Tag Archive for 'Incentives'

The perverse incentives of Queensland traffic law

In the Australian state of Queensland, a violation of traffic law is punished by a fine and the awarding of points.  Points for a conviction stay on your licence for three years.  If you ever have 12 points at the same time, you’re in trouble.  I’ll come to that in a moment.

Somebody I know, let’s call him Semaj, has recently got himself up to 11 points.  He doesn’t dispute that he broke the law for all of them; he did.  Most of them came from speeding, but the last three points came from driving through a yellow light.  In Queensland, just like everywhere else on the planet, you must stop at a red light; but for a yellow light, you must stop if you are safely able to do so.  Some people believe that the yellow light should just be to warn drivers that the red is coming and have no penalty tied to it, but that’s not what I want to focus on.  To really rub salt in the wound, the light was still yellow when Semaj left the intersection and the only other car in the area was that of the police officer that booked him.  That’s what those in the business call a “dick move” by the cop, but it’s not what I want to focus on either.  What I want to focus on is …


Perverse incentive #1

The punishment for not stopping for a yellow light when you were safely able to is the same as that for not stopping at a red light:  AU$300 and 3 points.  This is absurd, because it fails to make the punishment proportionate to the severity of the crime.  By doing so, the government offers an incentive to people to treat them as equivalent.  To illustrate the point, let me take the idea embedded here in Queensland law to a logical, but ridiculous conclusion:

The violation of all laws should be punishable by the same penalty. A serial rapist-murderer should be locked away for life. Therefore, overstaying your parking for just one minute should lead to your being locked away for life.

See?  Absurd.  Clearly there are gradations of severity and, just as clearly, there should be corresponding gradations of punishment.  If the punishment for running a red light is a fine and 3 points, then the punishment for running a yellow should be a smaller fine and 1 point.


Anyway.  Moving on.  Semaj now has 11 points on his licence.  The oldest of his points is only one year old, so he has two full years before any of them are removed.  If he gets even a single point over the next two years, he will be faced with the following choice when he turns up at the Department of Transport to pay his fine:

  • either give up his licence for three months;
  • or go on a probationary licence (with a limit of two points instead of 12) for a full year.

After this, he will be returned a regular full licence entirely clear of points.  Hopefully you can now see …


Perverse incentive #2

Semaj is in a position where he would be better off by breaking the law.  The government is giving him an incentive to break the law.  If Semaj follows the law, he will have a one-point buffer for two years, then a three-point buffer for a year before returning to a full licence.  That’s three years in total.  If he deliberately gets caught for a one point infraction tomorrow, he can have a two-point buffer for one year and then go immediately to a full licence.  The cost to him will just be the fine for tomorrow’s infraction; maybe $100.

Who wouldn’t take that option?  It’s crazy.  If you’re going to have a point system with the possibility of a probationary licence, then the length of the probationary period should be long enough that someone in Semaj’s position wouldn’t actually prefer to be on it.


As I’ve said before, I believe that all fines issued for misdemeanours should not be for a fixed amount, but for a percentage of the transgressor’s income. When faced with the prospect of a $400 fine, somebody earning $20,000 a year will pay attention, but somebody earning $200,000 will not care nearly as much.  The two people therefore face different incentives when it comes to obeying the law.

Of course, none of this comes close for the most ridiculous traffic law in Queensland.  That most dubious of prizes goes to this piece of nanny-state-run-amok trash:  Drivers on P-plates (that’s a “provisional” licence) “under 25 years of age can only carry one passenger under the age of 21 years who is not an immediate family member, when driving between 11pm on a day and 5am on the next day.”

For reference, the very earliest that somebody in Queensland can move from a provisional to a full licence is at the age of 20.  That is two or three years into university.  Most Queenslanders, if they go to university and don’t take a gap year, would turn 21 in their fourth year.

The “peer passenger restriction” of provisional licences is designed to prevent distraction (from drunk louts in the back seat) to the driver and so, presumably, lead to fewer accidents and thus fewer fatalities.  Whether it ultimately succeeds in reducing road deaths is an empirical question.  I don’t have access to the data, but to my mind there’s a fair possibility that we’ll actually see more road deaths from this, because …


Perverse incentive #3

By forcing university-age people to not share a car, the Queensland government is:

  • abandoning the idea of a designated driver; and
  • encouraging more traffic onto the roads at just the time of day when people are least likely to pay full attention to the road (what, did they think that those kids would stay home?).

