Saturday, October 25, 2008

"Incentives Matter"

Nearly every decision we make is driven by incentives. Why do we go to work? To receive a check every two weeks? Why did we spend $40,000 on a college education? Surely, because we believe it’s a good investment in the long run. What happens if these incentives were taken away? What could you expect to see in our economy?

In "An Age of Turbulence" Alan Greenspan recalled visiting the Soviet Union. At the time, the Soviet Union was an economic superpower and the two great competing economic theories were still in the midst of the Cold War. Greenspan recalls the Soviet finance minister assigning a senior aide to him with the task of explaining the centrally plan economic system.

Greenspan noted the complex and mathematically sound algorithms the Russians used to interpret their economy. He noted their "dazzling" mathematic capabilities. He remembers leaving the Kremlin in 1989 and seeing a farmer driving 1920 model steam tractor. He asked a security official, "Why do you suppose they still use that?"

Thinking little of it, the official said, "Because it still works?"

There was a similar conundrum after the fall of the Berlin Wall between communist East Germany and the democratic West Germany in 1989. In terms of GDP, East Germany only lagged West Germany by 15% to 25%. However, according to Greenspan, visiting both nations evinced a much larger difference in the standards of living. West Germany was at the leading edge of technology and East Germany was lagging. For example, there was a significant difference in the 1950 Mercedes and one built in 1988 in West Germany. However, the East German Trabant hadn't changed its design in over 30 years! East Germany never had the incentive to change in a centrally planned system.

There are many incentives to work: to provide for your family, to purchase property, to have health insurance, etc. To have increasing work opportunities, many spend longer in school to increase the probability of securing the many benefits of work. However, if these benefits are given away, truly how valuable are they?

If your idea of the "American Dream" is to earn property, health insurance, and a high quality of life, then perhaps you sacrificed dearly to earn an education and increase the probability of having these things. The sacrifice could be in time, long hours of work and studying, or a hefty student loan. If the government gives these benefits away for free - in the forms of wage increases, health insurance, or education subsidies - it discredits what you have worked so hard for. We will lose incentives to create the best, to provide the best, and to be the best.

-Reflection from "The Age of Turbulence" by Alan Greenspan

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