Saturday, 8 February 2014

Incentives matter

"Rule number one in economics: incentives matter".

So says Tim Worstall, in this post criticising me for claiming that state investment is not necessarily any less efficient than private sector investment. And he goes on to say that politicians and bureaucrats have different motivations from "profit-mad capitalist bastards" like him.

I don't disagree in the slightest. But that doesn't invalidate my argument. 

Tim's argument essentially is that the profit motive always results in better investments than philanthropic or public service motives. The idea is that people who want to make as much money as possible for themselves will make more efficient use of resources than people who want to help others. But why should the motivation to serve others necessarily make one less concerned about efficient use of resources than the motivation to make money? In short, why should selfishness necessarily ensure better outcomes FOR OTHERS than altruism? 

On the face of it, this seems illogical. If people who work in the public sector genuinely are motivated by the desire to provide the best possible services for others, why would they be any less efficient than private sector actors motivated by the desire to make as much money as possible? There is really only one possible explanation for this, and that is that is that those who work in the public sector are less able than those in the private sector, so are inherently incapable of deploying resources to their best effect. This amounts to saying that selfish people are cleverer than altruistic people. Really?

I suppose it is possible that the dim-witted self-select to work in public service, and are never weeded out because, er, their managers are dim too, but to me this seems rather far-fetched. So what other reasons might there be for inefficiency in public service? There are a number of possibilities. 

The first is that those who work in public service actually aren't genuinely motivated by altruism. And this is indeed possible. But is someone necessarily less efficient because they get their rewards in non-monetary forms - whether personal recognition, the satisfaction of a job well done, or the warm feeling that comes from seeing the lives of others made more comfortable? Or is someone necessarily less efficient because they are motivated by the desire to work locally, have a secure job and earn a comfortable living? Again, this looks far-fetched. 

Some claim that that anyone who works in public service - and in particular, anyone who goes into politics - is doing so because they expect to benefit personally and not out of any genuine public service motive. At its most extreme, this amounts to saying that all politicians and bureaucrats are corrupt. Some are, for sure - but all of them? This is not remotely supported by the evidence. The UK's record on corruption is rather good, actually. No, if there is waste and inefficiency, it doesn't stem from corruption. 

But it might stem from bureaucracy. Indeed there is a strong argument that the natural tendency of  managers in the public sector to build empires increases bureaucracy at the expense of efficiency. The public sector is not homogenous, but it is very large, and size and bureaucracy definitely go together. But the same argument can be made about any large organisation, private or public sector. The profit motive is no stronger for the thousands of employees of say, Barclays, than it is for the thousands of employees of Her Majesty's Government: they are all simply doing jobs for wages. But the empire-building incentive is at least as strong. It is illogical to assume that a private sector firm of a similar size to a public sector organisation is more efficient simply because it is in the private sector. And it isn't supported by the evidence, either. Large commercial organisations can be astonishingly wasteful. I have never seen so much money wasted in my life as I did in the finance department of Midland Bank. Though admittedly, Midland suffered the fate of large inefficient commercial organisations - it was taken over. Which brings me to the next criticism of the public sector: lack of competition. 

The story goes that private sector actors make efficient use of resources because otherwise they will be forced out of business by more efficient players. So a public sector organisation that has no competition will inevitably become inefficient, simply because it lacks the discipline of competition. 

But the discipline on the public sector is the democratic vote. Politicians that have presided over profligate spending programs can be voted out of office, and politicians can be elected on a cost-cutting mandate. Indeed successive governments, of both colours, have pursued the objective of "eliminating waste" in the public sector, cutting costs, privatizing functions and outsourcing services at an astonishing rate. The belief that profit motivation ensures efficiency has been the driving force behind public sector reforms for the last thirty years. 

