Incentive is a powerful tool for nudging human behaviour in a particular direction. In realm of economics, money is an obvious candidate that people think of incentive. It is often assumed that higher cash reward will always equate to higher performance, but psychologists now know that is not always the case. In fact, in some cases, money incentive may cause harms.
It is this assumption that we know the link between cause and effect that leads to unintended consequences. Often, we act upon the belief that action A will cause event B. We stop short of realising that event B often leads to event C, which often catches us by surprise. I believe strongly in outsourcing my learning: learning from others’ mistakes. Here are some examples to serve as valuable lessons.
Oil crash: The price of crude oil has plummeted by more than 50 percent since the 2014 high of US$107 per barrel in June. As I am writing now, the price is hovering around US$48 per barrel. At this price, majority of oil producers will bankrupt themselves (see here for nice infographic) So, one would expect OPEC to cut down the oil production. Well, no (here and here) I believe that OPEC sees the rise of shale oil as a threat to their market share in the oil market. Effectively, they are price-dumping in order to drive the American and Canadian oil producers out of business.
I don’t think they saw these consequences coming.
- Russian economy went under. Russian ruble continues its downward trajectory. Since 22nd December, it has lost further 15 percent against US dollar. Byron Wien, vice chairman of the advisory services unit at Blackstone Group LP, said that he wouldn’t be surprised if Putin’s “approval rating plummets and he resigns by year-end.”
- Early 2014, it is hard to see the US and Iran in a talk to ease economic sanctions. But that is exactly what they are doing right now. Iran relies heavily on oil export for its economy. With the oil price at current level, they are struggling to maintain a working economy under sanctions. Again, Byron Wien wrote that he wouldn’t be surprised to see the two countries signing agreement to reduce Iranian weapon programs in exchange for economic opportunities for Iran.
Monitoring of annual performance: In the name of transparency, publicly traded companies including all investment funds are required to produce annual reports, in some cases, quarterly reports. Performances of many fund managers are monitored annually with expectation that they do well every year. I am not suggesting that this is a bad idea. But as a consequence, these fund managers adjust their investing behaviour to suit this expectation. They tend to invest with shorter time horizon (see average stock holding period) But an average investor has time horizon that is at least five years. For Millennials, their time horizons are at least 30 years. This leads to a mismatch in expectation and overall fund performance generally suffers as a result.
Does this mean we should refrain from making decision because of a possibility of unintended consequences? No. A cure for this problem is humility. We should accept that we are making decision with incomplete information and knowledge in an uncertain world. A key question is: how does one protect oneself (to certain extent) from unintended consequences? Nassim Taleb suggests that having options allows one to reduce exposure to unexpected harms. It is like buying house insurance if you live in a bushfire prone region (Of course, you can refuse to buy a house insurance and expect the Government to give you taxpayers’ money to rebuild your home.)
When options are unavailable, we should seek to emulate good practices in aircraft industry, that is, by learning from past mistakes. Every plane accident makes the next one harder to occur. Same can be said about making any decision. We can look out for unintended consequences and adjust future decisions accordingly.
Same wise words are still relevant: Prepare for the worst, hope for the best, count on being surprised.