Let's take Citibank.

The government is involved in changing behavior right from the inception of a corporation. It is called limited liability. We as a society accept this as we believe it encourages people to take more risks. It used to be that a corporate charter could be revoked if it were decided that the company was somehow harmful to the public. I am unaware of the last time this has actually occurred.

The government also encouraged risky behavior through GSEs (Freddie and Fannie). There was an implication that the government would take care of things when they went bad.

I personally believe that all of these problems are exacerbated by large public companies. Other than the possibility of having to find another job there is generally little risk in performing poorly or even maliciously at an individual level. Those at the top likely make enough money to survive a lifetime if they were fired tomorrow.

Now let's shift to the issue of energy.

Every drop of fuel you put in your vehicle is subsidized by the government. We spend trillions of dollars to fight wars in order to secure energy resources. These costs are externalized through taxes and it is thus feasible to drive vehicles which are not fuel efficient.

I have only scratched the surface on these two issues. I'm not advocating abolishing all regulation and government institutions. I do wish for more discussion which considers the effects that the government has on society. As the original poster alluded to, good intentions are not enough.

I think that the field of game theory, and as the most simplistic example, the prisoner's dilemma, shows that libertarianism, as defined by the idea that individuals acting in their own self-interest will create the greatest common benefit, is flawed. Specifically, this will limit the benefit of each individual as well as the aggregate.

Individuals acting in their own self-interests categorically do not arrive at optimal solutions for themselves or for the whole society. It's a complete joke, mathematically provable, and thus ridiculous that it's still being argued. We need coordinators. All forms of government have been imperfect at achieving perfect coordination, which has inspired libertarians and objectivists and etc., but that doesn't invalidate the coordinators' work. Instead, a meaningful endeavor would be to improve the scientific rigor and quality of the policy-based coordination. This is what my research as an undergraduate was based around...

Libertarian, I invite you to go start an investment bank and act in your own unfettered best interest. I'd be hard pressed to see you not end up in a similar situation to investors in any of the past bubbles and collapses.

http://dieoff.org/page95.htm

The tragedy of the commons demonstrates that with certain shared resources, when everyone freely pursues their rational self interest not only is utility not maximized, sometimes the result is catastrophic.

Libertarian solutions to the tragedy of the commons usually involve attempted parcelization and privatization of existing commons, and while that's practical in certain cases, in many others -- fishing grounds, air quality, global warming, etc... -- it is not.

Again, this is a low priority issue, and the thing to look out for is when planners try to use the 'greater good of all' to give handouts to special interests, as has been overwhelmingly the case with eminent domain lawsuits around the country.

http://links.org.au/node/595

My guess is that you double check the government when it comes to your personal safety. So why should anyone believe automatically that just because the SEC exists, any investment bank will be a safe bet and act in precisely the way it ought to?

Any firm is prone to conflicts of interest, fraud, deception, lack of transparency, etc. Investment banks are no different.

It's a reality of life that sometimes people/groups will try to defraud/deceive others. Self-interest (being symmetric) offers a backstop against this, UNLESS regulation gets in the way.

The analogy I'd use is this? SEC regulations on iBanks were as effective as a paper seatbelt. In other words, not effective at all. What did the SEC spend last year doing while the financial meltdown was brewing? It shut down prosper.com!

You may think that it's optimal to declare that everyone should put on a paper seatbelt and that when things get bad just do a bailout, but libertarians would prefer to let people make decisions based on facts the whole time.

Just because the seatbelt is broken, doesn't mean we should abandon seatbelts. It means we should work harder to make better seatbelts.

An argument I see when libertarians are faced with such questions is that libertarians aren't 'against' seatbelts, but they want to explore the alternatives. And yet they don't seem to come up with any other alternatives...

What we should not do is idealize the paper seatbelt or pretend that it works when it does not, or pretend that the design of that paper seatbelt hasn't been heavily influenced by corporate lobbyists, corrupt politicians, etc.

I'd argue the opposite, that a big, opaque regulatory state is the perfect environment for corruption.

For example, the basic principles of a free market (e.g., supply and demand) are easy to state but result in complex transactions. When things don't "work out" for someone in the real work and they raise an argument against "free markets" (as in the current housing bubble), we need to be ready to point out all the complex ways that the free market worked correctly but where the non-free parts distorted it (government policies encouraging loans to unqualified applicants).