As a consequence, there is now significant competition in the public sector. Both central government and local put out services for competitive tender: these are fought over fiercely by a mixture of profit-making and non-profit-making providers, and it is not always the profit-makers who win. Nor is competitive tendering the only source of competition in the public sector. Failing schools are taken over by other schools in much the same way as failing companies are taken over by their competitors. Failing hospitals are heading the same way. Yes, it seems brutal: but it is a necessary discipline on the public sector. 

The growth of competition in the provision of public services is actually as much a discipline on the private sector as the public sector. This is because the need to make a profit is itself an inefficiency*. Public services are not necessarily provided by either the public sector or the private sector: the non-profit-making sector (the "third sector") is an immensely important provider of public services. If there is competition between profit-making and non-profit-making providers, the non-profit-makers should always win. If they don't, it could be due to bureaucratic inefficiency. Or it could be due to other factors. 

Organisations that provide a public service may additionally have other goals, such as paying living wages to their employees. This is no doubt what is behind Tim's suggestion that profit-making organisations would pay lower wages. The public sector is often criticised for high pay rates and gold-plated benefits, which is to some degree true, probably because unions have more power than in other sectors. But we do have to be a little careful with comparisons: the public sector has a high proportion of highly-qualified employees who would command good salaries in the private sector too. Most low-skill, low paid public sector jobs have long since been outsourced. 

But the third sector is an entirely different matter. It really can't be regarded as profligate with pay. In fact it can be astonishingly mean. Pay rates in the third sector are generally far below rates for equivalent jobs in the private or public sector: many charities would rather not pay their workers at all, let alone living wages. When I worked for a charity bank, I had to remind the directors that expecting to pay well below market rates simply because they were a charity did not help them to recruit or retain good staff. The existence of highly efficient non-profit-making organisations whose directors and staff are motivated by the desire to provide a good service is compelling evidence that Tim's argument is fundamentally wrong. Incentives do indeed matter, but the profit motive is no better an incentive than the desire to do some good.  

Tim comments that politicians may be more interested in creating jobs than providing efficient, low-cost public services. And Simon Cooke (a local politician in Bradford), in a comment on Tim's post, observes that: 

"The problem here, such as it is a problem, is that those “social motives” that define the objectives of state investment are ill-defined. For sure, we can look at the NHS and describe its objective as improving the health of the population, we can even quantify that objective (increased life expectancy, for example) but there is no incentive to see that objective as paramount. The result is mission creep.....
"Within the public sector decisions are compromised by this mission creep – be it environmental, ‘equalities’ or some other ‘social purpose’ that really has nothing at all to do with the real purpose of the institution. The classic examples is jobs – I was castigated at one meeting for saying that if we could run Bradford Council’s services without needing to employ a single person then, ceteris paribus, this would be a good thing – for the service and for the taxpayers who fund the service."

Here is the heart of the matter. It is not the motivation to make money that makes people efficient with resources. It is having a single clearly-defined purpose. 

When objectives are unclear, money is inevitably wasted. This is true in the private sector as much as the public sector. In the private sector, organisations that have no clear purpose eventually go out of business (Woolworth's springs to mind). In the non-profit-making sector, organisations that have no clear purpose never get off the ground - after all, who is going to give to a charity that has no clear idea what it will do with the money? And in the public sector, organisations that have no clear purpose are (we hope) eventually eliminated by politicians acting in accordance with their democratic mandate.  

Those who claim that the public sector is intrinsically inefficient and corrupt, so should be cut to the bone or, preferably, dismantled completely, are therefore doing us all a favour. Their disapproval provides the discipline for the public sector that competition provides in the private sector. And because of it, there is much less difference between the efficiency of the public and the private sectors than they think. So they are wrong, but - perversely - we need them to continue to believe that they are right.

By the way, the debate in the comments on Tim's post was one of the most interesting and good-natured online debates I have ever taken part in. I do recommend reading it. It develops the argument about bureaucracy and perverse incentives in the public and private sectors quite a bit, and concludes that actually it can be very hard to tell the difference between the public and private sectors.  

