Goodhart's law

What Is Goodhart's Law?

Goodhart's law is an economic adage stating that when a measure becomes a target, it ceases to be a good measure.¹⁶ This principle, central to Behavioral Economics, highlights how human behavior adapts to and often distorts metrics once those metrics are used for control or reward purposes.¹⁵ In essence, when an economic indicator or any statistical regularity is chosen as a primary objective for public policy or performance measurement, individuals or institutions may optimize their actions to achieve that specific target, potentially undermining the original intent or broader goals. This often leads to unintended consequences that can render the measure unreliable.

History and Origin

Goodhart's law is named after British economist Charles Goodhart, who articulated the core idea in 1975 in the context of monetary policy in the United Kingdom.,¹⁴ His original observation was: "Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.",¹³ Goodhart noted that when central banks attempted to control the money supply by targeting specific monetary aggregates, financial institutions would adapt their behaviors. This adaptation could make the targeted aggregate less effective as a reliable guide for policy, as market participants would find ways to meet the target without necessarily reflecting genuine economic activity.¹²,¹¹ The adage gained wider recognition and a more generalized phrasing, notably by anthropologist Marilyn Strathern, who succinctly stated it as: "When a measure becomes a target, it ceases to be a good measure."¹⁰,⁹

Key Takeaways

• Goodhart's law describes how a statistical measure loses its reliability when it becomes a target.
• It highlights the adaptive nature of human behavior in response to incentives and measurement systems.
• The law originated in the context of monetary policy but applies broadly to various fields, including financial regulation, education, and organizational management.
• Recognizing Goodhart's law is crucial for designing effective policies and performance measurement systems, as it warns against over-reliance on single metrics.
• Its implications suggest the need for robust data analysis and diverse indicators to mitigate manipulation.

Formula and Calculation

Goodhart's law is a qualitative principle and does not involve a specific mathematical formula or calculation. It describes a behavioral phenomenon rather than a quantitative relationship. Therefore, this section is not applicable.

Interpreting Goodhart's Law

Interpreting Goodhart's law involves understanding that no single metric can perfectly capture complex realities, especially when that metric is being actively optimized. If a system's accountability is tied too heavily to one specific data point, entities within that system will naturally adjust their behavior to improve that data point, sometimes at the expense of overall system health or other important, unmeasured aspects.⁸ For example, if a call center manager solely measures employee success by the number of calls processed, employees might rush calls, sacrificing customer service quality to hit their targets.⁷ This law underscores the importance of considering human responses when designing metrics and implementing policies that rely on those metrics. It suggests that a holistic view, incorporating multiple qualitative and quantitative factors, is often necessary to avoid perverse outcomes.

Hypothetical Example

Consider a hypothetical investment firm that introduces a new compensation structure for its portfolio managers. The firm decides to reward managers primarily based on their portfolio's annualized return, aiming to maximize client gains. Initially, this appears to be a clear and direct way to incentivize strong performance.

However, after a few quarters, the firm observes a subtle shift in manager behavior. Instead of focusing on a balanced approach to risk management and long-term value creation, some portfolio managers begin taking on excessive leverage or concentrating positions in highly volatile assets during periods of market exuberance. Their goal becomes solely to achieve the highest possible short-term returns to boost their bonuses, potentially ignoring underlying risks or the long-term sustainability of their strategies. As a result, while average returns might superficially increase, the firm's overall systemic risk exposure rises significantly, and client portfolios become more vulnerable to sharp market downturns. The "annualized return" metric, once a good indicator of overall performance, has become a target that encourages behavior detrimental to the firm's and clients' broader interests, demonstrating Goodhart's law in action.

Practical Applications

Goodhart's law manifests in numerous real-world settings, particularly in economics, finance, and public administration:

• Financial Regulation: In financial markets, setting rigid targets for capital ratios or liquidity can lead banks to engage in creative accounting or shift activities off-balance sheet to meet regulatory requirements without necessarily reducing actual risk exposure.⁶ Regulators must constantly adapt to counter such market manipulation and arbitrage.
• Monetary Policy: Goodhart's original observation stemmed from the challenges faced by central banks when using specific money supply figures as targets. As soon as these measures became policy targets, their relationship with inflation or economic activity often changed as financial institutions adjusted their practices.⁵
• Healthcare: In healthcare systems, setting targets for the number of patients seen or the length of hospital stays can inadvertently lead to rushed consultations or premature discharges, impacting patient care quality.⁴
• Education: Measuring school success primarily by standardized test scores can incentivize "teaching to the test," where educators prioritize narrow test preparation over comprehensive learning and critical thinking skills.³

Limitations and Criticisms

While Goodhart's law provides a powerful lens through which to view the pitfalls of target-setting, it is not without its nuances and potential critiques. It implicitly assumes that economic agents are rational and will always find ways to game a system when a measure becomes a target. However, human behavior is complex and influenced by various factors beyond pure optimization, including ethical considerations, organizational culture, and cognitive behavioral biases.

A criticism is that the law might oversimplify the relationship between measurement and outcomes. Not every measure that becomes a target instantly loses all utility; some measures, if carefully designed and continuously monitored, can still drive positive change. The challenge lies in anticipating and mitigating the adaptive responses. Furthermore, the law doesn't offer a direct solution but rather highlights a fundamental tension. Policymakers and managers must still rely on measures to gauge progress and direct efforts. The alternative—having no measures at all—would make effective governance and improvement impossible. The key is to employ a diverse set of indicators, understand their limitations, and remain vigilant to emergent behaviors.

Goodhart's Law vs. Campbell's Law

Goodhart's law is often confused with or discussed alongside Campbell's Law. While both describe similar phenomena, their origins and emphasis differ slightly.

While Goodhart's law emphasizes the inherent change in the nature of the measure itself, Campbell's law highlights the corruption of the social processes being measured due to high-stakes decision-making tied to the indicator. Both laws underscore the difficulty of using quantitative measures as proxies for complex systems without triggering distortive responses.

FAQs

What is the simplest way to understand Goodhart's law?

The simplest way to understand Goodhart's law is: If you try to control something by measuring it, people will find ways to make the measurement look good, even if it doesn't reflect the actual desired outcome. For instance, if a factory's success is measured by the number of nails produced, workers might make many tiny, useless nails.

##¹# How does Goodhart's law apply to finance?
In finance, Goodhart's law applies when specific financial regulation targets, like capital ratios for banks, lead financial institutions to adapt their behavior in ways that meet the target on paper but may not truly reduce underlying risks. This can result in market manipulation or unexpected behaviors.

Can Goodhart's law be avoided?

Completely avoiding Goodhart's law is challenging because it stems from human nature to respond to incentives. However, its negative effects can be mitigated by using multiple, diverse performance measurement indicators, regularly reviewing and adapting metrics, focusing on broader qualitative goals, and fostering a culture of genuine accountability rather than strict adherence to single targets.