In complex systems with non-linear behavior, we need to be very careful that we understand the full context of an event or we won’t be able to extrapolate the results. That’s why first-order approximations fail so often in mathematics and in real life.

I think it's somewhat absurd that Obama and Bush even pretend they can do anything about the financial crisis.

How can investing in stocks destabilize the economy? If I invest my money in stocks that aren't worth it, then I will lose my money but noone else. If my investment temporarily causes stocks to rise, and people therefore buy (hoping it goes higher), then it's obviously their fault and they too will lose their money. But if you don't invest in stocks, how can you be affected? The only way for this to happen is when government intervenes and takes money from taxpayers to bailout organizations that took too big risks.

http://en.wikipedia.org/wiki/Stock_bubble#Positive_feedback

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But if you don't invest in stocks, how can you be affected?

Market shocks affect the entire economy (through expanding and contracting credit, etc.). If one does a cannonball into a pool, how can it affect anyone else in the pool?

http://images.google.com/images?q=pool+cannonball

Which is weird! I've never understood why libertarians seem to discount external costs so deeply.

I think there is a breed of libertarian that values them sanely, but that it's the less rabid sort that tends not to rant on the internet. I'd include Friedman and Megan McArdle in this group.

I don't agree about valuing happiness instead of freedom, though. It's shouldn't be the government's job to worry about how happy you are, it should be government's job to make sure you're free to pursue happiness should you so choose.

Most libertarians are aware that the Government meddles heavily in the economy, and everything bad about the economy that's blamed on capitalism wasn't a fair test b/c it wasn't actually laissez faire capitalism that was tested. There is no good reason to expect external cost problem to be worse under a genuinely free market than they are now. So libertarians needn't say much about the issue.

And anyway, what do you expect libertarians to say about it? Either one can say that Government is the answer, or isn't. Libertarians are exactly the people who have knowledge about why Government is bad at solving problems, so they are the last people you'd expect to want the Government trying to solve this one.

Ah, we've pinpointed the nonsense! I'll leave you with some words from Milton Friedman on the New Deal:

> The other part of the new deal policy was relief and recovery … providing relief for the unemployed, providing jobs for the unemployed, and motivating the economy to expand … an expansive monetary policy. Those parts of the New Deal I did support. (…) Because it was a very exceptional circumstance. We'd gotten into an extraordinarily difficult situation, unprecedented in the nation's history. You had millions of people out of work. Something had to be done; it was intolerable. And it was a case in which, unlike most cases, the short run deserved to dominate.

With the point being, sometimes government is necessary and sometimes it's not. It's not an all-or-nothing endeavour.

Next you can add me. I think libertarianism today is too isolationist regarding war and terrorism.

But we cannot find the truth by analyzing who said what. The important thing is which ideas are right, not who said them.

At a very basic level this is simply a scientific, non-political world view. It's evidence-based. If you read through many of the threads on HN you can feel the deep sentimentality that people feel about things like Social Security, etc. It's an emotional, irrational, unscientific response.

Why are you critical of libertarianism? Do you support some special interest group that stands to lose simply from smaller government? Or are you sentimentally attached to the grand vision presented as the persuasive argument for some piece of historical regulation? Or are you a career burocrat :)

I'm a bit confused. The post you've replied to was in favor of libertarianism.

Isn't that what the defenders of communism say about the USSR and China? (Stalinim and Maoism respectively, rather than pure Communism as Marx et al. intended)

The point being that 'pure' libertarianism is possibly just as realistic as pure communism, or perhaps even democracy (either in the sense of 'pure' (i.e. direct) democracy at a national level, or even, with representative systems, that the majority of the population is well informed regarding issues at hand and actively participates in the democratic process).

To be clear, the items you state here aren't _rights_. Rather, they're privileges that aren't guaranteed. If you work and do a great job, you're not entitled to a big house in the suburbs, but you're increasing the odds of being able to afford it.

The Constitution guarantees rights to life, liberty, and property, as well as several other rights in the Bill of Rights and other amendments. But nowhere there will you find a right to have a job or right to make x% interest in the stock market (or right to be bailed out if you get in over your head in the real estate market).

As a nation we have a real problem of mistaking opportunities for rights, and feeling entitled to things that we want.

In other words, if you put toxic waste on your property, that's fine UNLESS it leaks onto someone else's property. So there is no need to open the discussion of how pollution impacts the greater good, because polluters just can't harm the neighbours' good!

