WEBVTT NOTE Greed in Public and Private Institutions 1 00:00:00.000 --> 00:00:05.000 Well, it's always wonderful to present at the Austrian Scholars Conference. 2 00:00:05.000 --> 00:00:12.000 And this time I want to talk a little bit about greed, something that is not on anyone's mind. 3 00:00:12.000 --> 00:00:17.000 If you ask the average person out there about the business cycle, they would say, 4 00:00:17.000 --> 00:00:24.000 well, it's greed that causes it. In fact, it's bouts of greed that punctuate stretches of moderation. 5 00:00:24.000 --> 00:00:27.000 That's why we have business cycles. 6 00:00:27.000 --> 00:00:37.000 And then if we look at the Occupy rallies, right, they're like down with the greedy bankers, down with the greedy banks, you know, just grubbing for their profits and such. 7 00:00:37.000 --> 00:00:48.000 And so what we really see is that this is just self-interest, right? Because if we ask ourselves what is greed, greed is just wanting something too much, right? 8 00:00:48.000 --> 00:00:52.000 The guy's greedy for it. Well, what is it? Well, he wants something too much. 9 00:00:52.000 --> 00:00:58.040 Well, in science we need precise definitions and in social science of economics we really 10 00:00:58.040 --> 00:01:03.120 have to adhere to this and so when we look at the word greed where we say we just want 11 00:01:03.120 --> 00:01:09.840 something too much, we have to absolutely reject that because it's not precise. 12 00:01:09.840 --> 00:01:18.560 So what we recognize then is that self-interest is omnipresent, it is what propels the butcher, 13 00:01:18.560 --> 00:01:22.560 the Brewer and the Baker to serve others. 14 00:01:22.560 --> 00:01:26.200 So it becomes a question of aligning incentives. 15 00:01:26.200 --> 00:01:29.360 It's a principal agent problem. 16 00:01:29.360 --> 00:01:34.720 So if we look at, suppose, Ken Lay of Enron or Bernie Madoff 17 00:01:34.720 --> 00:01:37.200 or some other suitable villain that you 18 00:01:37.200 --> 00:01:39.080 want to throw in charge. 19 00:01:39.080 --> 00:01:43.040 But put them in charge, not of a for-profit private company, 20 00:01:43.040 --> 00:01:46.000 but a bureau, a governmental bureau. 21 00:01:46.000 --> 00:01:49.640 What are the implications if you put those people in charge? 22 00:01:49.640 --> 00:01:58.080 Or take it another step, suppose it's a private, non-profit organization, now what are the 23 00:01:58.080 --> 00:01:59.080 implications? 24 00:01:59.080 --> 00:02:03.720 And so we have two questions that come up, and the first one is, can the institution 25 00:02:03.720 --> 00:02:09.800 effectively allocate resources to satisfy the most intense wants and desires of consumers? 26 00:02:09.800 --> 00:02:15.420 And the second one is, can the principal agent problem be overcome to ensure that the leadership 27 00:02:15.420 --> 00:02:20.420 will carry out its attendant purpose, or will the leadership use the entity as a means to 28 00:02:20.420 --> 00:02:23.500 a selfish or greedy end? 29 00:02:23.500 --> 00:02:24.780 So we have two problems. 30 00:02:24.780 --> 00:02:29.500 The first one is the economic calculation problem, and essentially it's this. 31 00:02:29.500 --> 00:02:35.340 We've got resources over here, we have plans of how to put resources together, and we've 32 00:02:35.340 --> 00:02:37.300 got consumers over there. 33 00:02:37.300 --> 00:02:42.260 But the consumers, they want stuff, they desire things, but it's all subjective. 34 00:02:42.260 --> 00:02:47.700 So how do we then combine these resources into useful things, but not just randomly 35 00:02:47.700 --> 00:02:52.460 useful things, we want useful things that satisfy the most intense wants and desires 36 00:02:52.460 --> 00:02:56.500 of the consumers first, otherwise it's wasting. 37 00:02:56.500 --> 00:03:00.620 And then of course you've got consumers and they don't tell us, they just show up, they 38 00:03:00.620 --> 00:03:05.140 will walk through Wal-Mart and they're not saying I want to bargain with you, no no no, 39 00:03:05.140 --> 00:03:10.180 if you don't have what they're looking for on the shelves, at a quality, at a price, 40 00:03:10.180 --> 00:03:14.180 and then they want it, what do they do? They just leave and they don't even tell you why. 41 00:03:14.180 --> 00:03:18.180 That's a tough, tough job to overcome. 