it's archaic. Civilisation is the process of moving away from that very idea.

It turns out that the State isn't even very good at the basic research stuff either.

Backyard economics gets taken out into the backyard....behind the woodshed actually.

And finally, meet Captain Brownadder (and do read the subsequent episodes).

The Underpants Gnomes

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Richard Murphy thinks that this idea from the Sustainable Development Commission is a very good one. So clearly there is less to it than meets the eye:

A further option would be to fund specific elements of a sustainable new deal through ‘green bonds’ – bond issues which are targeted directly at low-carbon investments. This idea has a strong rationale under current conditions for a variety of reasons. In the first place, it is clear that many of these investments offer considerable returns, at a point in time when the returns on conventional savings (particularly household savings) are disappearing. 

This has an air of the Underpants Gnomes from South Park to it:

The Underpants Gnomes are businessmen of sorts, and they know a lot about corporations, and explain them to the boys in their underground lair. Their business plan is as follows:

Phase 1: Collect Underpants
Phase 2: ?
Phase 3: Profit!

What's missing from the green bonds idea is that stage 2. How do we get the investments in these green bonds to turn a profit?

Assume for a moment, however strange it might be, that the SDC is correct in that these investments offer considerable returns. By their own numbers they do, yes. But not, you'll note, to the investors in them. The returns are societal. Reduced emissions and the damage they will cause (look, I know, but we're playing pretend their figures are correct). There is no mechanism by which those societal returns are to be paid to the investors.

This is the exact mirror image of the original point about the emissions themselves. They are externalities, outside the prices that prevail in the market. With our bonds, the returns to the society at large are outside the returns to the investors. So just as we get too many emissions because they are not priced so we will get too little investment as the returns are not included in prices.

We do know how to get externalities internalised. We can do it through Pigou Taxation for example. And we could indeed, in fact we're already trying to do so, get the costs of the emissions properly reflected in market prices. And having those costs, thus the profits to be made from minimising them, properly reflected would be a solution to our problems.

But if we do get these costs and thus potential profits properly included in market prices, then what is the justification for "green" bonds? None at all is the answer to that question. For investment in these sorts of green projects will be a money making opportunity just like any other.

What we come to in the end is that the structural changes, the incentives, required to make green bonds work obviate the need to have green bonds in the first place.

Yes, we do pay for the Sustainable Development Commission out of our taxes. Aren't we the lucky ones?

Coke and aidpods

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Simon Berry’s simple idea to add ‘aidpods’ inside of crates of Coca Cola distributed to developing countries is gaining some force. After years of trying to get the plan on the map, last year he finally started gaining major support from activist groups and individuals through social networking sites and other online resources. Berry is now working with Coca Cola and an international aid organisation to finalize the best method of preparing the aidpods. He will have to get information from varying regions in order to include the most appropriate medicines & materials in each of the packages. Berry is certainly on to something.

Do we need a radical shake-up of boards?

The whole issue of bank governance will now be reviewed by two independent inquiries: the first headed up by that old regulatory standby, Sir David Walker, a former chairman of the Securities & Investment Board (SIB);  the second by the Financial Reporting Council, which is rethinking best practice guidelines for boards.

It is increasingly apparent that directors of major bulge bracket banks are falling down in their ability to ensure shareholder influence over corporate strategy and control. Part of the problem is that non executive directors appeared not to understand what banks were getting up to, particularly when it came to trading such complex financial instruments as a CDO cubed. Indeed, it would be fascinating to know whether they could provide a definition of any of the many credit derivatives traded by the banks. Economists are fond of referring to this dilemma as an asymmetry of information problem, in other words the full time employees of the bank may know about things, but the non executive part-time directors sure don’t.

Lord Myners, the City minister and former chairman of Marks & Spencer and Gartmore, the fund manager, has urged both independent inquiries into board governance to “go outside the conventional framework" by testing unorthodox models. He suggests that non executive directors might attend classes on corporate governance (Myners himself might fail the test on ensuring proper accountability for retirement packages granted to outgoing CEOs). He also raises the important issue of whether non-executive directors should have their own full time secretariats.

The non-executive directors at both RBS and HBOS appear to have ducked asking awkward but pertinent questions of their CEOs.  This is puzzling since the boards included some highly intelligent and successful people – no one who has ever met Sir Steve Robson, the former Treasury mandarin who served on the RBS board for over eight years would describe him as a shrinking violet. It is also rumoured that some non-executive directors threatened to resign after arguments with Sir Fred ‘the shred’ Godwin. However, the record shows that no one ever did.

