If you incentivize it, will they come?

On Monday, I argued investment incentive policy is best understood within a political framework that takes seriously the electoral incentives state and local officials face. Looking through the New York Time's interactive database of investment incentives, it is striking how widely states vary in the amount of incentives offered. What explains this variation? One possible explanation is individual agency. Perhaps Texas has a very large incentive program because of the political influence of G. Brint Ryan; this is the implicit argument forwarded in the New York Times Investigative Series on Investment Incentives. Comparative political economists would point to institutional variation; differences in governance structures and how susceptible local governments are to corruption may explain the extent to which states pursue incentive programs.* Partisanship might matter too, although it is difficult to make the case that voters see incentives as clearly benefiting benefit at the expense of workers. Indeed, as I mentioned on Monday, experimental evidence suggests voters see incentives through the prism of job creation. This makes a partisan-based mechanism less plausible.

While people and institutions may help explain a portion of variation in incentive programs, I’d argue structural conditions are most important. (This probably won’t surprise readers of the blog – contributors here tend toward thinking about the world in such terms.) As I mentioned in Monday’s post, states and localities are working to attract jobs in a context of open capital markets. Consequentially, absent transaction costs, capital is mobile while labor is relatively fixed and this makes capital strong. Capital gets locational incentives because its exit option is credible. Labor, however, is captive so governments can tax it more. The problem with this view (besides the fact that suggesting governments face little pressure to reduce taxes on middle-class workers will get you laughed – and voted - out of Washington these days) is that the global economy, while open, is not frictionless. Transaction costs, or in network terms, negative externalities are important.

There is a large literature in economics on agglomeration effects – basically the idea that centers of economic activity form due to positive externalities generated by the success of a few enterprises.** In the 1950s, Detroit was perhaps the best example of one of these centers. Successful, large manufacturing enterprises require deep supply chains, preferably located with geographic convenience to reduce transportation costs and to decrease production times. Competitors often locate nearby to be better able to recruit management, design, and other knowledge workers. In network terms, when a fit enterprise center emerges, preferential attachment reinforces that center.

Today, thriving centers of economic activity in the US include New York City, the Silicon Valley, and perhaps even NC’s own Research Triangle Park. It is then not surprising that, according to the New York Times report, California is reducing its incentive program, which is already comparatively small at $112 per capita. New York and North Carolina have relatively low per capita incentive programs, $210 and $69 respectively. Compare that to the three largest incentive programs on a per capita basis – Alaska at $991, West Virginia at $845, and Texas at $759. Economic geography matters. The states with the largest incentive programs are those that either never generated large centers of economic activity, or whose centers have become obsolete as our economy has shifted from manufacturing to services.

Economic centers form due to a confluence of factors, some of which governments have control over and some that they don’t. Investments in education and infrastructure can provide a skilled workforce and inexpensive access to energy, telecommunication, water, and transportation networks. And, it is true that offering locational incentives may reduce governments’ ability to invest things that will actual increase their locality’s fitness. But, this ignores the fact that incentive programs are fundamentally designed undermine powerful network effects that concentrate economic activity. That is why they are so inefficient; because they are swimming against the current. Fitness is not the whole story – preferential attachment entrenches economic centers. So, incentives ultimately are big risks – if you are lucky, you may attract enough high-quality enterprises that you can build a thriving center. But, network dynamics are working against you.

* Nate Jensen pointed me to this particular NBER working paper , which finds evidence that corruption increases incentive programs.

**See here (firewalled) for a review.

The Politics of Basel III [1/2]

Basel III has not been settled yet; the kinks are still being ironed out. And some observers, like Joseph Cotterill at Alphaville, aren't too happy about the goings-on:

Can we talk a bit more about the scandal of Basel III allowing banks to give government bonds a zero risk weighting on their books? This time regarding Basel’s liquidity rules.

Sure. Governments negotiating Basel will leave the provision in because they want banks to buy their debt at low prices. Giving them capital relief for doing so is one way of ensuring that continues to happen. Is that scandalous? Maybe. But it's basic political economy. It gets more complicated, and I encourage everyone to read Cotterill's very good summary post for the details, but the culmination is this:

This would present a difficult situation for banks to be sure. They’d be asked to take on exposure to assets they might not want otherwise, in return for regulatory certainty.

