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“Super Freakonomics” by Steven D. Levitt and Stephen J. Dubner (HarperCollins Publishers, 2009) is the follow-up to their enormously popular book “Freakonomics.” Need one say more?
The theme of both books is incentives. Why? Because, as they emphasize right from the start, people respond to incentives. And how people respond to incentives is what Levitt and Dubner find interesting. Of course, Levitt is an economist and, as the authors explained in their first book, economics is the study of incentives. At least this is how more and more economists are now defining the content of economics. (The older view was that economics was the study of how scarce resources are allocated, but that definition had to do with how markets achieve equilibrium, something that microeconomists are less interested in today.)
The “freakiness” of economics, the authors contend, comes from the fact that many of the results economics uncovers are unexpected. In fact they go on to define the unifying theme of their book as: People respond to incentives, although not necessarily in ways that are predictable or manifest. Therefore, one of the most powerful laws in the universe is the law of unintended consequences.
Thus, in their first book they dealt with schoolteachers, realtors, crack dealers, expectant mothers, sumo wrestlers, bagel salesmen and the Ku Klux Klan. In the present volume they deal with drunk driving, horse manure, prostitution and department store Santa clauses, terrorists, the sources of talent, apathy and altruism, why doctors don’t wash their hands and what Al Gore and Mount Pinatubo have in common. Of course, you can easily see how all of these various things fit together.
The material in the book is presented in a light-hearted manner and their arguments are supported with example after example after example to explain and clarify where they are coming from. But, the underlying story is extremely serious.
Incentives matter!
And, incentives can either be related to positive outcomes or to negative outcomes. Incentives can either produce good behavior or bad behavior. Incentives can either build up society or it can help to tear down society. So, it is necessary to be careful what incentives you—or societies—are setting up because the consequences of these incentives can be substantial.
Perhaps the major underlying assumption of Levitt and Dubner is that, “people aren’t ‘good’ or ‘bad.’ People are people, and they respond to incentives. They can nearly always be manipulated—for good or ill—if only you find the right levers.”
And, to bring this analysis into the area of finance and the events that led up to the current economic crisis: “Believe it or not, if you can understand the incentives that lead a schoolteacher or a sumo wrestler to cheat, you can understand how the subprime-mortgage bubble came to pass.”
The author’s point, of course, is that all individuals will cheat or engage in what might be considered to be un-social behavior if the incentives are right. Another way the economist phrases this conclusion is that everyone has his or her price. My addition to this is that one should never say that they would not do something until they have actually been sufficiently tempted to do a thing and have resisted that temptation. Then that just raises the bar as to how high the price would have to go in order to cause you to succumb to that temptation.
Investment bankers and the originators of subprime loans act in their own self interest. But, when housing prices are rising at a 10% to 15% clip, year-after-year, due to the asset bubble that has been created by the interest rate policy of the Federal Reserve System, is it all bad to give loans to lower income people who cannot afford a down payment and who would really like to move their family into a house? Especially if, in recorded history, housing prices have never declined?
Why, you give a family a $50,000 loan (no down payment) for a house with a $50,000 sales price. If the rate of housing inflation is 10% then that house will be worth $55,000, $60,500, and $66,550 at the end of the next three years, respectively. That family is going to have equity in the house, and even though the house must be refinanced at the end of the three year period because the mortgage rate is going to re-set, they surely can find a borrower at that time that will give them a good rate because of the equity they now own in the house.
Is this just nasty greed? Is the borrower just a naïve, unsophisticated individual that is easy prey for the “system”? Is the mortgage broker just a slimly, greedy bastard that is taking advantage of an innocent, uneducated borrower? Or, are the incentives in place so that the family is willing to take a financial risk by stretching to move into the middle class and the American Dream? And does the lender have the opportunity to help someone achieve their lifetime dream?
What about the mortgage banker that writes the mortgage? And what about the investment bank that packages up mortgages and sells the cash flows generated by the mortgages to investors around the world? And what about the firms that provide a credit rating for the various securities that are generated? And the list goes on and on.
I am not saying that nothing dishonest happened is this example , just that the motives of different individuals will be different. And there will be some real people just trying to do the right thing.
Levitt and Dubner argue: “Human behavior is influenced by a dazzlingly complex set of incentives, social norms, framing references, and the lessons gleaned from past experience—in a word, context. We act as we do because, given the choices and incentives at play in a particular circumstance, it seems most productive to act that way. This is also known as rational behavior, which is what economics is all about.”
As Gary Becker, who is quoted in the book, explains, the economic approach “does not assume that individuals are motivated solely by selfish gain. It is a method of analysis, not an assumption about particular motivations…Behavior is driven by a much richer set of values and preferences.”
The economic approach “is a systematic means of describing how people make decisions and how they change their minds;…whether, upon coming upon a pile of money, they will steal from it, leave it alone, or even add to it;…why they’ll punish one sort of behavior while rewarding a similar one.”
The subprime example is my own and does not come from the book although, I believe, that the thrust of the story is the same as the theme which unifies the book. The book is too rich in examples to do justice to what is there in this short review. One must read it for themselves. Some parts will sound familiar if the reader has kept up with the material Levitt and Dubner have published in the New York Times Sunday Magazine or on their own website. It is still insightful to see how they integrate all this material into one publication.
The conclusion that we should take away from this book is that, in whatever we do, whether it be in relating to a lover, being a parent, being a banker, being an investor, or whatever, the incentives we set up and the incentives we respond to, matter. And we had better be careful about what they are so that we get the response that we want and do not fall victim to the law of unintended consequences.
