Home Economics: Perverse Incentives & Unintended Consequences

There are times when I am certain that managing my little platoon is not all that different than the way the Secretary of Treasury or Chairman of the Federal Reserve must feel managing the nation's economy. One of those times happened again this evening.

Yesterday was not good to bank stocks on the major indices. Business Week offers up a not un-compelling case that the TARP is the reason for the reduction in bank stock share price warning, "a growing number of investors and analysts warn that the TARP program may come at a large cost to bank shareholders. " This cost comes in several forms: reduced or eliminated dividends for regular shareholders, the high cost of repaying the government for its capital injections, the possibility that additional shares will be issued in the future (diluting current share value) and overall restrictions on operations of institutions that accept TARP funds.

So the TARP funds, intended to rescue ailing institutions, have the effect of driving down share price. While propping up share price is not a goal (at least not a stated one) of the TARP. Share price is certainly seen by the public at large in some way reflecting the success of the government's efforts at alleviating the economic turbulence. But now when the government rushes in with cash to keep a company afloat, shareholders abandon that same company. They don't leave out of fear, but out of a recognition that accepting government money, while unavoidable in the short term, may well mean a loss of value for them in the longer term. While this is not quite as Orwellian as former President G.W. Bush claiming he had to abandon free market principles in order to save them, it certainly gives one pause.

This state of affairs presents two valuable insights. The first is that actions (or failures to take action) have consequences. These consequences are notoriously difficult, if not downright impossible, to predict.

The second is that people, and by extension markets, respond to incentives. Incentive is a word that generally has positive connotations, but there certainly can also be incentives that lead to negative outcomes.

These two points were starkly illustrated in our home this evening.

As bedtime approached my wife surveyed the basement rec room and looked out over a medium sized debris field of children's toys, books, socks, and sundry items and realized that she wanted to get them cleaned up quickly. It occurred to her that people respond to incentives, so she immediately announced that if all hands participated in cleaning up the basement quickly and without complaining, they would be rewarded with what was described at the time only as a "treat".

Well, as you can imagine, her announcement went over like someone had shouted "Gold!" in the dusty main street of some 19th century boom town. And with her shout every pint-sized prospector rushed for the proverbial hills in order to secure his portion of the riches.

In no time the mess had disappeared and the proud helpers eagerly awaited the promised reward. Which in this case turned out to be a fruit and cream flavored life saver known as a Creme Saver. Once the available flavors were announced and a selection was made, each child wandered off to enjoy the high fructose fruits of their labor. Those that could unwrap the candy on their own did so, while those that had to be assisted delayed indulgence for just a moment longer.

Once every child began to suck on the candy the room grew silent except for the occasional slurping sound. Then, a few moments later, I overhead one child (aged 4) approach his brother (aged 6) and in a conspiratorial tone implore, "tomorrow we have to make another mess so that we can get another one of these."

So there you have it. We desired a tidy basement, but through an incentive have insured that it will be a mess again tomorrow.

I only hope that through our clean basement initiative we haven't also started down the road to major tooth decay.

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As an aside, one of the flavors of creme saver was pina colada, which was chosen by two of the children. As they went about telling their brothers just what flavor it was that they were enjoying, "pina colada" quickly morphed into "peanut brittle" which then mutated in "peanut butter riddle".