This gets right at what Jeffrey Friedman argues was a central cause of the crisis: banks were incentivized to hold assets -- particularly certain types of asset-backed securities -- because of the regulatory structure imposed on them, rather than for any rational investment reasons. Friedman originally proposed this explanation in a special issue of Critical Review (which he edits). His original chapter is here, and it has now been expanded into a book.

Anyway, it's not a surprise to see this continue in Basel III, but it means that the banking sector will continue to be susceptible to sovereign debt crises, and that governments will be able to get easier funding than they ought. Obviously this can lead to a vicious cycle. We've seen it already, but because Basel III tightens up capital and liquidity regulations the incentives to get capital relief by holding zero risk-weighted bonds will be even stronger. Not a recipe for public fiscal discipline and private financial stability, if you ask me.

Rum Diaries

Here's an interesting article on how an obscure provision in the U.S. tax code has caused two U.S. territories to go to the mattresses:

Now the spirit once called Kill-Devil has set off a bitter dispute between two United States islands, Puerto Rico and the Virgin Islands, over a tax that the federal treasury collects on rum.

The fight began when the Virgin Islands persuaded the world’s largest distiller, which said it was leaving Puerto Rico, to move to St. Croix by offering a staggering $2.7 billion in tax incentives. The new distillery, for Captain Morgan spiced rum, will provide no more than 70 permanent jobs on the south shore of St. Croix — but it will entitle the Virgin Islands to collect billions in rum tax revenue from Washington.

That bounty comes at the expense of Puerto Rico, where 90 percent of the revenue from the rum tax had been used for public projects and social services rather than corporate incentives. The Virgin Islands has promised to give nearly half its tax revenue back to the distiller, the British company Diageo, prompting a series of charges and countercharges between neighbors roughly 50 miles apart in the Caribbean. ...

The billions of dollars at stake are the result of a quirk in the tax code that was intended to aid the islands while preventing their offshore distilleries from gaining an unfair advantage over competitors in the states.

Because rum producers in the islands are exempt from federal excise taxes, the government imposed an “equalization tax” on Puerto Rican rum producers in 1917 and gave the money to the commonwealth. In 1954, the United States extended the arrangement to the Virgin Islands.

Now the islands are competing to lure producers with tax incentives. Many are complaining that the tax revenue should go to the people, not the corporations, but if the corporations leave there's no revenue for the people at all. So the islands compete against each other, some of the revenue gets redistributed from Puerto Rican citizens to the corporation, and some other revenue gets redistributed from Puerto Rican citizens to Virgin Islands citizens. Bad for Puerto Ricans, but great for Virgin Islanders.

Of course, absent the equalization tax the corporation would have moved out of the U.S. jurisdiction entirely, likely to Guatemala or Honduras, and both U.S. territories would lose. In any case, tax incentives matter, and they can be very distorting.

Politics Everywhere, Even Where It's Supposedly Not Allowed

A few days ago Yglesias wrote that China's domestic politics isn't as simple as many outsiders think:

Chinese political institutions aren’t the same as American ones, but what you can see here is that they’re not totally different either. This is not at all dissimilar to the debate playing out over the EPA’s Clean Air Act mandate to regulate greenhouse gas emissions. Public officials, whether in China or West Virginia or Ohio, often see it as their job to defend the interests of local employers and businessmen.

Yesterday, Drezner added that these kinds of misperceptions can have an effect on policy:

It's incumbent upon the American foreign policy community to develop a better appreciation of the domestic politics of other countries. But, damn, it would be good if other countries could get a better working knowledge of the U.S. foreign policy community. It's not like we're all that opaque.

