Wednesday, January 17, 2007

Keith Law Is Hazardous to Your Health

You don’t ask the coat check person at the restaurant to select your wine pairings for dinner. You don’t ask the bank teller to set your 401K investment strategies. And you shouldn’t ask a baseball columnist from ESPN to write a piece on economic principles.

Keith Law is a pretty decent baseball columnist for ESPN.com, albeit reasonably grumpy about most of the free-agent deals this winter (he liked the Jason Schmidt and Randy Wolf deals; he hated the Juan Pierre deal (he may not be alone there) and also hated the Barry Zito deal). He spent four years with the Toronto Blue Jays’ front office organization, and also had stints at Scouts Inc. and Baseball Prospectus. He speaks intelligently about baseball,and usually has nuggets of insight. However, for Law to speak about economics is, well, hazardous.

Law’s weekend ESPN Insider piece about foolish GMs, “Desperate GMs can cripple a franchise”, cites recent deals from GMs like the Cubs’ Jim Hendry and the Giants’ Brian Sabean as examples of what Law calls “moral hazard”:

The problem is that the best way to keep a GM job when you know you're in danger of losing it is to produce results in the short term, sometimes in the very short term. This idea of trading a dollar in the future for 10 cents in the present often manifests itself in moves like trading prospects or young players for "proven" veterans, signing well-known free agents whose name value exceeds their on-field value and back-loading deals to maximize disposable payroll in the current year without regard to the payroll consequences for future years.

At times, this aligns itself well with the best interests of the organization as most baseball team owners are in the business to make money, with a small number in the business to win; most economists agree that the best way to increase team revenues is to win more games. But most organizations with GMs who are on the verge of a firing are in that situation because of more fundamental and often systemic problems like poor scouting, inability to develop players or the most fundamental problem of all -- insufficient talent. For those teams, a baseball strategy built around winning more games this year, this month or this week is wrong. Trading away young talent, eliminating long-term payroll flexibility and alienating a portion of the fan base can set the team back several years.

Economists have a name for this problem: moral hazard. It refers to any situation where an agent (in this case, a GM) can take a risky action for which he will not have to face the full consequences if the action turns out badly. A GM who hands a player a seven-year deal knows that if the deal works out, he'll probably keep his job (and even earn a raise), but if the deal doesn't work out, he might lose his job. But he'll still earn the money he was guaranteed under his contract, and he won't have to deal with the albatross contract, or the restrictions it places on payroll. A GM who gives multiyear deals to his cronies to serve as special assistants, or in other high-paying roles, knows that if he's fired he doesn't have to pay for those contracts. It's the next GM who has to clean up the mess, fire the cronies and has less money to bring in his own people, forcing him to scrimp on payroll, or to restock the farm system.

Technically, moral hazard occurs “when the redistribution of risk changes peoples’ behavior.” The primary economic examples of moral hazard come in the fields of insurance, when the risk redistributes from the insured to the insurer. For example, someone who obtains a life or health insurance policy, and subsequently picks up the new hobbies of smoking and riding a motorcycle, is acting with “moral hazard” because he is taking on more risk what was assessed in the original premiums.

The use of moral hazard in this essay, though, is a bit of a stretch, as there is no risk being redistributed (since the organization maintains all the risk in any situation), nor is there any change in behavior on the part of the GM. The GM is merely acting as the organization’s agent, which is irrespective to the remaining tenure in the GM’s contract or the length of the specific deal signed with a player. GMs are at-will employees and thus always want to deliver short-term results, whether it’s their first day on the job or their fifth year at the helm, and as such, there is no change of behavior. That’s not moral hazard—that’s just simple survival tactics, particularly in a competitive job market with high visibility and limited supply of jobs available.

Should the GM succeed in the short-term, and ends up keeping his or her post, the GM is indeed stuck with the consequences of his or her prior actions. This would violate moral hazard.

Law is correct, though, in indicating the root of the true issue, which is a misalignment of incentives between the organization (long-term) and the GM (short-term). Just like any business / CEO relationship, the organization needs to institute mechanisms to protect itself from a CEO with short-term perspectives, which is (in theory) why many compensation packages include stock options (which reflect the stock price, which is forward-looking).

In the case of the baseball organization, there is a tendency for a GM to pillage the farm system to try and get established players on today’s roster. To align the incentives of the GM and organization, in theory, organizations could tie some of the GM’s salary or bonus to the team’s winning percentage (or incremental wins) in the future, even beyond the GM’s tenure. Unorthodox (and unprecedented), but possible.

Law brings up some good issues and valid points, but does not use the term “moral hazard” correctly. Which is why we should leave the economic arguments to Milton Friedman, Kenneth Arrow, and the rest of the economists. And not to the baseball columnists—even those with a “MSIA/MBA-equivalent” (whatever the heck “MBA-equivalent” means).

3 comments:

Orel said...

So that's why the wine is so bad every time I eat dinner out.

Seriously, fascinating article. I'm just glad there isn't a test afterward.

David said...

Quite frankly, that's a bit excessive. But then again, the standards of economic discourse I hold others to have been lowered to the point that I'm happy when someone gets some concepts right.

Although I think there is a better analogy to be made to politics than insurance, where the politician votes for the bill or entitlement that gets him elected but ends up being a bad idea. Terminology escapses me, largely because I haven't studied Public Choice a whole lot.

Or it could be that too many are guilty of taking liscensure from Keynes' famous quote "In the long run, we are all dead."

Steve Sax said...

Thanks David. I figure, someone's got to hold the torch for Uncle Milty now that he's passed.

SoSG may not be the best candidate, but we're ahead of Keith Law.

Thanks for your comment. Dodger fan economists, unite!