The perverse incentive for planners to identify the "greater good" is the same as the way priests and religious leaders do so -- and they are likely to shake their finger just as judgementally.

First, note that if it weren't for regulators deciding on the amount of reserve capital Citibank was required to hold, the market would probably have demanded that it hold much more. For a long time iBanks have been benefiting from the Fed's power to bail them out. Unlike banks, whose asymmetric liquidity is due to customer deposits, iBanks are risk-taking businesses who are just trying to make people rich. If Yahoo can fail, why not Citibank?

So you were actually a temporary beneficiary of SEC and Fed policies that led to the over-leveraging of Citibank's capital and your previous ease at finding a job. Your major life decisions were perhaps influenced by this false sense of reality.

On to your thoughts on happiness: Would people be happier if they weren't allowed to eat junk food? What about if they weren't allowed to drop out of college? What about if they believed in a specific version of the Christian God? What if they wore an American flag arm band at all times in public?

It's highly subjective what makes people happiest. I personally don't want anyone telling me what will make me happiest.

I am registered Libertarian, as I believe in marketizing problems whenever possible; however, the markets must be set up correctly to be truly free, and only the government can do that.

The psychology people seem to have is to believe that if the government regulates it, then anything that falls under the regulation requires no independent thought.

On the icy road, the safe speed maximum is probably about 30 mph, but many accidents are caused by people going the posted limit, as people seem to trust the wise planner above their own ability to judge.

Similarly, people assume that a firm that is regulated by the SEC and backed buy the FDIC is going to be a safe place to put money, which is not always true.

I agree with your last statement, but note that 1) the SEC required insufficient reserves, and 2) because the government set the reserve limits, there is the implication that it ought to bail out the firms that were "just following the rules".

Hence the view of firms being "too big to fail" comes from the idea that regulation is perfect and if only it's followed then everything will be fine.

In a better, more libertarian world, banking crises would result in some failures, and once-burned investors would look carefully at what reserves actually mean, look sceptically at rating-weighted reserve requirements, and expect that if things go wrong there will not be a bailout.

This would help put money into firms that actually know how to act in a trustworthy, sound way, not just the firms that are able to successfully lobby the SEC, the way Madoff's did.

In the car example, I think we have a difference of philosophy. I think that regardless of the posted speed limit, some people will not exercise the proper judgement because they have evaluated the conditions differently.

In the example of reserve funds, imagine a world with similar information asymmetry to today. Banks are semi-transparent, and deposits are backed to some extent by the FDIC. However, the SEC takes less of an active regulatory role, the result of which is that some unscrupulous banks have started offering insanely high interest rates based on dangerous fractional reserves. People will likely flock to those banks, especially given that the FDIC is backing their investments... and then the whole thing collapses.

One solution is to get rid of the moral hazard inherent in the FDIC, and make it clear that the only way to hold your money safely is in cash, in your home. But one of the signs of civilization is increased specialization of labor; I should not have to do the job of banker and regulator all rolled into one, just to have a place to keep my money. Worse, it's not even clear that this is possible, because of inherent information asymmetry.

We can argue about whether an adequate ad-hoc bank insurance solution would arise, however, I'm not sure that such an invention would increase efficiency in the market.

As for regulation, there doesn't really seem to be any real alternative, unless the direct consequences for the operators of failed financial institutions became much more dire. And criminalizing poor business decisions doesn't seem very Libertarian at all.

If I walk into a bank and consider depositing my hard earned cash, perhaps I'd demand enough transparency to determine whether to trust that entity with my cash, in exactly the same way that I must trust Amazon when I place an order online, etc.

Information will always be imperfect, but it's in both parties' interest to increase transparency. It's barely even a coordination problem in today's world.

As a note to your remark about my speed limit explanation, why is it then that on an extremely icy road people go exactly the posted speed limit rather than, say, 90 miles per hour? Clearly they are taking the sign literally and at face value.

So one regulatory approach that would be an improvement over the current one might be to require a reserves "rating" to be published, much like the smoking causes cancer warning. Perhaps right under the bank's logo it would have to say "This bank has a reserve score of 71 (moderately risky)".

