It is a bedrock belief in certain circles that the higher the incentives, the better the results. So for example, if you want more business growth, cut the taxes on capital gains and so increase the incentive to invest. Or, if you want more oil, give the oil companies higher and higher incentives by cutting their taxes, giving away valuable leases for free, granting generous depletion allowances, etc. Of course, there are excellent arguments for cutting capital gains taxes. The problem is that they are exactly the same arguments for cutting income and payroll taxes. This is not what the holders of large amounts of capital want. They want preferential treatment and the shifting of more of the tax burden to labor. Apparently, incentives stop at the assembly line.
The arguments for the view that more incentives lead to more production would seem to be intuitive. A glance at any supply/demand chart shows that the supply of any commodity increases with an increase in the price (its “incentive.”) However, things are never that simple. It turns out that there is an equally intuitive law called The Law of Diminishing Returns which works in the opposite direction; this law means, simply stated, that there is a limit to the effectiveness of incentives, or any other number in economics. “Diminishing returns” simply means that you can only throw so many “inputs” at a problem before the output starts to level off and then actually decline.
Because of the law of diminishing returns, all supply/demand curves are “backward bending,” although one never sees them drawn that way in the textbooks. In other words, that at some point, a higher price will actually bring forth less production, not more. At that point, the higher price becomes a “perverse incentive.” A perverse incentive is an inducement to “do the wrong thing.”
The sub-prime mess is a prime example of how perverse incentives work. Banks used to make their money lending money to borrowers who they felt could repay the loans. But they discovered that they could make even more money in a market composed of naïve borrowers by merely “originating” the loans, jacking up the loan fees, and selling the loans to investors. The virtuous incentives to be careful with the depositors money became a perverse incentive to be as reckless as possible. Then, as the market collapsed and the investors would no longer buy the suspect loans, the government, in an effort to “save” the housing market, shoved Fannie Mae into the gap. I never saw “moral hazard” work so fast. The mortgage companies kept on writing—and still write—the same bad loans that caused this mess. Now Fannie Mae needs to be bailed out, and the taxpayer will foot the bill. No one has a clue as to how big that bill will be. The bad loan practices continue to this day. Nothing has changed, except that the suckers buying these loans are now the taxpayers.
Another example of a perverse incentive is unfolding in the debate over off-shore drilling. The debate has a certain air of unreality to it because the oil companies already have leases on 34 billion barrels of oil and they could drill tomorrow, without so much as a nod to congress or anybody else. That is more oil than the leases under debate (about 18 billion barrels.)
So why the big push to get the leases in place before Cheney and Bush leave office? And why not punch a hole in the ground and take the oil out right now? Because the high price for oil is a perverse incentive not to drill, so long as they can be assured that they control the leases so that nobody else can drill either. $120/barrel oil is an example of the backward-bending supply curve. So long as they can be assured that some wildcatter or start-up outfit won't start sucking the oil out of the ground before big oil is ready to, there is no reason to drill now. With profits this high, punching more holes in the ground would only raise the supply and lower the price. Why do that? The oil is not going anywhere, and they can drill it as their present fields begin to run out, thereby keeping the prices sky-high for the foreseeable future. Since alternative energy sources won't be significant for at least a decade, if then, there is simply no reason to reduce their own return to investment by drilling more wells.
And the returns are impressive. Oil costs maybe $10-20/barrel to bring to the surface, but sells for more than $100. The oil companies advertise widely that they are only making 9%, but that is a highly deceptive number; in fact, if it were true, they could not get anybody to invest in the oil business. The truth is, their drilling operations earn closer to 50% return on investment, and even that is likely understated. If they can control all the leases, they can keep this up for years to come.
The same perverse incentives hold true in the refining business. The oil companies have not built a new refinery since the Ford administration. They like to claim that this is because of “regulations,” but that claim doesn't pass the smell test, for two reasons. One, most dangerous chemical plants operate under similarly strict regulations, but they have managed to keep up with demand for the past 30 years. And two, Big oil has actually bought out the smaller companies and closed their refineries. That's how perverse incentives work.
It is clear in this election that on this issue and many others, McCain is holding a pair of deuces against Obama's full house. Yet, McCain may be able to bluff his way into the White House. Obama is turning out to be a black Kerry, unable to respond to even the crudest charges. Kerry, a decorated veteran, was unable to respond to the scurrilous charges of a draft-dodger. Barrack seems similarly unable to respond to an empty but aggressive campaign. Obama is getting himself into a position where he will have to say that he voted against off-shore drilling before he voted for it. We already know how well that line of argument works.
Of course, the response is easy. Just tell the McCain-oil conglomerate that they can have a lease anywhere they like. But the lease has an expiration date. They must start sucking the oil out in five years, or the lease is automatically canceled and all lease payments forfeited. Further, the same rules apply to the leases they already have. Use 'em or lose 'em! Not only will there not be one single bid, but McCain will be instructed to quietly drop the whole issue, lest he endanger their control on the 34 billion barrels they already have but don't use. The Democrats have every natural advantage in this election, but that itself can be a perverse incentive to lose it. And so far, they are doing their best to do just that.