Related reading:

Public choice theory - EconLib

* Perfect competition forces down profits to zero. If costs are the same, therefore, a company that doesn't need to make a profit will always outbid one that does need to make a profit. The profit-maker's attempt to make a profit by cutting costs will be undermined by the non-profit-maker doing the same. The profit motive in the provision of public services therefore to some degree creates inefficiency.


  1. People behave similarly in public and private sectors, whatever the ultimate goal. Forty five years working in the private sector, mainly for public sector clients, has demonstrated that there are good and bad in both.

  2. You make a lot of good points and a lot of good caveats, but I think you are making it too complicated.

    There are public goods (and to some extent merit goods) which only 'the collective' can provide. This might be people on a street clubbing together to plant flowers on the roundabout, forming a Neighbourhood Watch all the way up to the UN mediating between warring countries. No individual can go up to Assad and ask him to stop using chemical weapons on unarmed citizens, only large bodies can do that.

    So as inefficient as the government might be at building motorways, running the police, fire service and refuse collection (and those things are all done relatively efficiently, I hasten to add) it wouldn't actually matter, because the benefit to the general public (the "profit") will always vastly exceed the cost, even if that cost is inflated (meaning extra "profits" for politicians and bureaucrats and their mates). These things still create wealth overall.

    Where the government is inefficient is where it does stuff for which there is no demand and which does not create any value (I'm not going to bore you with the list, make up your own). This is inherently wasteful and 100% inefficient (possibly more than 100% inefficient).

    I think you've covered just about everything else :-)

  3. The private sector can be just as inefficient as the public sector. But there is a significant difference - in the private sector bad investments have to be recognized and the associated financial claims liquidated. In the public sector losses due to wasteful use of resources are never recognized, nor are the respective financial claims ever liquidated. If the government borrows or prints $2 billion to build a bridge to nowhere, the productive capacity of the economy is not improved in any way; however, the $2 billion financial claim persists in perpetuity (unless, of course, the government ran a $2 billion surplus in order to liquidate such claim). As a result, persistent fiscal deficits tend to inflate financial claims and suppress productive capacity. Basically, bad government programs co-exist with good ones thus giving the public sector a reputation for inefficiency. Here's more on the core problems with the public sector and respective solutions

    1. Oh right. So you would eliminate the discipline of the public vote and replace it with the discipline of unelected technocrats, leaving elected politicians with no real purpose other than to preserve the illusion of democratic government - which would no longer exist. Good grief.

    2. "The private sector can be just as inefficient as the public sector."

      From my observation, most of the "inefficiency" of the public sector can be traced back to regulatory capture and other mechanisms by which the profit incentives of private sector actors manifest in corruption of public sector processes.

      Glibertarians are always on about the social costs of bureaucrats interfering in private enterprise, but are strangely blind to the social costs incurred by private enterprise interfering in bureaucracy.

      Incentives matter both ways.

    3. I think you misunderstand me. I have no problem with the public sector as long as government programs are paid for. In addition to the discipline of the public vote, I want to add the discipline of a balanced budget. The decision whether to run fiscal deficits or surpluses is strictly a monetary one (deficits increase money supply and surpluses reduce it) and as such it should be controlled by central banks. More importantly, by controlling fiscal deficits central banks will no longer be constrained by the lower zero bound. By lowering sales taxes into negative territory and increasing investment credits, they can easily replicate conditions similar to negative interest rates.

      Also, let's not forget it was elected politicians in the US that have racked up $17T in debt. Have those resources been used wisely? Have we received $17T worth of value + interest? The fact of the matter is that the budgetary process is entirely political in nature. Unlike central banks, which measure their actions against objective yardsticks such as price stability and full employment, politicians respond to partisanship and pressures by vested interests and narrow constituencies. Deficit spending is the crack-cocaine of politics. When times are good, it is all too easy to lavish constituents with government spending without imposing the costs of higher taxation - think two wars, a medical prescription drug benefit and large tax cuts all charged to the nation's credit card during the go-go days of the housing bubble. When times are bad, bashing government deficits and preaching the virtues of austerity is the tried-and-true playbook for gaining political leverage - think the rise of the tea party, multiple threats of default over the debt ceiling and insufficient fiscal stimulus to power a real recovery.