This led Farley to write a post about how the U.S. policy community seems completely uninterested in how politics actually works in other places:

In particularly, I was frustrated by the belief, apparently endemic to the US pundit and strategic class, that authoritarian states don’t operate under domestic constraints, and consequently can do whatever they want. It’s not quite right to say that academy has figured out how to successfully integrate domestic politics into theories of foreign policy behavior, but we’ve certainly worked on the question. The policy community, however, seems almost utterly uninterested in this literature, to the extent that “well, Ahmadinejad/Putin/Chirac/Chavez/Milosevic/Calderon/Netanyahu/Kim could comply with our demands, but his domestic coalition would almost certainly fracture, and it’s tough to expect leaders to do things that will lead to their downfall” becomes a repetitive refrain.

I think that this question is the one that I entered into grad school knowing the least about, or at least that I had the least appreciation for. I've since become persuaded that it is probably the most relevant variable in academic or policy work. I think Farley is absolutely right that the academic community has made greater strides than the policy community in this way. That doesn't mean that anything has been conclusively decided; many of the most discussed/cited works are also the most disdained. But where progress has been made it's been by analyzing how domestic political constraints can cause leaders to act in ways that are, quite frankly, perplexing to outside audiences.

I think that, in IR at least, Yglesias' take is the closest to the median position among academics. Politicians in different countries don't face the exact same structural constraints, but they do face similar ones. Political incentives come from interest groups interacting with structural constraints everywhere. The problem with much policy/punditry advice is that they completely ignore interest groups in other countries, because they have no idea what they are. The botched occupation of Iraq can at least largely be understood in this light. (For a crude example, remember that the coalition forces actually were greeted by liberators in some parts of Iraq, but certainly not everywhere.) Those who argue that China is an unstoppable force that will continue to grow 10% a year because they don't have to deal with messy local politics are wrong and should be ignored. (I'm looking at you, Captain Stache.)

In fact, as Rodrik argues in a well-put op-ed, authoritarian regimes face a very uncertain economic and political future precisely because of their local politics:

Democracies not only out-perform dictatorships when it comes to long-term economic growth, but also outdo them in several other important respects. They provide much greater economic stability, measured by the ups and downs of the business cycle. They are better at adjusting to external economic shocks (such as terms-of-trade declines or sudden stops in capital inflows). They generate more investment in human capital – health and education. And they produce more equitable societies.

Authoritarian regimes, by contrast, ultimately produce economies that are as fragile as their political systems. Their economic potency, when it exists, rests on the strength of individual leaders, or on favorable but temporary circumstances. They cannot aspire to continued economic innovation or to global economic leadership.

At first sight, China seems to be an exception. Since the late 1970’s, following the end of Mao’s disastrous experiments, China has done extremely well, experiencing unparalleled rates of economic growth. Even though it has democratized some of its local decision-making, the Chinese Communist Party maintains a tight grip on national politics and the human-rights picture is marred by frequent abuses.

But China also remains a comparatively poor country. Its future economic progress depends in no small part on whether it manages to open its political system to competition, in much the same way that it has opened up its economy. Without this transformation, the lack of institutionalized mechanisms for voicing and organizing dissent will eventually produce conflicts that will overwhelm the capacity of the regime to suppress. Political stability and economic growth will both suffer.

It's easy to observe the political controversies in the U.S., even if (as Drezner notes) other states don't always do it. It may be a bit harder for us to observe everything that's going on in less-transparent states, but it isn't impossible and it doesn't mean that there isn't any politics. China faces huge local political controversies related to the environment, public health, social welfare, demographics, worker safety and renumeration, immigration, secessionist groups, etc. Pretending that they are a unitary actor is foolish.

I've never felt it was my place to proffer policy advice, even into the seldom-read tubespace that this blog lives in. But the last half-century of American foreign policy reveals, to me, the importance of disaggregating the politics of foreign regimes, of closely examining political structures and constraints in other places, and of crafting nuanced policy that takes those factors into account. This is much harder than blustering, of course, but also much more beneficial.

