Incentive Compatibility Problem

Direct quote from Paul Krugman article in the New York Times more than 2 years ago:

"When I was young and naive, I believed that important people took positions based on careful consideration of the options. Now I know better. Much of what Serious People believe rests on prejudices, not analysis. And these prejudices are subject to fads and fashions. ... For the last few months, I and others have watched, with amazement and horror, the emergence of a consensus in policy circles in favor of immediate fiscal austerity. That is, somehow it has become conventional wisdom that now is the time to slash spending, despite the fact that the world’s major economies remain deeply depressed. This conventional  wisdom isn’t based on either evidence or careful analysis. Instead, it rests on what we might charitably call sheer speculation, and less charitably call figments of the policy elite’s imagination — specifically, on belief in what I’ve come to think of as the invisible bond vigilante and the confidence fairy."

Hmm, this does sound a lot like what the Troika has been trying to pull in Europe over the last couple of years doesn't it? To be honest, was young and naive until a few time ago. That was when I believed that people in power and in a position where they could influence policy knew what they did. Unfortunately this was not the case: Most of the politicians, policymakers, economists, specialists and experts have absolutely no idea what they are doing. Take a look at what is happening in Europe nowadays: the Troika proposes, with their experts, specialists and economists not thinking about the consequences such a thing would have on each nation's economy, and politicians, policymakers, economists and specialists in the nation accept it with no arguments. Even if they propose any arguments, they are usually either of the "won't do any reforms" or the "instead of these measures how about these harder ones?" kind.

The scenario boils down to three things: 

1. Economists, specialists, politicians, policymakers and etc do not think at all about the consequences

2. They do not care about the consequences because although they may affect them, it is unlikely that they will end up starving or without a job.

3. Both

Which of the three seems more possible?

Well you guessed it. Either the latter one or a combination of the two. It is always easier for someone to make a tough decision about slashing salaries and bringing the economy to a rapid recession when he/she knows that her/his salary will keep getting in his bank account at the end of each month. Obviously, most members of the parliament, economists, policymakers and others earn much more than the average wage. They reasoning is that they should provide an important job to the society and thus they should be rewarded. However, there seems to be an incentive compatibility problem.

Obviously, when a general wage cut occurs every person receiving a governmental salary should be affected. However who is more affected with a 10 or 15% cut? The one who makes 1000 euros a month or the one who earns 5000? I guess having to live with 4500 or 4250 euros beat trying to live with 900 or 850! Obviously, the one receiving the larger salary is doing something more than the one earning the lowest.  Still, a 10% decrease in wages is very hard for people who are not in the high income scale. The wages of public servants (those in the higher tax brackets that is) should not be awarded as a lump sum. They should be awarded based on their performance, as well as the performance of the general nation (in their area of expertise obviously). This would allow for them to think twice before they accept or condemn policies which are prone to throw GDP down the drain.

What should be done, is that nothing more than a 5% decrease every two years should occur. If the South wants a more effective public sector it is better off limiting entries than reducing salaries that much. This would allow an economy to exit the recession and not make the debt unsustainable, provided of course that they try to limit budget deficits to a minimum.