Incentives rule the world

Warren Coats Contributor
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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.

While capitalism’s profit motive rewards and thus encourages virtue, without supportive moral values it can promote and inflame greed. Economists often look at capitalism (competitive, market economies) as directing man’s natural greed (self interest) to the service of the public good (Adam Smith’s invisible hand). Before he wrote his most famous work, “The Wealth of Nations,” Adam Smith wrote the “Theory of Moral Sentiments” (1759). It provided the ethical, philosophical, psychological, and methodological underpinnings to his later works, including “The Wealth of Nations” (1776). In it he elaborates far more fully his views on the supportive and reinforcing relationship between man’s nature (self-love, reason, sentiment, etc.) and morality (propriety, prudence, benevolence, etc.) and the invisible hand of the market place that leads mans’ quest for personal gain (profit) to serve the public good.

But whether capitalism tends to promote morality or not, any economic system will perform better if supported by moral values of mutual respect, compassion, and honesty. Our persons and our other property—our very lives—are best protected by the voluntary respect and honesty of our neighbors. If everyone (or almost everyone) is honest and does not steal, our property can be protected at negligible cost and we will all be wealthier. Today’s need to imbed security sensors in merchandize is a cost of business, like a tax, necessitated by weakened public morality and it makes us poorer. It is a cost with no benefit other than counterbalancing a failure of morality. Whether capitalism makes us more virtuous or not, the quality of our lives will be better in a moral society than an immoral one. Thus we need to be concerned with the inculcation of such values in each generation as much as with the preservation of free markets.

Beyond some point, a larger government, responsible for more and more of our needs and behavior, begins to displace and to undermine the morality that supports our prosperity. Our sense of self-reliance and personal responsibility begins to give way to reliance on others through state institutions. Profits become more reflective of the ability to gain favors from the state than from satisfying the wants of our neighbors. The incentives for corruption thus created bring forth more corruption. Capitalism begins to slide into socialism.

I replied to the young Kenyan man that capitalism is not immoral nor does it encourage or promote immorality. But it is not in itself a set of moral principles that any society needs to be prosperous and good. We need to worry about preserving such values as much as our freedoms to develop our talents and serve our fellow man as we each see fit.

Warren Coats retired from the International Monetary Fund in 2003, where he lead technical assistance missions to central banks in more than twenty countries. He is Senior Monetary Policy Advisor to the Central Banks of Iraq and Afghanistan. His most recent book, “One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina,” was published in November 2007. He has a Ph.D. in economics from the University of Chicago and lives in Bethesda Maryland.