Mission oriented innovation creates moral hazard – shielding companies from risk reduces innovation

Once a decision has been taken to implement a particular mission, significant resources are made available to selected actors, in the form of preferential loans, R&D grants, various subsidies or protectionist measures. The availability of these resources influences the behaviour of actors. Many (large) companies may systematically take advantage of such government/policy allocations and become less cautious in their investment decisions– a scenario that can lead to increased moral hazard (moral hazard occurs when an actor has an incentive to increase its risk exposure because a large part of the cost of the risk is borne by someone else).

The actions of Fannie Mae and Freddie Mac during the US financial crisis are a clear example of the problem of moral hazard. While the institutions were guided by policy measures to increase lending to minority groups, they delivered profits to shareholders. They could meet these two objectives only by assuming ever greater risks, which eventually became so large that they threatened the stability of the entire financial system. With hindsight, it became clear that this was because too much of the risk was borne by taxpayers, which provided an incentive to guarantee loans to people who were not creditworthy.

The problems of distorted incentives are also illustrated in several other contributions to our collection. For example, Waldron and Coyne (2024) show how foreign aid programmes can distort incentives in ways that threaten the nation-building project that is the ultimate purpose of aid. The authors show how aid programmes can create destructive incentives. If firms can obtain large resources by lobbying for (more) foreign aid instead of focusing on producing and delivering valuable goods and services to voluntarily paying customers in a competitive market, firms may spend more and more time and effort on unproductive activities.

Under such circumstances, the probability increases that companies and organisations become “subsidy entrepreneurs” (Gustafsson et al., 2020), that is, actors who spend time and effort to benefit from politically decided grants and subsidies. Gustafsson et al. show that those who systematically apply for and receive subsidies from the state tend to have lower productivity. Companies that receive ‘free money’ for (technical) high-risk projects become immune to risk, which can ultimately result in significant losses for society.

Illustrative examples of unsuccessful technological initiatives due to distorted incentives, where the state believed it had the ability to get it right and tried to steer development in a certain direction, can be multiplied. In addition to the examples in the collection, one can, for example, highlight projects to produce ethanol from corn in the US and from cellulose in Sweden and biogas from tree residues (Sandström & Alm, 2022). Without large public subsidies, these investments would not have been made and the resources could have been used for other purposes.