Politics Is (Usually) Not a Coordination Game

Matthew Yglesias sees a bipartisan rationale for overhauling the American political system:

In Canada, their health care system is more equitable and it spends less taxpayer cash per patient. Traditionally, conservatives don’t point to Canada’s health care system as a conservative victory but they do point to Canada’s low taxes which are in part a consequence of its efficient single-payer health care system. So is that a conservative win or a liberal one? Well, it’s both. The main upshot of many features of the US political system that I don’t like is to enhance the influence of interest groups and decrease the influence of ideologues and technocrats. This is basically by design and reflects 18th century state of the art thinking about the dangers of liberal governance being trampled by demagogues. Insofar as the balance we’re currently striking is inappropriate to the conditions of the 21st century United States that’s bad for the right and the left.

This assumes, of course, that politicians are primarily motivated by ideology, and therefore mutually-beneficial common ground is easy to find. Unfortunately for Yglesias, if that were true it would (most likely) have already happened, and he'd have nothing to complain about. His complaint that interest groups are able to successfully lobby policymakers indicates that his assumptions are probably wrong.

But even if the assumptions weren't wrong, his conclusion still would be. Yglesias cites the Canadian health care system as an example of positive-sum policy: both liberals and conservatives can be happy about the outcome. But is that so? Low taxes are not contingent on an efficient single-payer system. After all, taxes could be lower still without any public health care system at all, as I imagine was the case before Canada's universal health care system went into effect. Conversely, the health care system could be even more egalitarian if taxes were higher or more progressive. Any tilt in policy in one direction or the other is generally zero-sum*.

Moreover, even if efficiency gains were created by a new policy, the surplus still has to be distributed somehow. That distribution is by definition zero-sum.

The point is that it's not enough to simply point to some policy outcome and claim it is positive-sum. That judgment must be made relative to some baseline scenario.

*This can get a little bit complicated, but an exception to this rule could occur when there are scale returns at that particular policy margin. But partisans are unlikely to value those scale effects in the same way; e.g. conservatives probably don't want a more efficient public health care sector if the result is a crowding-out of private health providers. Liberals probably don't want a more egalitarian system that leaves all consumers subject to a private monopoly. Etc.

How the Chinese One-Child Policy Caused the Financial Crisis

What caused the financial crisis? A new (to me) argument says it wasn't regulation. It wasn't greedy bankers. It wasn't predatory lenders. It was the Chinese one-child policy. Tyler Cowen points us to Eric Barker, who passes this along:

“The increased pressure on the marriage market in China might induce men and parents with sons to do things to make themselves more competitive,” Wei says. “Increasing savings is one logical way to do that, to the extent that wealth helps to increase a man’s competitive edge. Parents increase household savings mostly by cutting down their own consumption.”

Wei worked with Xiaobo Zhang of the International Food Policy Research Institute in Washington, D.C., to see if his hypothesis held up, comparing savings data across regions and in households with sons versus those with daughters. “We find not only that households with sons save more than households with daughters in all regions,” Wei says, “but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed sex ratio.”

The effect is significant. The household savings rate in China rose from about 16 percent of disposable income in 1990 to over 30 percent today, which is much higher than most countries. About half of the increase in the savings rate of the last 25 years can be attributed to the rise in the sex ratio imbalance.

Here's the sequence: the Chinese one-child policy led to a greater male-to-female ratio (since cultural norms valued male children over female children, and if you only get one...), which increased competition among men for the affection of women; this incentivized good-husbandry signals like lots of savings; lots of savings among many Chinese men led to excessively high savings rates, which led to a "global savings glut"; all that savings had to go somewhere, so it came to the U.S. and found its way into risky mortgages; these risky mortgages were then packaged and sold under wrong risk calculations, leading to the spread of systemic risk throughout the domestic and international financial systems; this led to the failure of some financial institutions, which caused a credit crunch, which led to the financial meltdown, which led to the current Decession.

Got it? As Cowen notes, this means that macroeconomic imbalances cannot be addressed through exchange rate mechanisms alone:

You'll note, by the way, that low wages and a high savings rate are the fundamental reasons for global imbalances, not Chinese currency policy. If this is true, one implication is that the Chinese attempt to cut population leads indirectly to those global imbalances. If you "fear China" (whatever that means), the current imbalances might be better than the relevant alternatives, namely a China with high and growing population and all the environmental problems which that involves.