And yes, there would be room for 3rd party ratings to be applied to bank solvency as well. I'm not sure what the best approach would be, but consider that most securities regulations were made in the 20s before the information revolution (ironically, the "Financial Services Modernization Act" removed a few of the depression-era regs that were actually smart and prevented moral hazard and conflict of interest). Surely there would be a lot of clever approaches. One idea that intrigues me is that the government could offer its rating, but banks would be required to obtain several. I'd love to see someone like Michael Moore create his own such agency and use his genius to publicize it.

Analogously, consider the FDA drug approval process. Everyone knows that the FDA process is flawed, as people are routinely killed by side-effects of drugs. So why not have several ratings: One from a consortium of insurers, one from the AMA, and one from the FDA -- each group has a slightly different downside risk (and upside) to approving a dangerous drug or failing to approve a safe one in a timely fashion. Why not have a grid of 3 checkboxes on every drug. The absence of an AMA approval might be a warning sign to some, but not others.

If you think this idea is silly, consider what happens when the FDA gets it wrong and lots of people die because of a drug... exactly nothing but a too-late knee-jerk reaction. Usually the drug is immediately pulled even if it has other valid uses, etc. One perverse example: many doctors knew the dangers of Vioxx well before the scandal (the same risk exists in lesser form with all such drugs, even Ibuprofen) and good ones didn't use it on patients at risk for bleeding without great caution. Yet it took a few years and then bang, it's gone from shelves even though there are a few essentially identical drugs that stayed on the market and do still occasionally kill people when used without caution by docs.

I'm not claiming to have the whole idea of optimal regulation for the 21st century figured out, but I'm just brainstorming. Surely there would be a lot of great and clever ideas. The current, one-size-fits-all approach leads to massive and often ineffectual regulatory apparatus.

Why shouldn't coming up with ad-hoc regulatory / information-dissemination / transparency-reducing systems be something that startups do? Why not in the case of medical trials have data published to the web so that people can make mash-ups with all the data that is being considered by regulators? A few weeks ago the SEC approved a plan to put financials in XML format, but it's all very primitive and is unlikely to be all that useful, but the core idea of transparency through an API is a good one, I think.

The role of the "regulator" of the future, I think, is to design a good API spec (metaphorically and literally) and possibly make a list of all of the watchdog groups offering analysis. State and federal governments could fund their own watchdog groups too -- maybe I notice that Wyoming's prescription-drug watchdog group has been right a bunch of times in a row, so I begin trusting it more than the one in my own state. Maybe I decide to trust Michael Moore's group or Paul Graham's. Over time the best would rise to the top and every mistake would give new groups a chance to enter the limelight -- maybe a YC startup was the only one not to approve Vioxx, for example.

Toward the libertarian goal of efficient, small government, we should be focusing on regulation that increases transparency and also increases the number of entities that can act as private watchdogs. It's exceptionally telling that the SEC received repeated complaints about Madoff's fund from various sources and still did nothing. One might argue that the SEC is understaffed, but it found the staff to shut down prosper.com, a startup that was making humanity better off, on a technicality, not even on any remote accusation of fraud. More likely, prosper.com competed with the established finance powerhouses, so the SEC was probably just acting to keep competition out of the industry.

Most of what all of the regulatory agencies do is coordinate information, and if the modern world (and the internets) have done one thing, it's make such problems extremely easy and inexpensive to solve. My basic argument is that the antiquated structures create a false sense of security and get in the way, as well as soak up tons of industry lobbying dollars to the point where industries tend to become highly regulated and highly protected, the two biggest characteristics of libertarian dystopia. The military industrial complex and now the financial and auto industries are that sort of thing. Big agriculture is too, as well as many others.

But according to your own line of thought, shouldn't people be fully responsible for their own conduct, regardless of the surrounding circumstances? If so, how is lack of governement regulation going to help people determine the correct speed to go at on icy roads?

The heuristic becomes one of people believing that the government must have already looked out for all dangerous possibilities, so anything that is legal is safe.

I don't feel the need to look down my nose and say "people should be individually responsible" because I don't consider that productive. I think people are naturally responsible enough to look out for their own interests, unless they are misled.

One example: investors in Madoff's hedge fund were misled by the SEC stamp of approval on that fund. Don't you think that normal scepticism about the returns ought to have led to some scrutiny?

I don't think financial regulations are any different, but unfortunately most people take the fact that a firm is regulated to mean that it's totally safe. Similarly, many foods that will result in an early death are perfectly legal and consistent with the USDA food pyramid.

If this were true (and it certainly is not!) then the market really would be just as incompetent as its critics say it is.