42 00:03:18.180 --> 00:03:22.180 Now, the question is how do we communicate this information? 43 00:03:22.180 --> 00:03:26.180 Well, markets have a solution. These are for-profit companies. 44 00:03:26.180 --> 00:03:30.180 But there are also non-market solutions. 45 00:03:30.180 --> 00:03:34.180 We have government bureaus and non-profit organizations. 46 00:03:34.180 --> 00:03:38.180 Now, regardless of the type of organization, we have decision makers 47 00:03:38.180 --> 00:03:45.060 have personal preferences and when we see that the decision maker makes good 48 00:03:45.060 --> 00:03:49.420 decisions that they're able to over that their their decisions benefit both the 49 00:03:49.420 --> 00:03:55.460 organization and themselves but there's an incongruity that can arise between the 50 00:03:55.460 --> 00:03:59.240 two and this is an opportunity for personal benefit and this is where the 51 00:03:59.240 --> 00:04:05.540 principal agent problem emerges so in my paper I look to for-profit firms and we 52 00:04:05.540 --> 00:04:29.540 Economic Calculation, Mises Economic Calculation, Socialist Commonwealth, Socialism, Bureaucracy, Profit and Loss in Planning for Freedom, Hayek, 1935, Use of Knowledge in Society, 1945 53 00:04:29.540 --> 00:04:39.540 So here's the big thing about for-profit firms, and it's a dirty little secret, but the purpose of a for-profit firm is to make profit. 54 00:04:39.540 --> 00:04:45.540 I know, surprising. But what happens here? Well, both sides trade, both sides benefit. 55 00:04:45.540 --> 00:04:50.540 We see that profit is when revenues exceed cost, but which costs? 56 00:04:50.540 --> 00:04:55.540 Well, the only cost that's relevant is always opportunity cost. 57 00:04:55.540 --> 00:05:10.540 And so what we then see is that the firm then is the best approximation, a for-profit firm then uses these tools for the best approximation to satisfying the most intense wants and desires of consumers. 58 00:05:10.540 --> 00:05:18.540 And it's these prices that convey the relative scarcities and allows economic actors to adjust and integrate themselves into the greater whole. 59 00:05:18.540 --> 00:05:23.040 And this part is also fairly important. It's the loss side. 60 00:05:23.040 --> 00:05:31.040 So when economic decision-makers make wrong choices, well, they lose control of these resources, okay? 61 00:05:31.040 --> 00:05:35.040 So that's the feedback mechanism on the for-profit firm side. 62 00:05:35.040 --> 00:05:41.040 And so the principal agent problem then says, we have owners that hire decision-makers. 63 00:05:41.040 --> 00:05:45.040 Then these decision-makers engage in perquisites, or PERCs for short. 64 00:05:45.040 --> 00:05:51.040 And they basically have the big corner office, the mahogany desk, and line-and-dine clients 65 00:05:51.040 --> 00:05:53.720 Private Jet Out to Tahiti for Nine Rounds of Golf, 66 00:05:53.720 --> 00:05:54.560 sort of stuff. 67 00:05:54.560 --> 00:05:57.920 Well, we have a lot of literature out there 68 00:05:57.920 --> 00:06:01.200 about creating incentive compatible contracts 69 00:06:01.200 --> 00:06:03.680 to overcome these features, 70 00:06:03.680 --> 00:06:06.160 and they have varying degrees of success. 71 00:06:06.160 --> 00:06:08.240 But ultimately, the principal agent problem 72 00:06:08.240 --> 00:06:10.720 is backstopped by the market test. 73 00:06:10.720 --> 00:06:14.200 Enron and Madoff were revealed by the market, 74 00:06:14.200 --> 00:06:16.120 not by the SEC. 75 00:06:16.120 --> 00:06:19.960 So what we then see is that greed is usually checked 76 00:06:19.960 --> 00:06:22.920 by the Fear of Losing Wealth. 77 00:06:22.920 --> 00:06:26.600 And so after a long discussion and excellent discussion 78 00:06:26.600 --> 00:06:29.920 about that in my paper, I then move on to bureaus 79 00:06:29.920 --> 00:06:31.920 where I talk about economic calculation. 80 00:06:31.920 --> 00:06:35.720 Now, the governmental bureaus do not have the tools 81 00:06:35.720 --> 00:06:39.840 to engage in calculating economic efficiency. 82 00:06:39.840 --> 00:06:42.240 Revenues are decoupled from their output 83 00:06:42.240 --> 00:06:45.120 and distribution decisions. 84 00:06:45.120 --> 00:06:47.160 The inflows of fund are not dependent 85 00:06:47.160 --> 00:06:50.520 upon the Sales by Bureaus. 