      On the other hand, if government programs could no longer be financed with debt, all vested interests will be brought into the budget process including those who will bear the costs. Such representation is the key to limiting political corruption and fostering a competitive and free market place.

    4. No, I do not misunderstand you. You wish to remove government financing from democratic control, and force governments to run balanced budgets at all times irrespective of economic conditions. I do not agree with this - in fact I think we have already gone far too far with dilution of democratic control by placing monetary policy decisions under the control of unelected technocrats. But to lose democratic control of tax policy? Absolutely not. No way should unelected officials have the right to decide on the level of sales taxes - or any other sort of taxes, for that matter. They must be accountable to the electorate who will pay those taxes. Yes, taxes can be used as monetary policy instruments - indeed I have suggested that myself. But they must remain under democratic control.

    5. You make good points, and I do agree with you that checks and balances need to be in place. For example, the elected body can set the maximum level of taxation with the central bank only having authority to lower the tax but not increase it above the cap, which limits the amount of surplus central banks can run at any one time. On the deficit side, the debt ceiling in the US is currently an exercise in tautology - the money has already been appropriated and often-times spent by Congress. Under the proposed regime, the debt ceiling gives the elected body ultimate control over cumulative deficits and the maximum amount of money creation the Fed can engage in. Furthermore, in the US the President and Congress have control over Fed appointments, so it's not like the Fed is unaccountable.

      The fundamental issue, though, remains the same. Government debt is nothing more than a tool for money creation, and as such it should be controlled by central banks.

      Such regime will be even more beneficial to Europe (even though, the ECB may have to be reformed to ensure that appropriate checks-and-balances exist). One of the problems with the Euro is that it enforces one-fits-all monetary policy to a continent that is still defined by national, cultural and economic borders. However, if the ECB controlled a VAT credit, it could fine-tune policy by region. Back in the boom days when German savings were flooding the periphery, the ECB could increase rates to prevent overheating in Spain while funding a VAT credit in Germany to spur domestic consumption and absorb excess savings - in effect replicating conditions associated with lower rates. Today, when monetary conditions in the periphery are severely constrained by a shortage of money and the lower zero bound, the VAT credit will go to Spain, Italy and Greece providing a much needed infusion of newly-printed euros.

    6. "Government debt is nothing more than a tool for money creation, and as such it should be controlled by central banks."

      This is simply wrong. Government debt is a claim on future taxation, and as such must be subject to democratic control.

      You will never, ever get the German government to permit the ECB to control VAT. Nor should they. VAT is a tax and should therefore be under the control of fiscal authorities, not the central bank.

    7. H Publius

      Just to correct you, when private sector investment takes place - as it typically does - using bank borrowing, then even though these loans may be liquidated, the money which was created by the banking system at the outset remains in existence. Similarly if the investment is via shares in a joint stock company, even though the shares may become worthless, no modern money is destroyed.

      Only the Central Bank - as fiscal agent of the Treasury - can destroy modern money.

      So your (Austerian) liquidationist point is invalid.

    8. Chris - a correction. Indeed, banks create money when they extend credit. Basically, they substitute their liabilities, which can be used as money, for those of their borrowers, which cannot be used as money. The cumulative money created by banks is the excess of the respective monetary aggregate such as M1 or M2 over Monetary Base.

      So if a private investment is partially funded with bank loans, new money is created. However, as soon as that loan is paid off or charged-off that money is destroyed. As I explained above, the raw material for money creation by banks are borrower liabilities. As soon as the borrower liability is extinguished, so is the corresponding bank money.

      If an investment is 100% funded with equity no money is created in the first place. So technically, you are correct. If the investment fails, no money is destroyed, but no money was ever created, either...

