Bad Carrots: Incentive Structures for Governments

Levitt and Dubner revealed in Superfreakonomics the hidden theme of their first book, that people respond to incentives. I’d say that it’s a principle of economics that people respond to incentives in order to maximize their utility, the twist Levitt and Dubner put on this principle was to include social and moral incentives in addition to the common financial incentives.

Gary Becker is one of my favorite economists of all time because he also understood this and applied these principles of economics to varying topics such as crime and marriage and demonstrated how important incentive structures really are in governing behavior. Economists have known this for quite a while, and have also recognized structures with perverse incentives, yet have failed begin to correcting many of them.  — On a side note I think a lot of academics quite wrongfully refrain from actively promoting their scholarship. For years the World Bank used the Harrod-Domar model to assign foreign aid when we knew the model was fundamentally flawed. This is why I commend people like Jeff Sachs, Dick Thaler, Dambisa Moyo etc, who might not have the right answers, but challenge the status quo and will eventually lead to better decision making because they questions the underlying assumptions of our current practices and policies.

But back to the previously scheduled blog post:

African government structures have a very bad incentive system in place. The lack of strong law enforcement, transparency and accountability of the government have led to several government officials embezzling national resources and trying to acquire power and wealth instead of focusing on the development of the country. There is a moral hazard when it comes to obtaining power: greedy citizens seek government posts because they know it can make them wealthy and you have the wrong people trying to claim power. I can speak on behalf of Tanzania, who have had former Prime Minister Edward Lowassa resign due to him being caught in a scandal, and former President Mkapa who was accused of amassing incredible amounts of wealth during his presidency. I’m not the best person to tell you what’s what, but I wouldn’t be surprised if most African leaders have used their power to enhance their personal fortunes – ask Mohammad Ibrahim who failed to give a prize for African Leadership last time around.

African Dictators

Good governance has become a buzz word in UN circles and is claimed to be the reason for a lot of growth for African nations. Given the moral hazard of rising to power in Africa, how can we re-engineer the incentive structures to improve governance?

Heres a thought: what if we were to use aid to pay governments. Instead of the World Bank assigning it based on need and project financing, aid could just be a reward for good governance. Obviously there are a lot of problems with that and it gives a significant amount of power to developed nations – but what if they gave all the money to the African Union who was to distribute it based on government performance? Would that enforce good governance (and also reduce the World Bank meddling with policies set by governments)?

What if governments were engineered in such a way that presidents didn’t have to earn a salary but instead were paid directly by the tax payers. That definitely wouldn’t stop leaders from misappropriating national resources, but it incentivizes them to work for the people. If a certain amount of every citizens’ taxes were allocated just to pay a political leader, they could choose whether to pay the president, their local MP, or an opposition leader based on the work that was being done for them. And to add a further twist, lets say the president or the prime minister of a country failed to ‘earn’ a certain threshold from the people, they would be ‘fired’ from their post – as if the president is the CEO of the country and each (tax-paying) citizen is a shareholder.

This sort of system has problems of its own for example: if presidents are fired too often it could cause instability. Or only political leaders with a lot of money to advertise their impact would get paid and not those who did a lot of work but were to busy to parade their accomplishments.

I don’t claim these are good or even feasible ideas. Just thoughts that have the potential of reforming the way current incentives play out. And that’s really what modern-day economists and policy makers should be questioning. How can we rethink our incentive systems and redesign them to get desired results? And this can be on a smaller level than trying to tackle the problem of top-level governance. How do we make sure the local village deputy isn’t misappropriating funds for the village clinic? How can we keep a local NGO accountable to spend foreign donations just on malaria eradication schemes and not on a new bicycles for their kids?

These carrot problems don’t exist as much in the West. But if most African governments could establish and enforce a rule of law like the West, maybe us African economists wouldn’t be so concerned with carrot problems either.

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Damn you China!

Now you might have seen the news this weekend, the Chinese Central Bank has finally decided to unpeg their currency to the dollar and despite the fact that the Yuan/USD exchange rate has remained constant this morning, everyone is expecting the Yuan to appreciate. Now the news everywhere has a lot of comments on how this will effect, China, the US and the G-20. But what I haven’t seen mentioned is how this is going to affect the rest of the developing world. Well I can tell you first hand that it isn’t going to be positive.

Focusing just on Sub-Saharan Africa, China has been praised as being a major driver of growth in the region. Apart from being a major investor, China is also a large trade partner for the region. Here are some outdated stats on their trade situation:
2. China’s Engagement: the extractive sector in Africa
China-African trade: 2005 total $39.75 billion,
Export to Africa $18.68 billion, increase 35.2%; machine and electric
products $8.17 billion, hi-tech products1 $1.83 billion, totally 53.8% of the
export;
Import from Africa $21.06 billion, increase 34.6%; extractive sector, 86.7%
Import oil: $14 billion (38,470,000 tons; 30% of imported oil $47 billion).
China-African trade: 2006 (Jan-Sept): $40.557 billion;
Export to Africa: $18.721 billion, increase 38%; Import from Africa $21.835
billion, increase 45%.

I’m going to assume trade has increased (both import and export) between China and Africa as both regions have grown.

Now here is one major detriment to sub-Saharan Africa and the rest of the region: imports from China will become more expensive.
The simple reason being that due to massive inflation in most sub-Saharan African countries (more than 5% a year), imports are often bought in dollars.
Specifically, most importers purchase ‘containers’ of durable goods from China at a specific dollar rate, and the soon to appreciated Yuan will dictate rising import costs for the rest of sub-Saharan Africa (and all other countries that purchase imports in dollars). Given the very young manufacturing industries in sub-Saharan Africa, most durable consumer goods are purchased from China and this could have some serious problems for retail shops.
With a GDP growth rate that has decreased over the last year, this could be another setback to the region this year, though the magnitude of which I’m not too sure about since the durable retail sector isn’t as large in these countries.