In an environment where the government decides what is prudent, there is no incentive for a bank to say "We are sounder than our competitors because we keep more reserves". Why not? Because they would be competing against the government for their definition of soundness.

Sure it could happen theoretically, but it would be a tremendous competitive disadvantage.

The way it is today, any bank that is legally allowed to operate is considered equally sound by borrowers and investors, and banks have no incentive to try to prove to customers that they are actually more sound than their competitors.

In a highly regulated environment, that works for all banks because they know that if there is a major economic downturn everyone will get bailed out.

Notice that all banks were required to accept TARP loans whether they needed them or not. Why? To avoid SIGNALING which banks were hurting and which were not. Why? To avoid capital flowing to the banks that were actually sound!

Why? Well, partly because government wants to avoid a crash, and partly to keep the status quo going strong. Also, consider what all of the major industry players in banking want... what does any firm want? No competition. They were all happy to share a big market and to have as few as possible attributes on which to have to compete for business.

Simple, smart, behaviorally sensible regulations make sense, but the SEC has been notoriously behind the curve for years. The missing piece has been to regulate appropriately while allowing there to be an incentive for banks to actually compete on the basis of soundness. The decision not to let the concept of bank soundness enter the brains of mere citizens must be a knee-jerk reaction to the great depression.

Instead, in exchange for various political concessions, banks were given every incentive to be extremely leveraged. Consider the impact of the GSEs on housing prices, MBS prices, etc? The implicit guarantee of Fannie and Freddie alone probably led to banks thinking (rightly, it turns out) that any housing related crash's impact on banks would be bailed out.

Side note: Are the banks going to be better off after the bailout? Of course they will be. The desired "sweet spot" for most firms is to be in a heavily regulated, heavily protected industry, as it means that there are huge barriers to entry and the profits (though sometimes essentially set by regulators) roll in year after year. See the military industrial complex for an example of the idealized sort of model.

Market forces have been very far from banking for a long time. Why else would financial services be the biggest donors to both parties. Libertarians are not opposed to regulations, just not ones that create perverse incentives and lead to massive bailouts! Any time a firm would rather spend its money on lobbyists and campaign contributions rather than innovation, there is a big problem.

This was your original point. Let's stay on track.

Your claim that regulators decide how big Citibank's reserves should be is false. They set a minimum, not a maximum.

You then tried to draw an analogy between speeding and regulation, one that, as I have explained, is totally inappropriate.

You then claimed that "most people take the fact that a firm is regulated to mean that it's totally safe", which is a massive exaggeration. If that were true, bank bonds would be considered as safe as government bonds and bank runs would never happen. All other regulated industries would be exactly the same. Also, you are confusing reserve requirements with broader regulation as a whole.

You then claim that banks raising their reserves would be "competing against the government for their definition of soundness", despite the fact that no government has ever claimed any 'definition of soundness'. This appears to be something that you have invented.

You then give an argument as to why other forms of regulation encourage banks to hold lower reserves. This contradicts your original point, which was that if reserve requirements were abolished then the market would force banks to raise reserves. What you have demonstrated is that the market, bail-outs and broader regulation would actually force reserves to even lower levels in the absence of reserve requirements. You have changed your argument from one about reserve requirements to one about broader regulation, and bail-outs such as TARP.

I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks.

Reserve requirements are a good example of this effect. Industry lobbyists try very hard to have the limit decreased while benefiting from the public perception that the regulator has assured that the bank's assets are sound.

If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves.

The alternative view of humanity is that people are sensible enough to demand sound practices from institutions they deal with on important matters.

My argument is that banks don't use reserves as a way to win customers the way they would if regulators weren't giving an A+ to every bank that holds the minimum :)

One exception is Goldman Sachs. It did not need TARP funds to remain solvent. Yet Treasury forced all banks to accept the funds. What did Goldman do? It immediately paid a huge dividend to its investors.

What happened? Goldman actually had more sound practices than the rest of the industry and was not in danger of failing. It would probably have waited for bankruptcy proceedings and picked through the assets of the other banks, strengthening its already strong balance sheet.

Regulators did not want more money to flow to the firm that had good practices, so it insisted on bailing everyone out. This was to hide information from investors and customers. Goldman angered regulators by paying out the dividend right away, but managed to signal its health.