    9. Frances, final point. I don't expect that we will come to a meeting of the minds here, but it has been a great discussion, and I definitely take to heart the concerns you raised. As to your point on government debt, future taxation is simply the collateral that enables governments to borrow today. Also, as to democratic control - just ask yourself, how much democratic control went into the accumulation of the current government debts in Europe or the bank bailouts or the austerity imposed on the periphery to ensure that such debts are paid back?

    10. Future taxation is not "collateral", in the sense of being "pledged" against failure to repay. Repaying the debt REQUIRES future taxation. That is why it must be under democratic control.

      Yes, democracy is imperfect - not least because future generations only have a voice to the extent that their parents and grandparents are prepared to speak for them. But is better than no democracy.

  4. "Tim's argument essentially is that the profit motive always results in better investments than philanthropic or public service motives."

    That's rather more extreme than what I did actually say. Mark W above has an example of when this really isn't true, in the provision of public goods. What I did actually say was that because the incentives are different then the decisions will be different. Which is an entirely obvious point I would have thought.

    I'm also interested by your point that it is us shouting that the public sector that is inefficient that provides the impetus to make it more efficient. Which does seem to rather admit to the point that the public sector is, absent that market competition and the incentives which it provides, inherently more inefficient.

    1. "What I did actually say was that because the incentives are different then the decisions will be different."

      You then leap from near-tautology to absurdity, claiming without substantiation that the consequent "different decisions" will be "more efficient".

      Take, for example, the profit-maximising and deregulated "efficient" decision-making that led the entire private sector global financial system into insolvency. So "efficient", that today it would be a smouldering post-apocalyptic ruin if not for the extraordinary and heroic "inefficient" intervention of the public sector, incentivised by protection of the public interest.

      In fact, there is a quite clear direct and empirical correlation between the degree to which private sector profit incentives play a role in public sector "decision making", and the degree to which said public sector is "inefficient":

      The problem is not size of the public sector economic share; the problem is the degree to which the public sector has been corrupted by profit incentives.

      Greed, for want of a better word, is not good.

    2. Tim,

      This was the argument against state investment that I was questioning:

      "It is often stated that the State is unable to assess risk properly or make rational investment decisions, and that therefore any investments the State makes are likely to be inefficient relative to private sector investments."

      This is an argument frequently made by those who want a smaller State. I argued against it on the following grounds:

      "...the State uses the same management consultancies to advise it on investment projects as the private sector does, engages the same contractors as the private sector uses and recruits people from the private sector. Admittedly, bureaucracy can have a deadening effect, but the same is true of large organisations in the private sector. Bureaucratic inefficiency is certainly not a public sector specialism."

      In other words, there is no reason why a public sector actor providing a particular service should be any less efficient than a private sector actor providing the same service..

      Of course different organisations have different incentives. But that is confusing the purpose with the means to achieve it. Having a social purpose does not imply or require inefficiency.

      If all you meant to do was point out that organisations have different incentives, you weren't actually addressing my point at all.

    3. Oh, and on the point about democratic discipline.....I would have thought this was obvious.

      Inefficiency is the consequence of lack of competition in the private sector. It is reasonable to assume that it is also the consequence in the public sector. I don't deny that.

      My point is that competition is not the only means of achieving efficiency. The democratic vote can have the same effect. Which is just as well, because in some parts of the public sector competition can actually create inefficiency, with worse outcomes for the users of the service: multiple bus companies competing for business on the same road, for example. I've actually seen this in practice and it is a disaster.

  5. Private Sector = Good: Public Sector = Bad.

    This is not longer a question of economics or even politics, for some it has become a religion. Attempting to reason with the religious using facts or logic is doomed to fail, that way madness lies. Bill40

  6. There's nothing inherently different between a public sector tax demand and a private sector invoice except that the latter involves demands for economic rent in some form or another.

