Incentives rule the world

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Warren Coats
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      Warren Coats

      Dr. Coats has over 26 years of experience in monetary policy and central banking in developing and transition economies. When he retired from the IMF May 2003 he was Assistant Director of the Monetary and Financial Systems Department (MFD). Prior to that he was a visiting economist at the Board of Governors of the Federal Reserve System and at the World Bank and an assistant professor of economics at UVA.

      While at the IMF Dr. Coats led technical assistance teams advising on and assisting with the development of a number of monetary authorities—including the introduction of new currencies (Bosnia and Herzegovina, Croatia, Kazakhstan, Kyrgyzstan, Moldova, West Bank and Gaza Strip) and advising on emergency measures and the longer run rebuilding of money and banking systems in post crisis countries (Afghanistan, Bosnia, Iraq, Kosovo, Yugoslavia). Dr. Coats also assisted the governments of Bulgaria, Croatia, Moldova, Serbia and Turkey in recent banking crises, provided assistance in developing inflation targeting monetary policy frameworks in the Czech Republic, Kazakhstan, Slovak Republic, and Turkey, and lead Financial Sector Assessment Program (FSAP) assessments of Bangladesh, Egypt, Israel, and the Slovak Republic. Since retirement, Dr. Coats has advised the central banks of Afghanistan, Iraq, Kenya, Southern Sudan, and Zimbabwe and is currently a Director of the Cayman Islands Monetary Authority.

Our behavior is profoundly influenced by the incentives we face. Money is a very important motivator but money is not everything. Our behavior is also influenced by prestige, power, benevolence, and all the feel good stuff. All of these help determine the incentives we face to work hard for our own benefit and for the good of man kind. Our cultural and moral values are also important more directly for the quality of our lives and for the success of any economic system—capitalism or socialism—by supporting or failing to support voluntary compliance with the needs of that system. They provide the lubricant that helps the economic system function smoothly.

Knowing that I favored market economies, a bright and idealistic young man in Kenya asked me recently if I thought capitalism encouraged immoral behavior. I don’t think he had the Madoffs and Stanfords of the world in mind as that kind of criminality exists everywhere (though generally on a smaller scale). He was reacting, I think, to his impression that the profit motive had driven many greedy players on Wall Street to risk and lose a lot of other peoples’ money. He was reflecting an image of capitalism as greedy and socialism as benevolent.

My reply to him had two parts. The first part was that I see capitalism as driven primarily by the nexus of service and profit (the better we serve the wants of others the more we profit) and of socialism by the nexus of need and power (those in power politically define what we need and strive—in the best of worlds—to satisfy them). The second part was that capitalism and socialism are economic systems, not moral systems. Societies with either economic system will be more successful if their citizens also largely embrace cultural and moral values that respect honesty and the rights and property of others.

From the beginning of time societies have enforced rules of behavior meant to protect and enrich their existence. The more successful they were in convincing their members to voluntarily live by these rules, the less time and resources they needed to spend on their enforcement. Such societies prospered relative to others. If every member of society were totally honest and lived by the Golden Rule, the substantial share of our resources devoted to our security and enforcing rules and agreements (military, policy, courts, security equipment, fences, etc) could be used to produce goods and services we would actually like.

People and their values differ but also have much in common. Almost all of us work hard to survive (feed and cloth ourselves and our families) and when possible to live more comfortably. But most people are also genetically hard wired to please. Once we have satisfied our basic needs, we desire to win the approval of our families and friends and to make the world a better place, not just make a better living. In his new book “Drive,” Daniel Pink “argues that the most powerful emotional motivators are the desire for autonomy, the satisfaction that comes from mastering a skill or a task, and the need to serve some larger social purpose.” Capitalism better aligns these motivators with economic success. Those people and firms that are the most successful in providing other people with what they want at the lowest cost are the most profitable and the most likely to survive. Capitalism rewards virtue and thus encourages virtue.

Socialism starts out proclaiming the virtue of sharing—giving—but does not reward it and thus provides little incentive to achieve it. In its fully equalitarian form, it provides no reward for harder work and effort at all, leaving every thing to our good hearts. Power—the control of the levers of government—displaces profit as the system’s most tangible reward. The best but imperfect example of a capitalist nation is the United States and of a Socialist nation was the USSR. The results speak for themselves.