This Just In: Incentives Matter

(By Fisher Investments) Politicians seem pretty universally confused—about many things, but particularly incentives. Merriam-Webster defines "incentive" thusly: "Something that incites or has a tendency to incite to determination or action." But incentives can be perverse things, too—for though the definition might imply incentives typically spur folks to do something they should (for whatever reason), they can equally inspire folks to do things not intended or less than ideal (at least from politicians' perspectives).  It seems, though, politicians may be getting (yet another) first-hand lesson in the finer points of incentives this summer—with corn prices.

Back in 2007, the federal government passed the Energy Independence and Security Act, which mandated fuel refiners blend corn alcohol into petroleum-based fuels. (It also required oil companies blend certain amounts of cellulosic ethanol into fuel or face steep fines. But cellulosic ethanol doesn't exist in terribly meaningful quantities—so most companies are paying billions annually in fines for their failure [read: incontrovertible inability] to comply. But that's for another column….)

Near-instantaneously, corn producers began increasing production—which, according to basic macroeconomic theory, would typically result in lower overall prices, all else equal. But all else wasn't equal: Some 40% of the annual corn crop was scooped up by energy producers in order to comply with the new federal mandates.

Fast-forward to 2012 and factor in a drought, and the situation starts looking trickier, to say the least. As supply has shrunk this summer due to the drought alone, the fact energy producers must still comply with (fixed) ethanol mandates means there's even less corn than usual to meet demand. In other words, just because there's less corn this year doesn't mean energy producers must include less ethanol in petroleum-based fuels—ostensibly resulting in energy taking a bigger chunk of corn harvests than usual.

Adding to the difficulty, rising corn prices are incentivizing (that word again) beef and pork producers to slaughter stock sooner because of incrementally higher feed costs this year. Which is potentially setting us up for not only a corn shortage next year (as farmers dip into excess stores this year to meet demand), but also potentially a beef and pork shortage—which would likely incrementally increase those prices, too.

Now, to be sure, capital markets are flexible animals, as we've said before. And prices are themselves incentives. As they increase, they'll likely encourage a couple complementary actions: Consumers likely decrease their consumption of increasingly expensive goods some and find substitutes to the extent they can, and additional suppliers likely begin producing corn, beef, pork, etc. as they're attracted by the possibility of bigger profits from higher prices.

But that doesn't diminish the silliness of the ethanol mandate in the first place—without which it's entirely possible all the shuffling just described would be relatively less necessary (though there'd no doubt still be some shifting due to the drought's effects alone).

The reality is, no matter the attractiveness of the end goal—in this case, ostensibly increasing America's "energy independence" by encouraging alternative energy development—if it's not economically viable without government propping up, it's far more likely to create perverse incentives and/or unintended consequences that do more harm than good. Maybe not immediately—we're five years out from the Energy Independence and Security Act's passage—but certainly at some point.

A far better alternative, in our view, would be allowing the free market to determine whether, when, who, in what quantities, etc. to produce alternative energy. How does it do that? Through its own incentives—namely, through prices and profit potential.  And through millions of choices made by billions of consumers over time, all of whom are pursuing their own (usually) rational self-interest. As new technologies surface, folks will undoubtedly capitalize on them. And when the time's right, economies will shift to those technologies, capturing whatever benefits are to be had—increased efficiency, decreased costs, etc. But until such time, attempting to force change through "incentives" likely yields poor results. A lesson of which it unfortunately seems our politicians need continual reminding.