Of course it's worth asking whether Chinese currency policy incentivizes those low wages and high savings rates. If the yuan is under-valued, then imports and even domestic products are relatively more expensive than they "should" be. Factor in the low wages, which is also somewhat intentional, and that lack of a social safety net and it's no wonder why having a lot of savings is attractive to a potential mate. This pushes incomes into savings rather than consumption.

But it doesn't have to be that way. After all, in some other societies males signal their worth to female by conspicuous consumption, not conspicuous savings. If China wanted to incentivize consumption they could begin constructing welfare programs, let the yuan appreciate (and thus let the real purchasing power of Chinese citizens increase), and we'd (presumably) start to see behaviors change.

So there is certainly a currency/exchange rate component to this. Chinese men are acting according to the incentives the government has given them to save rather than the incentives the government *could* be giving them to spend.

I have no idea how rigorous this theory is, but it's certainly intriguing. I'm kind of surprised Malcolm Gladwell hasn't gotten ahold of it yet, to be honest.

Slashing Pay on Wall Street

Yesterday's announcement by the Obama administration that they "will order the firms that received the most aid to slash compensation to their highest-paid employees" has drawn much criticism and discussion across the blogosphere, including right here on this blog.

The plan, for the 25 top earners at seven companies that received exceptional help, will on average cut total compensation this year by about 50 percent. The companies are Citigroup, Bank of America, American International Group, General Motors, Chrysler and the financing arms of the two automakers.

I've spent a decent chunk of time today watching CNBC (I love Fall Break) and following the arguments being put forward by the guests on the afternoon shows as well as CNBC's highly opinionated news anchors.

There are two main arguments being leveled at the proposed slashes in executive compensation at these seven TARP-funded firms: 1) The government should not get involved in decisions regarding executive compensation and 2) Capping compensation for these executives will incentivize them to leave these companies and make it easier for competitors to lure these executives away with higher compensation. The combination of those two factors, it is argued, will drastically hurt these troubled companies at a time when they need these executives to steer them back to profitability.

I'm going to spend very little time with the first argument and most of this post on the second. There were many banks/financial companies that took TARP funds last fall, some that needed the funding in order to survive and other that didn't need the funding but were asked/required to take it anyway. Those that took it and didn't need it have, for the most part, already returned the funds. The seven aforementioned companies that took TARP funds were struggling and would have collapsed had the government not invested boat loads of taxpayer money in them. The government is now a major shareholder (for some the largest, for others the sole owner) in these firms and with that investment comes the right to change management and production practices and that includes compensation levels. I see absolutely no valid legal or moral argument against the government intervening to change pay rules or business practices.

Now whether government mandated pay cuts for executives are a good thing for productivity or company performance is a different question altogether. Many claim that if the government slashes salaries (by as much as 90% in the immediate short run and 50% as a whole once deferred stock options are included) for those 25 executives at those seven firms, those executives will simply leave the firm and this flight will damage firm performance at the time that their leadership is needed most.

Most of the articles written and discussed, including the one that Will linked to earlier, have reported that

At Bank of America, for instance, only 14 of the 25 highly paid executives remained by the time Feinberg announced his decision. Under his plan, compensation for the most highly paid employees at the bank would be a maximum of $9.9 million. The bank had sought permission to pay as much as $21 million, according to Treasury Department documents. At American International Group, only 13 people of the top 25 were still on hand for Feinberg's decision.

These articles are presuming that these executives all left to take higher paying jobs at competitors, they left because they believed that the government would impose pay restrictions and that their departure will hurt the firm that they left.

I have a handful of questions because I really don't buy into the logic above. Where in the hell are these executives moving to? What financial companies, in the midst of the worst recession since the BIG ONE, are hiring executives at $30+ million a pop? Every company that I know of has been slashing jobs across the board. Where is this robust market for high ranking executives coming from? These claims are flying around with no hard evidence as to where these executives are going and who is luring them away with these large sums of money.

