TCS Daily

The Invisible Helping Hand

By Stephen Bainbridge - September 8, 2005 12:00 AM

At this point, there seems little doubt that government -- at all levels from small localities all the way up to the federal government -- fumbled the response to Hurricane Katrina quite badly. As President Bush correctly observed, the response was "unacceptable."

Politicians and partisans are desperately trying to assign -- and shift -- blame and, in fairness, there is plenty of blame to go around. Yet, it's important to recognize that we are dealing with a longstanding problem with bipartisan credentials.

The government's delayed response to Hurricane Andrew, for example, is widely seen as having contributed to former President George H.W. Bush's loss to Bill Clinton in 1992. In turn, Clinton revamped FEMA, turning it into one of the biggest pork barrels in the federal government, using it for political advantage by stretching "the concept of 'major disaster' to cover routine mishaps."

In Katrina's wake, there doubtless will be investigations, commissions, and reform proposals beyond number. As writer Radley Balko aptly observed, however:

        I find it refreshing that so many media figures are demanding accountability 
        from government officials and at least recognizing the government failure, here. 
        The problem is, inevitably, they'll do as E.J. Dionne has done, and determine that 
        the solution is a bigger, more comprehensive, richer version of the same 
        government that failed, and continues to fail on a massive scale with its 
        most basic responsibility.

In light of repeated tragedies in which government has failed us, it's time to think outside the box. WSJ columnist Daniel Henninger offers a provocative idea: outsourcing.

        We should consider outsourcing some of these functions, for profit, to 
        the private sector. In recent days, offers of help have come from such 
        companies as Anheuser-Busch and Culligan (water), Lilly, Merck and Wyeth 
        (pharmaceuticals), Nissan and GM (cars and trucks), Sprint, Nextel and 
        Qwest (communications gear and phone cards), Johnson & Johnson 
        (toiletries and first aid), Home Depot and Lowe's (manpower). Give contract 
        authority to organize these resources to a project-management firm like 
        Bechtel. Use the bureaucracies as infantry.

This proposal will shock those who intuitively regard disaster relief as a core government function, but consider how many functions traditionally regarded as public sector responsibilities are already being outsourced to the private sector. Charter schools educate many of our children. Many more of our children are educated in public schools operated by for profit educational management companies. Many prisons are operated by for profit corporations. Even as basic a government function as war making has been partially outsourced, as illustrated by the military's extensive use of private contractors in Iraq and Afghanistan.

If we can outsource war, why not disasters?

Some will have an immediate knee-jerk antagonism to the idea that someone will make money off the suffering of others. We've known the answer to those complaints for centuries, however, thanks to Adam Smith:

        ...every individual necessarily labours to render the annual revenue of 
        the society as great as he can. He generally, indeed, neither intends to 
        promote the public interest, nor knows how much he is promoting it. 
        By preferring the support of domestic to that of foreign industry, he intends 
        only his own security; and by directing that industry in such a manner as 
        its produce may be of the greatest value, he intends only his own gain, 
        and he is in this, as in many other cases, led by an invisible hand to promote 
        an end which was no part of his intention. Nor is it always the worse for 
        the society that it was no part of it. By pursuing his own interest he frequently 
        promotes that of the society more effectually than when he really intends 
        to promote it. I have never known much good done by those who affected 
        to trade for the public good.

Outsourcing works precisely because it takes advantage of Smith's invisible hand.

In the public sector, employee objectives tend to be defined around vague concepts of social welfare maximization that lack determinate metrics. In addition, because government compensation generally does not reward managers whose activities increase asset values or reduce costs, incentives in the public sector tend to be low powered. Civil service and other forms of job tenure make it difficult to discipline government bureaucrats who shirk. Finally, the public sector is subject to capture by rent-seeking interest groups whose private benefits from government regulation often are inconsistent with the public good.

In the private sector, by way of contrast, incentives tend to be much more high powered. The capital, product, and labor markets give corporate managers directors incentives to produce goods and services efficiently. Indeed, these high-powered incentives encourage private firms both to reduce costs and improve quality in a way that the low-powered incentives intrinsic to the public sector simply cannot match.

The principal problem with outsourcing disaster relief will be one of contract design. I'm not referring here to the rather straightforward issues of coordinating private sector relief with, say, public law enforcement. Instead, I'm raising a more basic problem.

Under real world conditions of uncertainty and complexity, contracts are inevitably incomplete. In turn, incomplete contracts permit shirking and even outright opportunism.

Suppose, for example, that we outsourced disaster relief to a private corporation like Bechtel or Halliburton. If a disaster occurred that fell through the cracks of the contract, would the company nevertheless perform? Even if the government could get ex post relief for breach of contract, moreover, that will be of little satisfaction to the disaster's victims. By some accounts we have seen versions of this problem in failures by contractors to deliver services to the military in Iraq.

The good news is that the principal-agent problem, which is what economists call this phenomenon, is well known and contractual technology exists to solve it.

Fixed price contracts, under which the contractor gets a set fee no matter what it costs the contractor to perform, provide particularly high-powered incentives for cost-saving because the contractor profits only to the extent it can hold costs below its fee. Although cost savings of this sort may be what we want in some contexts, the incentive fixed fee contracts provide for the contractor to shirk on quality likely will rule it out as an option in this context.

Cost-plus contracts reimburse the contractor for all expenses and provide a set fee on top thereof as the profit margin. These contracts provide low-powered incentives for cost reduction, but provide higher-powered incentives to produce high quality. Indeed, the economic literature on contracting finds that cost-plus contracts often yield "gold plated" services. Where complex tasks must be performed at a high level, with no margin for shirking or opportunism, cost-plus contracts therefore often are the way to go.

In sum, we need to do better. Throwing money at the problem and creating new programs will be Washington's instinctive response. It hasn't worked in the past and there's no reason to think it will work now. It is time to think outside the box.

To see more of the extensive coverage of Hurricane Katrina from TCS, click here.



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