Financial Meltdown and Your Farm...More in Common Than You Think

As you watch the U.S. financial system come close to a meltdown, the key phrase which will go down in history as the root of this problem is: "Socializing Costs and Privatizing Profits".  At the root of this problem is the vexing issue of incentives.  As I watch commentator and legislator impugn the "free-market" as the cause of this current crisis, I get a sinking feeling that the "fix" which eventually comes out of this will miss the root cause by a wide mark and not lead us to a stable, growth-oriented future.

The root of the problem here is poorly crafted incentives, which are at the root of the current sub-prime situation that exists on many pork and beef farms (and dare I say it, even poultry production).  As a general rule, people follow financial incentives and try to maximize their outcome.  The problem most farms face is they incentivize the wrong things.   The usual result is that as the object of the incentive comes closer and closer to being realized, the gap between the profit maximizing solution and the incentivized outcome grow farther and farther apart.

One of the first principles of a good incentive is that it aims at the "end" which the farm is trying to achieve, not one of the "means" to the end.  The proper end of a business is profit maximization carried out within the proper legal and regulatory structure within which the farm must always operate.  Too many times, incentives are constructed piecemeal around "means" to the end such as throughput.  Since we all know that you can produce lots and lots of "off product" (culls, lights, subprime carcasses etc.), it is critical that incentives which do not differentiate the basic end of the farm...which is to produce the full value (profit optimized) carcass, from sheer lbs, head, or tonnage be refined.

We also know that producing every carcass at full value will not result in profit maximization.  The reason is that eliminating every source of variation in the production system is far too costly compared to the gain in value of "fixing" the last bit of imperfection.  Most farms however, are far from getting close to that conundrum.  One of the first lessons in the economics of the environment is that a "pristine" environment (one devoid of any pollution whatsoever) is not the ideal societal solution.  The social cost of such a goal far exceeds the social gain from cleaning up that last bit of pollution.

The financial mess the U.S. economy is enduring is related to the fact that risk takers, within the rules that were given to them by congress, pushed for more and more financial gain.  No problem with that.  The problem stemmed from the fact that Fannie Mae and Freddie Mac were allowed to become the principal respository for almost all high risk mortgages sourced by private sector originators.  Once Fannie and Freddie took them on, the private originators were off the hook and out to make more mortgages.  Since we know that no risk is ever really eliminated, just transferred to someone else, Fannie and Freddie became top heavy with risk, which of course only works when the risky outcomes are not being realized (which is to say the market value of real estate was rising).  Social goals of having everyone in their own home whether they could afford it or not kept Fannie and Freddie from having much oversight on the risks they were allowed to assume.  Don't blame the mortgage originators (at least the ones that played by the rules), it was the poorly constructed rules (read incentives) that caused the problem, not greed.

We want people to be responsive to incentives, so it is not a good idea to "punish" people who simply try to maximize their benefit within the rules they have been given.

More on incentives coming...