Also, I'm curious as to how many of these 27 (out of 50) executives from AIG and BoA that left over the past year were in their positions before the financial crisis? Are any of them responsible for some of the bad management and financial decisions that put these two companies in the horrible position that they currently face? If so, I don't see how them leaving would hurt their respective companies anymore than their decisions have already done. How many of these were retirements and how many were fired? You can't just look at 27 out of 50 executives leaving and assume that they all left because they were anticipating future government mandated pay cuts.

Next up is the claim that AIG, BoA and the other five firms aren't going to promote from within because their rising stars will be able to earn more remaining in their positions than being promoted to one of these few positions where pay has been capped. They claim that if they were to promote these people to high ranking positions, other companies will simply offer them more money and hire them away. In my very limited experience with Wall Street banks and other financial firms, I know that everyone at the top of these companies know each other and I'm really surprised that people are taking this claim at face value. These companies know exactly who the big whigs and top performers at each of the other firms are. You don't have to be promoted to CEO of AIG or BoA for people to know that you're big time. I go back to my previous point: where are all these $30+ million jobs? How are they going to hire all of these executives away? Look, these positions are going to be filled and these companies will put (hopefully) highly competent and smart people in charge. There are many qualified people who will agree to a $10 million dollar compensation package and the challenge of turning one of these companies around. There is no shortage of top level talent on Wall Street. Money means a lot to people, but it isn't everything. You don't simply pack up and leave because one company is going to pay you more.

To the last question: Will turnover in upper management positions at these seven firms really damage firm performance moving forward? Doubtful. As we all know, most of the day to day decisions are not made by the CEO, CFO or COO. These executives spend most of their time dealing with members of the board of directors, dealing with public relations and marketing issues, wooing potential investors and signing off on decisions made by their underlings. These executives aren't involved in daily trading decisions or most of what actually matters when earnings season comes around. Sure there will be some adjustment to new management but the claim that the departure of an executive will damage company performance is a bunch of bull.

Maybe the incentives for those traders who aspire to be members of upper management in the future will deter them from putting in all of their effort today because of slashes in compensation for high ranking executives. I don't know how much a cut in pay from $30 million to $10 million will undercut ambition but I'd venture to say that for someone making $100,000 to $1 million as a trader today, the ambition to make $10 million and be named CFO of a major company will still be there. I'm pretty confident in that.

To sum this long post up, I think all of this discussion of pay cuts for executives has been blown out of proportion. I don't think the feds coming in and mandating pay cuts for 25 executives hurts company performance, incentives for mid-level managers/traders or will promote some sort of intra-industry brain-drain.

UPDATE (11:26pm): The NYTimes has a "Room for Debate" blog where six experts provided commentary on the cuts on executive pay at the TARP firms. The experts are Tyler Cowen, Yves Smith, Nicole Gelinas, John Coffee, and Lynn Stout. I don't think Cowen actually addresses the issue. He claims that

These earners did not cause the crisis and they are working hard to bring their companies back from the brink. Cutting their pay is the last thing we should be doing because the best of them can simply move elsewhere, thereby undercutting the profitability of the firms we are trying to restore.

The odds of top traders sticking around at A.I.G. for $200,000 a year are small. There is a grain of a good idea in the recent proposal, namely that we should discourage firms from getting into a position where they need a taxpayer-financed bailout. But the new policy goes about this the wrong way.

No one is talking about capping a trader's pay at $200,000. The cap is on the top 25 high ranking executives making millions of dollars (I have no idea why he claims that $200,000 earners will be capped. Top traders make substantially more than that). The earners that the pay cap would affect may very well be those that were responsible for running these companies into the ground. My post above refutes his other points. I don't get to say this very often, but Tyler is wrong.

The Price of a Pound of Flesh

The United States government hold large equity stakes in some financial firms. It has decided to punish those firms by heavily restricting the pay of the top employees. Proponents say that it is unfair for financial executives to benefit from taxpayer-funded bailouts. Skeptics of this plan agree that it's unfair, but note that this incentivizes the best employees to seek employment elsewhere, leaving the U.S. taxpayer with few qualified employees overseeing the trillions of taxpayer dollars invested in those companies. In fact, the government may wish to pay employees more in order to lure the top talent to the firms with public investment in order to maximize the return on that investment.