    Orwell would recognise the way that our language has been hijacked by the Right. When they say 'productive' they don't mean productive of value - they mean 'productive of claims over value'. So a nurse in a public hospital is an unproductive drain on the private sector wealth creators, but the minute she works for a private company she's creating wealth.


    But the truly pernicious thing which the public sector and private sector have in common is that both use the same 'least £ cost' economic assumption which is based upon the use of a negative - debt-based - currency and unit of account.

    Until that changes, and we transition to a positive unit of account, the current debate about altruism is interesting, but going nowhere.

  7. It is a great post. I agree with you anymore. Also great blog here with all of the valuable information you have. Keep up the good work you are doing here. Thank you for sharing such a useful post.

  8. The answer to why if people who work in the public sector are genuinely motivated by the desire to provide the best possible services for others, would they be any less efficient than private sector actors motivated by the desire to make as much money as possible - is that the private sector entrepaneur's efficiency is the product to their self interest motive = return = price of his product - the price of the resources used, ulike the wages of those who work in the pulic sector.

    1. Dinero,

      You are confusing the returns to entrepreneurs with the wages paid to their staff, and your are therefore comparing apples and pears. The correct comparison is entrepreneurs (who lose their shirts if they get it wrong) with politicians (who get voted out of office if they get it wrong), not entrepreneurs with public sector workers.

      The wages of those who work in the private sector are determined by competition (market price of labour). The wages of those who work in the public sector are likewise determined by competition if there are private sector and/or third sector competitors. If there are no competitors, then I agree that wages may be driven up, just as they are in any monopoly. Driving them down then becomes the function of the democratic vote - as I said. The biggest enemy of public sector efficiency is voter apathy.

    2. even then, for voters input to have that function you would have to have in mind the scenario of a particular politician who was voted out because of a project in their department was completed, but completed in an inefficient manner, voters having that cost infomation, and also some metric as whether or not that was inefficient. More importantly voters by constituency don't tend vote for the constituency MP based on their performance in the minestry they are appointed to.

  9. Surprised nobody's mentioned "Exit, Voice and Loyalty".

  10. There is no huge difference between the private sector as well as the public sector from the perspective of the company. Indeed it's a matter of incentives.

    From my experience the major difference is - Who does pay the companies turnover? Is the customer thankful and willing to honor the companies achievements in general?

    If you are aiming at putting public services into the hands of private companies - be careful. Organizing public services in a way private sector companies work does make sense - in a sense of modern organization. Honestly. How do investment banks call it, 'Overcoming/Eliminating inefficiencies found in markets'. Sounds good - make something cheaper. What they mean is, 'Rip out the white from the customers eye'.

    The difference between a private and public service is a different one. If you are an electricity supplier and owned by the publicity you will not stop servicing people that cannot afford to pay their bills, especially when times are hard in general. Maybe you offer Electricity, natural gas, public transportation, swimming bath, ... there are things that do make sense together. Employees in the public sector are not behaving like clerks - maybe because of bureaucracy.

    The more bureaucracy is involved the more money is wasted. Can clean pipes produce dirty water?

    1. I maybe should have addressed this more from A-level economics. Public sector investment is appropriate when the social good outweighs the profitability.

  11. Hallowed Be, ,, Your piece accepts that incentives matter yet questioned why profit motive is given exalted status. Ok fair enough question.
    I would say for all the term ‘Social good’ represents a collective goal don’t forget, so too does a market price. It is after all the distillation of all the decisions of individuals in the marketplace. And at that market price there will be a profit or a loss. I’d hope you’d agree that it is the signal that is the really valuable thing. The signal to all the profit mad bastards given by all those want mad bastards (a.k.a humans) . Now where is the signal to all the socially improving mad bastards? Well, with the best will in the world, it’s not so clear is it? That ‘social good’ has to be judged and distilled through our democratic institutions, aka politics. And when your 10 maybe 20 votes a decade are the feedback mechanism for 40 plus % of the economy, I am pretty far from being persuaded that social good incentives are on a par with the profit motive for allocating scarce resources efficiently.