Friday, March 20, 2009

Remember...People Respond to Incentives

This post relates to the following Keystone Economic Principles:
4. Economic systems influence choices.
5. Incentives produce “predictable” responses.

Earlier this week, I was listening to an interesting podcast on EconTalk about the Political Economy of Public Transportation. Of particular interest was an anecdote about how the bus system of Santiago, Chile was transformed after going from a myriad of private companies to a single, government-run entity.

The "system" went from generating an annual profit of some $60 million, to an annual loss of $600 million. Average commute time went from 40 minutes to 2 hours. Now that information doesn't tell us much, but other information in the interview does - specifically how drivers were compensated under both systems. Without giving away the story, let me just say that "Incentives produce predictable responses."

While the podcast was interesting, I was hoping something else would come along that I could link it to. I now direct your attention a story from today's edition of The Wall Street Journal. (Story is currently free content. I can't say for how long.)

The headline reads "Raters See Windfall in Bailout Program." It seems the credit rating agencies that played an important part in the current financial situation, are now in a situation where they may again benefit. What I find interesting is the incentive system has not changed, from what I can tell in the article. Prior to the financial problem, credit rating agencies were paid by the institutions issuing the securities. One could make a case that it would be in the interest of the agencies to give the securities a good rating - perhaps indicating a conflict of interest.

If I read the story correctly, those same agencies will now be hired by firms taking Term Asset-Backed Securities Loan Facility (TALF) money to rate the new securities. The TALF program lends money to investors to facilitate the purchase of certain asset-backed securities. (The financial firms issuing the securities will be required to get ratings by two credit-rating agencies.) Critics of the program seem to feel that the incentive would still be to rate the bonds highly to move the product. The rating firms are countering that they have taken steps to make sure the problem is not repeated. But, superficially, the incentive system does not seem to have changed.

The question for you and your students is this. "Might there be a better incentive for the credit-rating agencies if payment was based on something other than the sale of the securities by financial firms?"

I admit I haven’t been following all the details of the many programs that have been put in place. And I may be missing something. I welcome your thoughts.

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