Obama sided with the crowd who wants the pound of flesh. The result: employees at Bank of America and AIG have already jumped ship:

Many executives were driven away by the uncertainty of working for companies closely overseen by Washington, opting instead for firms not under the microscope, including competitors that have already returned the bailout funds to the government, according to executives and supervisors at the companies.

"There's no question people have left because of uncertainty of our ability to pay," said an executive at one of the affected firms. "It's a highly competitive market out there."

At Bank of America, for instance, only 14 of the 25 highly paid executives remained by the time Feinberg announced his decision. Under his plan, compensation for the most highly paid employees at the bank would be a maximum of $9.9 million. The bank had sought permission to pay as much as $21 million, according to Treasury Department documents.

At American International Group, only 13 people of the top 25 were still on hand for Feinberg's decision.

That's a 27 out of 50, a majority, who jumped ship before the plan was even announced. These folks were able to get other jobs quite easily, indicating that they have some skills that are highly valued by other firms. The ones who haven't left presumably will in short order if they have similar skills, leaving the least-qualified workers to manage trillions in public funds.

But maybe setting a strong precedent is worth it?

On Wall Street, reaction to Feinberg's ruling was swift, with some executives arguing that it will further handicap the most troubled firms by driving away top employees while making companies unwilling to promote rising stars for fear of bringing them to Feinberg's attention.

But Nomi Prins, a former Goldman Sachs employee, said Feinberg's rulings are unlikely to change the culture of bonuses on Wall Street.

"I don't think Wall Street is afraid of this at all," said Prins, author of "It Takes a Pillage: Behind the Bailouts, Bonuses, and Backroom Deals from Washington to Wall Street."

"It's going to affect a small portion of a small portion of the industry. It won't have a lasting impact."

Great.

(Via MR)

Incentives Matter

President Lula da Silva doesn't understand public choice theory. He also can't outsmart a cheeky Newsweek reporter:

Newsweek: You often criticize the privatization process. But thanks to the sale of state companies even the poorest Brazilians have cell phones, and former public companies like Vale have become world-beaters under private ownership.

Lula: But the state could have done the same things.

Newsweek: Except that it didn't.

Lula: It didn't because the Brazilian elite used public companies for their own ends. When you do that, any company will go broke, anywhere in the world.

Er, yep.

Via KPC, who also quote Lula's views on the state of Venezuelan democracy.

Power Corrupts

Last week I pointed to Yglesias not understanding basic public choice theory. Apparently several other people also noticed and responded with lessons on... basic public choice theory. Yglesias didn't like that, says he understands public choice theory but doesn't understand the psychology of corrupt politicians, and then says this:

If some weird situation somehow resulted in me becoming a United States Senator, I would spend six years making trouble, having fun, and trying to do the right thing. Probably I’d lose a primary or something since I wasn’t bothering to raise money or campaign. Then I’d right a book about it.

I think it’d be a blast. And I think that’d also be the totally intuitive way to handle the situation. Obviously that’s also why I never will be a powerful politician. Instead, we’re fated to be ruled by the sort of people who are really desperate to cling to power. But it still strikes me as a very odd mentality.

Why is it odd, or hard to understand? Power is a form of status, just like money, fame, reputation, consumption, intelligence, etc. People go to extreme lengths and sacrifice much to gain those things, so why shouldn't they also do it for power? Indeed, as the infamous Stanford prison experiment showed, power is something that transforms many people, not just a rare few, and not just the ones who actively seek it. And one way of signaling power is flaunt it, or even abuse it with impunity.

Of course many people are not primarily motivated by power and instead pursue the quiet life, or lots of time with family, or an easy schedule, or high income, or privacy, or flexibility, or ethics, or whatever else. But there's no reason to think that if they suddenly got a bunch of power through some "weird situation" they wouldn't abuse it or try to keep it. In short, I think Yglesias is giving himself too much credit here: if he actually did become a senator, he might very well find himself raising money and campaigning for a second term, and eventually find himself compromising much more than he now thinks he would. (I think Lord Acton wrote something about this once...)