86 00:06:50.520 --> 00:06:53.760 So even though we have these sort of entities 87 00:06:53.760 --> 00:06:57.440 that will charge for services like the post office, 88 00:06:57.440 --> 00:06:59.200 they never can go out of business. 89 00:06:59.200 --> 00:07:03.600 And so they fail this, they don't have these sorts of tools 90 00:07:03.600 --> 00:07:07.760 because they don't have to fear losses. 91 00:07:07.760 --> 00:07:10.720 The decision makers also don't lose control 92 00:07:10.720 --> 00:07:13.560 when they do have losses. 93 00:07:13.560 --> 00:07:16.320 Take for example, failing schools, right? 94 00:07:16.320 --> 00:07:20.800 If a school doesn't educate a kid, not only do they not get shut down and go out of business, 95 00:07:20.800 --> 00:07:22.800 we give them more money. 96 00:07:22.800 --> 00:07:26.160 How insane is that? 97 00:07:26.160 --> 00:07:29.960 And so we don't have a feedback channel for bureaus. 98 00:07:29.960 --> 00:07:32.200 They don't even use prices. 99 00:07:32.200 --> 00:07:36.280 In Wake County, North Carolina, where I live, we had a drought a few years ago. 100 00:07:36.280 --> 00:07:40.200 And so the politicians were saying, oh, how can we ration water? 101 00:07:40.200 --> 00:07:43.600 And the economist, the good economist said, well, why don't we just raise the prices? 102 00:07:43.600 --> 00:07:44.920 No, we can't do that. 103 00:07:44.920 --> 00:07:45.920 Why? 104 00:07:45.920 --> 00:07:55.920 So instead what we'll do is we'll limit how you can wash your car and when you can water your lawn and ask restaurants not to give water when you walk in, blah, blah, blah. 105 00:07:55.920 --> 00:07:58.920 And of course this is all very wasteful and awful. 106 00:07:58.920 --> 00:08:09.920 But then after people started using water-saving devices, rain barrels and everything, and the drought was over, the revenue to the water department was way down. 107 00:08:09.920 --> 00:08:14.920 Why? Because people weren't using as much water because they were saving and conserving water. 108 00:08:14.920 --> 00:08:23.920 And so the water department did what? They raised prices. Amazing that the poor weren't hurt by this at this time, but anyway. 109 00:08:23.920 --> 00:08:29.920 So the point is that they don't use prices to help them figure out what is efficient. 110 00:08:29.920 --> 00:08:33.920 And so then this brings us to the principal agent problem facing bureaus. 111 00:08:33.920 --> 00:08:41.920 The decision maker is not selfless. When decision makers' preferences are in discord with the purpose of the bureau, we have the principal agent problem. 112 00:08:41.920 --> 00:08:49.800 Now, we all own the Bureau, so nobody really owns the Bureau, so losses are not coming 113 00:08:49.800 --> 00:08:57.220 out of anyone particular's pocket, but fortunately, governments have long recognized that these 114 00:08:57.220 --> 00:09:01.980 bureaucrats can get out of control, and so they impose rules. 115 00:09:01.980 --> 00:09:06.700 We don't just give to the superintendent of the school system, here's a check for $14 116 00:09:06.700 --> 00:09:09.440 billion, go educate some kids, right? 117 00:09:09.440 --> 00:09:13.880 With all of this, we give them a rule book and we give them regulations, they say under 118 00:09:13.880 --> 00:09:18.980 this sort of circumstance behave this way and under this is your rule of conduct and 119 00:09:18.980 --> 00:09:21.740 what this creates is a tension and a trade-off. 120 00:09:21.740 --> 00:09:28.400 It reduces rules and regulations, reduce flexibility for problem solving and so it binds them, 121 00:09:28.400 --> 00:09:33.540 but on the other hand, when we try to introduce flexibility, up comes the principal agent 122 00:09:33.540 --> 00:09:34.540 problem. 123 00:09:34.540 --> 00:09:40.700 And so then I turn to non-profits and we have again the economic calculation problem. 124 00:09:40.700 --> 00:09:47.740 Now again non-profit organizations decouple revenue from production and distribution of 125 00:09:47.740 --> 00:09:51.240 goods but it differs with governmental bureaus in two ways. 126 00:09:51.240 --> 00:09:57.200 First they can go out of business and then the funds also come from donations. 127 00:09:57.200 --> 00:10:01.340 Now government grants can be treated as a form of donation. 