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The Trouble With Perverse Incentives

Thursday June 30th, 2016   •   Posted by Craig Eyermann at 6:26am PDT   •  

The Debt Trap The existence of perverse incentives explain a lot of the bad behavior that we see among government bureaucrats.

A perverse incentive can be said to exist whenever an incentive to achieve a specific goal instead creates an unintended and undesirable result, which is often entirely contradictory to the intentions of the people who created the incentive.

Perhaps the best example in recent years of perverse incentives at work within the U.S. government is the performance bonuses that provided a financial motive for the Department of Veterans Affairs’ supervisors and scheduling staff to create the phony wait lists that were at the heart of the scandal that resulted in American veterans being denied medical care.

Although the performance bonuses had been established with the intention of rewarding those supervisors who succeeded in reducing the amount of time that veterans seeking medical treatment had to wait before seeing a VA doctor, the VA’s supervisors and staff realized that they could more easily pocket the money if they kept two sets of appointment books to make it look like the veterans were getting the care they were seeking within a short period of time, which then allowed them to claim they were meeting the goal of the performance incentive, entitling them to claim bonuses.

For thousands of veterans, the fraudulent wait lists meant that instead of their getting to see a VA doctor more quickly, they were instead told they had to wait months or even years to even get an appointment, with the consequence that hundreds of veterans died waiting to get care – the exact opposite intention of the performance incentive to shorten the time that veterans had to wait for medical treatment.

Not long ago, we identified a perverse incentive that would give the U.S. government a financial motive for creating instability elsewhere in the world. Because global investors avoid investing in other parts of the world that become consumed by instability, their flight from risk can benefit the U.S. government because it can lower its cost of borrowing money as they seek the relative safety of investing in U.S. Treasury securities.

For a nation whose national debt is well over 80% of the way to doubling in the 7+ years since January 20, 2009, such an incentive would be fairly powerful and could very well influence how it goes about achieving its foreign policy objectives. Or rather, how it goes about failing to achieve its stated foreign policy objectives, where its failure to achieve success in its stated objectives results in an increase in international instability, where the primary benefit that the U.S. realizes in continuing its ineffective policies without reform exists because of its perverse incentive.

It can be argued that the financial turmoil of the recent Brexit vote is just such an example, where President Obama’s April 2016 comments to the British people produced the opposite effect of the President’s stated desires, with the result of increasing instability overseas and with the benefit of having the interest rates that the U.S. pays on its national debt fall significantly as a result of the heightened political and economic turmoil produced by the vote’s outcome.

Lower borrowing costs are not the only benefits a nation might realize from the political or economic instability in other nations. Alberto Ades and Hak Chua considered whether a nation might realize positive gains in trade if its neighboring countries were experiencing turmoil. In the following passage, note that no distinction is made with respect to whether the cause of a nation’s political turmoil is homemade or if it has been fomented by external actors:

There are however cases in which countries may benefit from political unrest in neighboring countries. If neighbors compete for a scarce pool of foreign capital or aid, political instability in the rival country can lead to a larger share of that pool. If neighbors are competing oligopolists of a good or resource, production disruptions in a rival country can lead to an improvement in the terms of trade as well as an increased share of the export market. Neighboring countries may also benefit from the huge capital flight and the migration of talented people that often occur in countries with political turmoil.

Ades and Chua go on to note that such benefits can be completely overwhelmed in the case where instability spreads beyond the affected nation’s borders and produces instead a strong adverse effect, harming all nations in the affected regions through the disruption of trade and the diversion of resources toward military expenditures rather than toward productive investments that might grow the economies of all the nations.

The same principle would apply to the pursuit of the perverse incentive of increased international instability as a means to lower a nation’s cost of borrowing money to finance an excessively large national debt. Such a strategy would undoubtedly be overwhelmed in time by more negative political and economic outcomes that would outweigh whatever hoped benefits might be realized. As a general rule, if you think you can profit by going out and causing trouble in the world, eventually the world’s trouble is going to come looking for you with a bigger bill than you can ever hope to pay.

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June 2016