This effect is magnified by self-selection: almost every senator is not granted his seat by "weird situation," but rather by extreme effort and intention. Many of them have oriented their entire lives to reaching that pinnacle, have compromised much along the way, and will sacrifice almost anything to stay there. In short, what motivates corrupt senators is the same thing that motivates doping athletes.

Wilkinson picked up on some of this too, and took Yglesias' logic to its end:

So I agree with Matt that politicians are probably odd, and in a bad way. But then I wonder what Matt takes the general lesson of that to be. Maybe if I thought about it longer, I could imagine a story in which this doesn’t tend to imply skepticism about the efficiency and justice of a system in which politicians are given a great deal of discretion to shape individual and public life, but I can’t think of one right now. So I’m curious what Matt takes to be the broader implications of the idea that “we’re fated to be ruled by the sort of people who are really desperate to cling to power.”

Where else could you go with it? The only alternative that I can see is that you believe that other elites in society are even more corrupt, so you'd prefer the corruption of the politician to the corruption of the corporation.

Coincidence?

Yesterday it was announced that 10 companies would be exiting the TARP plan, paying back with interest all the money borrowed from the government.

Today it was announced that 7 companies, including several still on TARP plus GM and Chrysler, would have their executive pay set by a Treasury-approved lawyer.

FWIW, the government turned a profit on the companies that paid back the loans. This is not to say that TARP will make money overall; but the final cost to taxpayers should be well under the $700bn sticker price on TARP.

Political Incentives and the Israel/Palestine Situation

Matthew Yglesias asks a question about the American government's willingness to pressure Israel into ceasing settlements in Palestinian territory:

Unfortunately for us, we’re not in one of those periods of time when Israel has a government that’s probably actually not that sympathetic to the settlers but faces domestic political difficulties in cracking down on them. If that were the case, then strong words from the United States might be enough to force change in Israeli policy. But the current government is a coalition between the right and the far-right, and gives every indication of being extremely committed to settlement expansion. This, naturally, raises the question of what American policymakers are prepared to actually do about the fact that the world’s largest recipient of American aid seems to have so little interest in our perspective on crucial regional issues.

"Our perspective" is in fact a reference to Yglesias' perspective, which happens to be roughly in line with Obama's perspective. But it is not necessarily the perspective of the public at large, who tend to side with the Israeli government come hell or high-water. Politicians want to stay in office, and the best way to do that is to get the public on your side. In this case, that means taking a hard-line approach against the Palestinians:

[T]he thrust of US policy in the region derives almost entirely from domestic politics, and especially the activities of the ‘Israel Lobby’. Other special-interest groups have managed to skew foreign policy, but no lobby has managed to divert it as far from what the national interest would suggest, while simultaneously convincing Americans that US interests and those of the other country – in this case, Israel – are essentially identical.

Now, I don't entirely agree with the 'Israel Lobby' argument advanced by Mearsheimer and Walt, but the broader point is impossible to deny: the broad public sides with Israel over the Palestinians for a variety of reasons. This is evident in both political parties and in every national election. Indeed, last week 76 U.S. Senators sent a letter to Obama urging him to "support Israel" without conditions but to demand a host of concessions from Palestine before affirming its right to a state. (Interestingly, the Jerusalem Post article linked above omits the senators' affirmation of the Palestinians' right to a state if they achieve certain pre-conditions; this AFP story keeps the relevant passage in. The letter itself is here [pdf].) This is actually a very different line than the one Obama is taking -- a much harder line towards Palestine -- which shows that even a very popular president will have difficulty galvanizing Congressional support for any policy that is even remotely critical of Israel.

The lesson is that legislators respond to incentives just like anyone else, and the incentives are all aligned in such a way as to practically guarantee universal support for Israel in the Congress, because that is what the electorate wishes to see. So the Congressional movement that Yglesias wishes to see is very unlikely to actually happen.