128 00:10:01.340 --> 00:10:07.940 Now, donors will withhold donations when the marginal benefit is less than the marginal 129 00:10:07.940 --> 00:10:11.340 cost, which reduces the size and scope to command resources. 130 00:10:11.340 --> 00:10:14.140 Now it's similar but not the same as profit and loss. 131 00:10:14.140 --> 00:10:21.900 There's no way to know if a non-profit uses excess, use of resources exceed its opportunity 132 00:10:21.900 --> 00:10:22.900 cost. 133 00:10:22.900 --> 00:10:26.500 Those that consume the product are not paying the full price. 134 00:10:26.500 --> 00:10:31.300 Here at the Scholars Conference and at Mises University, these are subsidized. 135 00:10:31.300 --> 00:10:37.080 or we don't even approximately know the intensity of the preferences of the participants. 136 00:10:37.080 --> 00:10:46.080 And so because production is subsidized, resources are most likely used for lowered valued uses. 137 00:10:46.080 --> 00:10:51.880 We can suppose that particular big donor might give a whole bunch of money to the Mises Institute, 138 00:10:51.880 --> 00:10:59.680 you know, and he gets a lot of value out of it, but that point itself just confirms that 139 00:10:59.680 --> 00:11:04.600 and the narrowness of that ever happening, and so it should confirm the general point 140 00:11:04.600 --> 00:11:10.040 that when we subsidize these sorts of things that it's for a lower opportunity cost use 141 00:11:10.040 --> 00:11:13.920 or a lower value use. 142 00:11:13.920 --> 00:11:18.920 So nonprofits, the bottom line is that nonprofits cannot calculate economic efficiency. 143 00:11:18.920 --> 00:11:22.320 Now notice that the division is not between private and public. 144 00:11:22.320 --> 00:11:28.680 It is between for-profit and not-for-profit entities and the not-for-profits, they don't 145 00:11:28.680 --> 00:11:31.620 have a feedback loop to guide the decision makers. 146 00:11:31.620 --> 00:11:35.280 Non-profits compare wrong opportunity costs. 147 00:11:35.280 --> 00:11:38.500 A for-profit firm uses weighted average cost of capital 148 00:11:38.500 --> 00:11:40.040 or internal rate of return. 149 00:11:40.040 --> 00:11:42.680 Non-profits, they move on to the next profit 150 00:11:42.680 --> 00:11:43.920 that fulfills the mission. 151 00:11:43.920 --> 00:11:46.480 There isn't a minimum internal rate of return 152 00:11:46.480 --> 00:11:49.200 that they have to use in order to justify a project. 153 00:11:49.200 --> 00:11:51.580 If they have the funds, they're gonna do it. 154 00:11:51.580 --> 00:11:56.400 So the ultimate backstop for a non-profit are donors. 155 00:11:56.400 --> 00:11:59.040 but this doesn't solve the efficiency problem 156 00:11:59.040 --> 00:12:02.560 and to the extent that donations come from political sources 157 00:12:02.560 --> 00:12:05.880 insulates the non-profit from market conditions 158 00:12:05.880 --> 00:12:08.960 and so here comes the principal agent problem. 159 00:12:08.960 --> 00:12:12.120 There's no market test and so there's really nothing 160 00:12:12.120 --> 00:12:13.960 to align incentives with. 161 00:12:13.960 --> 00:12:18.120 We can't just say to the CEO, go out and make profit 162 00:12:18.120 --> 00:12:23.060 and so the president of Stanford University, Donald Kennedy, 163 00:12:23.060 --> 00:12:26.860 use federal grants to live big, right? 164 00:12:26.860 --> 00:12:30.020 The Board of Trustees can set some sort of rules, 165 00:12:30.020 --> 00:12:32.540 but when they do that, there's high monitoring costs 166 00:12:32.540 --> 00:12:36.400 and it reduces the flexibility of the decision makers. 167 00:12:36.400 --> 00:12:38.640 But now, let's take another step. 168 00:12:38.640 --> 00:12:41.980 What if the decision maker and the Board of Trustees 169 00:12:41.980 --> 00:12:44.820 both agree to use these sorts of things 170 00:12:44.820 --> 00:12:47.980 and conspire against the donors? 171 00:12:47.980 --> 00:12:50.660 Well, we have a tremendous amount of research 172 00:12:50.660 --> 00:12:54.660 showing the misuse of funds in universities. 173 00:12:57.340 --> 00:13:00.740 This is from Vance Fried from the Cato Institute. 