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Beware the unintended consequences of bad incentives.

By Nancy Rapoport

What do these stories have in common?  From the Wall Street Journal (written by Liz Rappaport and Michael Rapoport--distant relations at best), "Ernst Accused of Lehman Whitewash" (here); from the New York Times and David Streitfeld, "Homes at Risk, and No Help From Lawyers" (here); and from John Stossel, "Uncle Sam Will Help You Buy an Alpaca" (here).

Each of these stories has the same subtext:  people behave according to the incentives that reward them.

If it is true that Ernst facilitated the bad accounting at Lehman (let's wait and see, but I wouldn't be particularly surprised), my guess is that the facilitation was due to the twin incentives of (1) rewards for pleasing clients (remember Enron?) and (2) no rewards for calling shenanigans on accounting tricks that--at the very least--violate the spirit of accounting rules, if not the technical wording of those rules.  (For the basic advice to avoid all actions that can be explained by, "Well, technically, it's ok," see the paper that Colin Marks and I wrote for the Fordham Law Review, "The Corporate Lawyer's Role in a Contemporary Democracy," which you can download here.)

Want to prohibit fraudsters from preying on distressed homeowners?  California tried, by enacting a law that prohibits lawyers from being paid for doing loan modifications until the modifications are approved.  Good for California for trying to squeeze out those businesses that took the modification money and ran, before getting their clients the modifications.  But give California a big "oops" for not exempting legitimate lawyers who just can't afford to float the entire fees for a process that might take years to complete (and which could be discharged in bankruptcy if, after the modification, the client still needs to restructure debt).

And those alpaca subsidies?  Tax credits can be great ways to shape behavior but, well, they shape behavior.  All regulation shapes behavior--again, by providing incentives or disincentives.  Much of regulation is important:  criminal penalties, pollution standards, food and drug standards, etc.  But lawmakers need to understand that regulation can create unintended behavior as well and to think hard about what might go wrong with a poorly written or ill-conceived regulation.  For example, rage at the bizarrely high pay for poor-performing executives and the revolving door for inattentive board members has created a backlash of irritation at all high salaries.  (Well, maybe not the high salaries of athletes, but the high salaries of non-athlete businesspeople.)  Redistribution of wealth from all high-earners to more low-earners wouldn't be the correct response to that rage.  (I still remember enjoying Robert Nozick's Anarchy, State and Utopia, which is actually available--yay!--here.)  Again, cutting too wide a swath will create more off-target incentives.

People are hard-wired to behave in certain ways.  If we're going to create incentives for behavior--and we will always create some incentives--we need to try to think those incentives all the way through.

Full post as published by Nancy Rapoport's Blogspot on December 23, 2010 (boomark / email).