To understand the point of libertarians on this issue, consider the world in 10 years from today. We might have had a world where chastened investors and customers looked a lot more carefully at the risk management practices of banks before trusting them. Instead, we have a world in which our government owns 30% of all banks and regulators are being hailed as the saviors of the banking industry.

Do you want to live in a world where people act based on reality, or one where taxpayer money is appropriated without congressional approval and given to selected industries, and the appropriators are hailed as heroes that helped the little guy keep his job, prevented another great depression, etc.

It all comes back to the burden that people take upon themselves to assess the riskiness of the decisions they make. Industry loves to have its status quo practices rubber stamped by regulators, to add additional credibility. It all works out well as long as there can be another bailout, etc., but it's not based on reality and represents the slow transfer of wealth from the most productive companies to the ones with the most effective lobbying.

My point was that you analogy doesn't apply. Pointing to ice on the roads is completely missing the point: that the analogy doesn't hold in the first place.

>I do not think you have refuted my claim that regulation leads to people suspending critical judgement about risks.

I did not say this! I said that specifying a reserve requirement does not reduce bank reserves. Please keep this argument to reserve requirements, not general regulation.

>If you don't buy my argument then you probably believe that people are so stupid that without regulation banks would hold $0 in reserves.

The UK does not have reserve requirements and they don't have zero reserves. But they did not raise their reserves to safe levels either, refuting your original point.

Incidentally, it's you that's arguing that regulation encourages banks to hold lower reserves than they would without reserve requirements. You are constantly conflating reserve requirements and general regulation, moving an argument about one to a conclusion about the other.

You then go on to talk about TARP again, illustrating my point.

To manage the risk of your car going out of control, you choose a safe speed.

To manage the risk of a bank becoming insolvent, it chooses an amount of capital to keep in reserve.

I seriously doubt you take exception with any aspect of the analogy so far...

A speed limit sign suggests a speed that is safe to drive. However like any regulation it is only an imperfect estimate. Yet people seem to drive at that speed under adverse weather conditions completely irrationally.

A reserve requirement suggests an amount of reserve capital that is safe for operation of a bank. However like any regulation it is an imperfect estimate. Few banks carry reserves in excess of those set by the requirement.

These are completely identical scenarios. In each case, humans cluster around the regulation without exercising independent judgment. Drivers slide off of the road all the time, and a bit of recent price volatility sent many banks into insolvency.

Your example about the UK is noteworthy but I would argue that due to the dominance of US banks (and US regulations) in financial markets, UK banks are inclined to mirror US policies in order to remain competitive with US banks. Analogously, a Russian firm may adopt some US accounting practices if it wishes to attract investment from the US.

There are two factors: The first is the way that the bar is set by the regulation in the first place. T

he second is the grouping/incentive effect. If your competitor has too few reserves then you are at a disadvantage for not copying that behavior unless the economy crashes (such that your competitor goes out of business and you don't).

In one case we have members of the public who have passed a driving test. In the other, we have the foremost experts in the field, using the latest theories of risk, working with millions of dollars of modelling and statistical equipment, with their jobs on the line. For what good reason would a single one of them look at the reserve rate and say "Although the government doesn't claim that this is a safe rate for banks to operate at, but instead sets it completely arbitrarily, and admits to the fact that it's totally arbitrary, and has not changed this rate in several decades because it is an obsolete tool of monetary policy, I am nevertheless going to take it to 'suggest' a safe level of reserves, totally ignore all of my models and education, and just pick that number on a completely irrational basis."

We have a name for that.

http://en.wikipedia.org/wiki/Risk_compensation

risk compensation is an effect whereby individual people may tend to adjust their behaviour in response to perceived changes in risk. It is seen as self-evident that individuals will tend to behave in a more cautious manner if their perception of risk or danger increases. Another way of stating this is that individuals will behave less cautiously in situations where they feel "safer" or more protected.

Mirrlees also did highly theoretical work on another incentive problem: “moral hazard.” As is well known to those who study insurance, insurance coverage gives the beneficiary an incentive to take more risks than would be optimal. This is called “moral hazard.” Mirrlees’s insight, based on a complex mathematical model, is that the problem can be solved with an optimal combination of carrots and sticks. Insurance payments are essentially a carrot. But “sticks” could be designed also, so that an insured person who takes risks pays a penalty for doing so. With this combination of carrots and sticks, the insured person acts almost as if he is uninsured, and the insurer acts almost as if he were the insured.