174 00:13:00.740 --> 00:13:03.380 He says, the more subtle forms of the principal agent problem 175 00:13:03.380 --> 00:13:05.580 manifest in a number of ways, such as, quote, 176 00:13:05.580 --> 00:13:07.460 spending on some combination of research, 177 00:13:07.460 --> 00:13:09.860 graduate education, low demand majors, 178 00:13:09.860 --> 00:13:12.620 low faculty teaching loads, excess compensation, 179 00:13:12.620 --> 00:13:14.140 and feather bedding. 180 00:13:14.140 --> 00:13:17.000 Fried measured the extent of this problem, quote, 181 00:13:17.000 --> 00:13:18.840 based on tuition revenues alone, 182 00:13:18.840 --> 00:13:20.460 the average private undergraduate school 183 00:13:20.460 --> 00:13:22.820 makes about 5,500 per student. 184 00:13:22.820 --> 00:13:25.120 When donations and endowment income are added, 185 00:13:25.120 --> 00:13:27.900 profits jump to about 12,800 per student. 186 00:13:27.900 --> 00:13:30.820 That's more than 60% net profit margin per student, 187 00:13:30.820 --> 00:13:34.260 double the margin of for-profit University of Phoenix, 188 00:13:34.260 --> 00:13:36.200 and that's just the average. 189 00:13:36.200 --> 00:13:38.980 Now, case after case, colleges, universities, 190 00:13:38.980 --> 00:13:41.960 United Way of North Carolina, Media Matters, et cetera, 191 00:13:41.960 --> 00:13:44.860 they all abuse donations and status. 192 00:13:44.860 --> 00:13:47.780 So if you're a university and you get a grant, 193 00:13:47.780 --> 00:13:52.100 who knows that they even get a grant right you don't know they don't open the 194 00:13:52.100 --> 00:13:55.620 books because they're private they don't just let any faculty member look at the 195 00:13:55.620 --> 00:13:56.660 books right 196 00:13:56.660 --> 00:14:00.260 this decreases the scope of whistleblowing 197 00:14:00.260 --> 00:14:04.260 and and not even the donors know if their funds are being used 198 00:14:04.260 --> 00:14:10.340 properly so are there any solutions and the short answer is well no 199 00:14:10.340 --> 00:14:14.420 now that doesn't sound very good but but look at the non-profits and 200 00:14:14.420 --> 00:14:16.900 and the not-for-profit sector, 201 00:14:16.900 --> 00:14:18.700 you don't have economic calculation, 202 00:14:18.700 --> 00:14:20.300 you have no feedback loop, 203 00:14:20.300 --> 00:14:22.700 they're basically flying blind. 204 00:14:22.700 --> 00:14:25.540 Private non-profits, they set their own goals 205 00:14:25.540 --> 00:14:27.020 by which they measure success 206 00:14:27.020 --> 00:14:31.420 and they set their own rules on their use of funds. 207 00:14:31.420 --> 00:14:34.620 You can have a private entity like Charity Navigator 208 00:14:34.620 --> 00:14:37.660 which sort of helps out in how they manage their money 209 00:14:37.660 --> 00:14:40.620 but really that doesn't solve the principal agent problem 210 00:14:40.620 --> 00:14:42.740 and so an approximate solution is this, 211 00:14:42.740 --> 00:14:44.780 So I divide people into two groups. 212 00:14:44.780 --> 00:14:47.100 You have your ideologues or your true believers, 213 00:14:47.100 --> 00:14:49.340 and you have your careerists, the people who are just there 214 00:14:49.340 --> 00:14:50.700 for a job. 215 00:14:50.700 --> 00:14:54.300 Well, the thing is, and I get through this in the paper, 216 00:14:54.300 --> 00:14:57.500 the more careerists you have, the higher the principal agent 217 00:14:57.500 --> 00:14:58.220 problem. 218 00:14:58.220 --> 00:15:00.860 And the further removed you are from the founding 219 00:15:00.860 --> 00:15:06.020 of the nonprofit, like Harvard University or Duke, 220 00:15:06.020 --> 00:15:08.180 you have mission drift. 221 00:15:08.180 --> 00:15:10.740 And so the basic point is that you 222 00:15:10.740 --> 00:15:15.060 You need to hire the true believers, but that reduces your talent pool. 223 00:15:15.060 --> 00:15:23.620 And so basically, even though you have no tool then to curb any of this greed, if you 224 00:15:23.620 --> 00:15:31.380 put them in charge, they have no tool to say, that's greedy, this is the feedback that stops 225 00:15:31.380 --> 00:15:32.420 all of that. 226 00:15:32.420 --> 00:15:38.340 And so the conclusion is this, for-profit firms, for all their faults, are far better 227 00:15:38.340 --> 00:15:43.380 and government bureaus and private non-profit organizations for solving the economic calculation 228 00:15:43.380 --> 00:15:45.620 problem and the principal agent problem. 229 00:15:45.620 --> 00:15:46.120 Thanks.