It is disturbing to discover that some leading institutional shareholders, notably Legal & General, have criticised the boards of major banks for ignoring their views. When Legal & General sought to dismiss the chairman and chief executive of RBS following the rights issue held in 2008, their expressed opinion was overruled by the board. This led Peter Chambers, Legal & General’s CEO to tell the Treasury select committee that, “One would have to conclude that non executive directors were not effective in controlling the actions of the executive directors ". Legal & General was one of the three largest shareholders in RBS.

The wide ranging issues centering on non executive directors’ proper role in the banking sector is one that will be discussed at our next REG roundtable and the debate will be led by Mark Austen,  who sits on the board of Standard Bank and was previously global head of banking & finance at PWC. We will return to this issue as the debate hots up.

Keith Boyfield is the chairman of REG, the ASI's regulatory evaluation group.

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Testament to the inability of non-executive directors to maintain a rigorous oversight over the activities of banks’ executive team is reflected in the mounting losses reported by those two ugly sisters of Scottish banking, RBS and HBOS. Cross-examined by the Treasury select committee earlier this year, it was clear that the non executive members of the board had failed to rein in their CEO’s meglomania. What is more, it was revealing to learn that neither the chairmen nor the CEOs of the two banks had any banking qualifications. Nor had Adam Applegarth, the CEO of Northern Trust, or Matt Ridley, the chairman, ever sat a banking exam. [Cont'd]

Gibbon and Waugh had it about right

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Decline and fall.

Do we need a radical shake-up of boards?

Testament to the inability of non-executive directors to maintain a rigorous oversight over the activities of banks’ executive team is reflected in the mounting losses reported by those two ugly sisters of Scottish banking, RBS and HBOS. Cross-examined by the Treasury select committee earlier this year, it was clear that the non executive members of the board had failed to rein in their CEO’s megalomania. What is more, it was revealing to learn that neither the chairmen nor the CEOs of the two banks had any banking qualifications. Nor had Adam Applegarth, the CEO of Northern Trust, or Matt Ridley, the chairman, ever sat a banking exam.

The whole issue of bank governance will now be reviewed by two independent inquiries: the first headed up by that old regulatory standby, Sir David Walker, a former chairman of the Securities & Investment Board (SIB);  the second by the Financial Reporting Council, which is rethinking best practice guidelines for boards.

It is increasingly apparent that directors of major bulge bracket banks are falling down in their ability to ensure shareholder influence over corporate strategy and control. Part of the problem is that non executive directors appeared not to understand what banks were getting up to, particularly when it came to trading such complex financial instruments as a CDO cubed. Indeed, it would be fascinating to know whether they could provide a definition of any of the many credit derivatives traded by the banks. Economists are fond of referring to this dilemma as an asymmetry of information problem, in other words the full time employees of the bank may know about things, but the non executive part-time directors sure don’t.

Lord Myners, the City minister and former chairman of Marks & Spencer and Gartmore, the fund manager, has urged both independent inquiries into board governance to “go outside the conventional framework” by testing unorthodox models. He suggests that non executive directors might attend classes on corporate governance (Myners himself might fail the test on ensuring proper accountability for retirement packages granted to outgoing CEOs). He also raises the important issue of whether non-executive directors should have their own full time secretariats.

The non-executive directors at both RBS and HBOS appear to have ducked asking awkward but pertinent questions of their CEOs.  This is puzzling since the boards included some highly intelligent and successful people – no one who has ever met Sir Steve Robson, the former Treasury mandarin who served on the RBS board for over eight years would describe him as a shrinking violet. It is also rumoured that some non-executive directors threatened to resign after arguments with Sir Fred ‘the shred’ Godwin. However, the record shows that no one ever did.

It is disturbing to discover that some leading institutional shareholders, notably Legal & General, have criticised the boards of major banks for ignoring their views. When Legal & General sought to dismiss the chairman and chief executive of RBS following the rights issue held in 2008, their expressed opinion was overruled by the board. This led Peter Chambers, Legal & General’s CEO to tell the Treasury select committee that, “One would have to conclude that non executive directors were not effective in controlling the actions of the executive directors ”. Legal & General was one of the three largest shareholders in RBS.

The wide ranging issues centering on non executive directors’ proper role in the banking sector is one that will be discussed at our next REG roundtable and the debate will be led by Mark Austen,  who sits on the board of Standard Bank and was previously global head of banking & finance at PWC. We will return to this issue as the debate hots up.

Keith Boyfield is the chairman of REG, the ASI’s regulatory evaluation group.