In a spirited opposition to limiting compensation in the financial sector the Wall Street Journal correctly, I think, identifies the greater causes of the financial crisis:
Far more important than bonuses were the incentives to issue and take on debt, especially housing-related debt, created by . . . the politicians who now want to blame banker pay. There’s the systemic risk that the Federal Reserve created with the ultralow interest rates that subsidized credit for so much of this decade; the privileged status bestowed upon the ratings agencies by the SEC and others; and regulatory capital rules that favored securitized mortgages over the same loans when held in portfolio by the banks. True reform would grapple with these issues, rather than the calculated distraction of bank pay.
Since I’m ready to blame Congress for practically anything (for the record: I felt the same during the Bush Administration and the Clinton Administration and the previous Bush Administration and the Reagan Administration and so on), far be it from me to defend it now. Yes, the Congress is to blame. But so is the Federal Reserve. And the SEC. And the ratings agencies, as I noted yesterday. It’s not, as Megan McArdle claimed, that there are no villains in the financial crisis. In that there is an embarrassment of riches.
It’s hauling them into the dock that will be difficult.
So, let’s paraphrase Megan. Incentives work, except for when it is really huge amounts of money going to traders and CEOs. They would never let the lure of billions of dollars make them take too much risk.
Steve
But Steve, do you have an alternative? The best I know is that those gains are at risk. And many of the participants lost a lifetime of wealth accumulation.
The financial markets are one of the most regulated of all. We see how that worked out.
If you’ve got a solution I dare say a Nobel Prize is in your future.
Hmm, my ideas are probably best qualified for an Ignobel prize. We need to somehow put real risk back into the equation. The large majority of these guys are not owner- managers, so they can often walk away financially secure. I have many fantasy ideas for this, such as being forced to work at Wal-Mart if you bankrupt your bank, but I concede that real solutions are difficult.
The solutions need to directly affect the CEOs and traders, not the companies. Perhaps we require that very large percentages of bonuses and compensation over X amount of dollars be placed into escrow for 5 years after they are earned or after retirement? Then, if the company performs poorly during that time period that money can be kept by the company prorated by performance. Or, accepting any compensation over, say, $1 million dollars will require signing an agreement to submit to an examination by a pre-agreed upon arbitration board. Accusations of poor performance or fraud will allow the board to recover damages up to the limit of all compensation received by the employee.
I just throw out these scattered thoughts to show the direction I think we need to go. I really have no problem with an investment banker making a bazillion dollars if he really earns it and does it without jeopardizing the finance system, I just want them to have real risk on the down side. I suspect the best way is to actually limit the size of financial institutions. Then, let them do whatever they want in terms of compensation or anything. If they crash, let them crash. However, this is not a politically viable solution I suspect.
Steve
steve,
I think you mischaracterize Megan’s thesis. It isn’t that incentives work until they are swamped by the positive payouts for misbehaving. It is that the risk wasn’t understood. That is information was not complete. When this happens you can get markets doing bad things. There is no villain then, merely a lack of information.
Our financial system has changed quite a bit over the last couple of decades adn that is has probably been the biggest reason, if Megan’s thesis is correct. The rise of a host of new financial insturments could have led decision makers to make the wrong deicsions or wrong allocations. IIRC there is some experimental evidence supporting this as well. That changes in the insturments can lead to a bubble/more bubbles as people make mistakes and then learn from them thus leading to a period of fewer bubbles until new insturments are introduced.
So, considering that you are operating from a flawed premise, your conclusions are somewhat in doubt.
Steve- Maybe, but I still think incentives actually do matter. A lot. I have not seen this current mess as due to a single cause, but rather multifactorial. Compensation is not the only factor, but it is hard for me to ignore, but apparently not Megan. If you had billions of dollars as a potential reward, with relatively little down side for you, would you not take risks to get that much money? Megan notes that many of these people lost money. Well, yes, but many are still wealthy after losing all of that money. Many lived very, very well for several years.
Just for arguments sake, how much should execs earn when they have demonstrated they do not understand risk? The new financial instruments Megan mentions were created by these same people we are talking about compensating with millions. Ideally, they would have already been bankrupted by their financially imprudent/incompetent behavior. The market could then adjust payment. Instead, we already see big bonuses coming out again. That seems more like entitlement and cronyism at work than market price setting.
I will agree that this probably represents ineptitude and greed rather than true villainy.
Steve
steve,
I’m inclined to agree with you. For example I can easily imagine the following converstation:
Top Fund Manager: Wow, look at what these clacs show, we’ll make a kiling.
Second from Tom Fun Manager: Yeah, but…what if those calcs are wrong, what if the model isn’t telling us everything we need to know.
TFM: Hmmm, yeah good point.
STFM: Should we…I don’t know, spread things around a bit, look at the risks again.
TFM: Naw, we’re too big to fail. Even if it goes south in a few years, Uncle Sugar will likely help us out.
STFM: Heh, that’s true.
I would say they should lose alot, and many of them did. Are the impoverished? I don’t know.