Friday, May 21, 2010

Letter to the Editor (as published in the Wall Street Journal)

My published response (The Wall Street Journal, Friday, May 21, 2010, page A14):

Mr. Gordon's contention that changing incentives would lower the amount of government waste is faulty. The real answer is simple: privatize. Take the government out of operating, managing and controlling things. Bureaucrats will figure out a way to game any system. Incentives cannot be encompassed in 2,000-page laws filled with complex regulations and prolix language. Incentives must be simple. Simplicity is anathema to politicians who use complexity to derive campaign contributions and support from those who benefit.

It is very difficult to devise correct incentives and to anticipate unintended consequences. Let millions of concerned humans each make informed decisions and, voilá, correct incentives. As for the uncovering of Bernie Madoff's vast fraud, giving bureaucrats a share of the loot would set them on every possible source of money throughout the land. This is exactly what the Democrats have encouraged with their friends, the trial lawyers. That's not the answer. Perhaps the answer is making individuals responsible for their decisions, as was the case with Madoff's investors: They lost their investments. That is the market working.

Theodore M. Wight


The article (The Wall Street Journal)

OPINION MAY 14, 2010 Incentives vs. Government Waste

What if bureaucrats could benefit financially from finding cost savings?Article Comments (80) more in Opinion »Email Print Save This ↓ More


Why are profit-seeking corporations so much more efficient and innovative than bureaucracies? A significant part of the answer to that question lies in the fact that bureaucracies are often hamstrung by legislation, and amending legislation is always a cumbersome and politics-ridden process. But another significant part of the answer lies in the phrase "profit-seeking."

Corporations exist only to create wealth. The more they create, the more their stockholders and employees prosper. Thus it's a corporate manager's job to look for ways to increase profits. More, their personal success depends on doing so. For the employees who come up with the really bright ideas prosper even more than their fellow workers, being rewarded with raises, bonuses and promotions.

But there are only three basic ways to increase profits: raise prices, cut costs or innovate. Raising prices is easy. Just cross out $19.95 and write in $22.95. Unfortunately, in a competitive economy, raising prices is going to cost you market share and is thus self-defeating. So corporate employees have no choice but to pursue the far more difficult second and third options, searching for ways to make the same product cheaper or to create a better product at the same cost. They do this hard work because they are highly incentivized by self-interest to do so.

Bureaucrats, alas, are not. In fact, they are highly disincentivized to increase efficiency and to innovate. In business a penny saved is a penny earned, the savings flowing directly to the all-important bottom line. But in a bureaucracy, a penny saved is a penny likely to be cut from next year's budget. And prestige in a bureaucracy comes not from profit but from the size of one's budget. So even accidental savings are likely to be suppressed with make-work.

How can this unfortunate human reality be changed? How can we make the Department of Motor Vehicles as efficient and innovative as, say, Google or Goldman Sachs?

Well, good luck with that.

But it is possible to incentivize public (and nonprofit) employees to find ways to save money rather than waste it, to find new and better ways of doing business. There is no better example of how to go about that than the British Royal Navy in the age of Admiral Lord Nelson (1758-1805).

The navy's job in the endless wars of the 18th century was to capture enemy warships and to sweep enemy commerce from the seas. As the novels of Patrick O'Brian and C. S. Forrester so vividly bring to life, the Royal Navy was exceedingly good at doing exactly that. No small reason was that the navy gave its officers and men an enormous incentive to capture enemy warships and merchantmen: the whole value of the ships and cargoes they captured.

The Cruisers and Convoys Act of 1708 established a prize court to condemn captured ships and, if they were merchantmen, sell them and their cargoes. If they were warships, the Royal Navy would buy them, which is why so many British warships in the 18th century had French names.

The money gained was then distributed by eighths according to a formula. One-eighth went to the admiral who signed the orders under which the ship or ships sailed. (All ships in sight at the moment of capture shared in the prize money.) Two-eighths went to the captain, one-eighth to the commissioned officers, one-eighth to the senior warrant officers, one-eighth to the petty officers and midshipmen, and two-eighths to the crew.

This could amount to a very great deal of money. When HMS Active and HMS Favourite captured the treasure-laden Spanish frigate Hermione on May 31, 1762, the two captains each received £65,000 in prize money, enough to make them quite rich by the standards of the mid-18th century. The crew received £482 each, many times a year's pay for an able seaman.

Now, to be sure, bureaucracies can't sally forth, capture an enemy bureaucracy, and sell it to the highest bidder. But they can certainly find new ways of doing their jobs that are cheaper and better than the old ways, especially if they are handsomely rewarded for doing so.

Let's say the federal widget inspection office in Seattle comes up with a way to save a million dollars a year by changing the method it uses to inspect widgets. Why not give personnel in that office the first year's savings, distributing it according to a set formula akin to that of the Royal Navy's? A million dollars in "prize money" would certainly be an incentive to motivate even the most slothful government office to find new ways to do things.

It wouldn't cost the government anything (it's found money after all, just like the Spanish treasure in the Hermione's hold). And it would pay big dividends to the government year after year, as the innovation was adopted in other widget inspection offices across the country. Further, it would powerfully influence other offices and other government departments to be the first to come up with their own innovations and efficiencies in order to get on the gravy train.

Had the personnel of the Securities and Exchange Commission been as richly and personally incentivized to uncover securities fraud as the sailors of the Royal Navy were to capture enemy ships, Bernard Madoff would have been in jail years ago.

Self-interest is an immensely powerful force in human affairs—the very engine behind capitalism's success. Harnessing it to save money and increase innovation in a bureaucracy, just as the Royal Navy harnessed it to capture enemy ships, would be the biggest innovation of all and save the government billions.

Mr. Gordon is the author of "Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt," out in a recently revised edition from Walker & Company.

Printed in The Wall Street Journal, page A17

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