Both of those effects will serve to push up the accident (and thus, fatality) rates.

If you want to keep drunk 20-year-olds off the roads, then give them a way to avoid them.  Improve public transport.  Lift the licencing restrictions on taxis.



Once more on bankers’ pay

Megan McArdle makes a perfectly sensible point when she writes:

More than one smart analyst thinks that the yearly bonus regime encouraged both traders and their managers to take excess risk. I’m not sure, as an empircal matter, that I buy this argument. Most of those bankers who were allegedly gambling for free with (implicit) taxpayer money in fact lost half or more of their own fortunes in the ensuing crash. From this I infer that they did not, in fact, realize that they were gambling.

I still think that some regulation on bonuses is warranted. Indeed, I think it warranted precisely because the bankers didn’t fully appreciate the risks they were taking. By holding bonuses in escrow for, say, five years, we serve to increase the risk aversion of those bankers.  Megan implies partial agreement with the conclusion, if not the logic, a little later on:

But enforcing, say, a multi-year bonus scheme wouldn’t be terribly destructive, and it might help.

Continuing immediately on, she writes:

On the other hand, if the government starts meddling with the level of compensation, this will be disturbing both because it will not do good things for the American financial services industry, and because, well, who the hell is the government to start telling private firms that are not receiving any taxpayer money how much to pay their employees?

In general I’d agree, but we should also consider the recent work by Thomas Philippon and Ariell Reshef suggesting that remuneration in the finance sector relative to the rest of the economy for a given level of education has been especially high lately.  Here is an ungated version of their paper.  Here is the abstract:

We use detailed information about wages, education and occupations to shed light on the evolution of the U.S. financial sector over the past century. We uncover a set of new, interrelated stylized facts: financial jobs were relatively skill intensive, complex, and highly paid until the 1930s and after the 1980s, but not in the interim period. We investigate the determinants of this evolution and find that financial deregulation and corporate activities linked to IPOs and credit risk increase the demand for skills in financial jobs. Computers and information technology play a more limited role. Our analysis also shows that wages in finance were excessively high around 1930 and from the mid 1990s until 2006. For the recent period we estimate that rents accounted for 30% to 50% of the wage differential between the financial sector and the rest of the private sector. [emphasis added]

… which is prima facie evidence in support of some sort of regulation on remuneration in the finance sector.

Bankers’ pay

I’ve been meaning to read this piece by Martin Wolf (chief economics commentator for the Financial Times) for the last week. As it happens, it’s a “me too” response and a minor expansion to this brilliant piece by Raghuram Rajan (professor of finance at the Graduate School of Business at the University of Chicago and former chief economist at the IMF). I recommend reading both of them in full. Here are some cut-down snippets from Rajan’s efforts:

The typical manager of financial assets generates returns based on the systematic risk he takes – the so-called beta risk – and the value his abilities contribute to the investment process – his so-called alpha.

[T]here are only a few sources of alpha for investment managers. One of them comes from having truly special abilities in identifying undervalued financial assets. [e.g. Warren Buffet]

A second source of alpha is from … using financial resources to create, or obtain control over, real assets and to use that control to change the payout obtained on the financial investment. [e.g. a venture capitalist]

A third source of alpha is financial entrepreneurship or engineering – creating securities or cash flow streams that appeal to particular investors or tastes. As long as the investment manager does not create securities that exploit investor weaknesses or ignorance (and there is unfortunately too much of that), this sort of alpha is also beneficial, but it requires constant innovation.

How do untalented investment managers justify their pay? Unfortunately, all too often it is by creating fake alpha – appearing to create excess returns but in fact taking on hidden tail risks, which produce a steady positive return most of the time as compensation for a rare, very negative, return.

True alpha can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

Martin Wolf’s addition comes in like this:

By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

Dani Rodrik has been noting for a while that Martin Wolf seems to be coming ’round to his point of view in economic development. I’ve seen the same thing and it’s great to see.