Bonuses
It’s pretty weird that the Democratic congress, and more specifically the Senate, is moving sharply to Obama’s left and put in provisions greatly restricting executive bay in their version of the stimulus bill. This is weird because it shows how misplaced, or if not misplaced, how oddly aligned the leftism is in the Congress. So, the Senate Democrats could have pushed for a bill without an AMT patch and with more money shifted towards infrastructure and transit spending, which would have moved their position to the left without being openly antagonistic towards the president. Instead, they inserted these pay provisions.
But let’s talk about the pay provisons. The Times says that they would “would prohibit cash bonuses and almost all other incentive compensation for the five most senior officers and the 20 highest-paid executives at large companies that receive money under the Treasury’s Troubled Asset Relief Program, or TARP.” Clearly, there are going to be two reactions from Wall Street. One is ceaseless complaining about the provisions. And so we see in the Post story on the provisions, the financial services industry’s cheap lobbyist crowing about how these provisions “undermine the current incentive structure.” The more sophisticated response would be to simply rearrange compensation for executive around the new restrictions. For example, the awards of restricted stock or other bonuses, under the Dodd Amendment, are limited to “one-third of their [executives] annual pay.” The other way around the restrictions is to give back the TARP money (or never receive it) and get a different job.
And so we have the dilemma, both in the short term and the long term. Clearly, we don’t want executives at banks which only exists due to incredibly generous taxpayer support to be taking huge bonuses and pulling down large salaries. But more important than just restricting salaries in general is to try to reform the institutional set-up of financial institutions that encourages relatively little money paid in salary and instead has most compensation be paid in large, performance based bonuses.
The problem, and this has been known for a while, is that big bonuses encourage excessive risk taking. And while one would hope that some people who overleveraged on bad bets would get out of the game or not get bonuses, thus encouraging people to be more conservative, the facts of the last 6 or so years of the housing bubble clearly refute that. The problem is that, for reasons of human psychology and due to the general nature of finance, bubbles form and so it basically always makes sense to get a bunch of people to give you money, leverage it, and make bets on assets whose price you think are going to go up indefinitely.
And once so much of your pay is tied to performance, you realize that the ones taking the bigger, more leveraged and riskier bets are getting even bigger bonuses. In fact, the guy working at the next office may not have any skepticism about whatever bubble you’re both investing in and is thus making better returns than you are. You may even be at risk for losing your job, so you start making similar big bets. Expand this dynamic out to an entire industry with trillions of dollars are their disposal, and you get our current crisis.
Now, I don’t know how to reform the bonus-incentive structure in the long term. After the government no longer has the excuse of only restricting those receiving government money, real, harsh pay restrictions will be impossible to pass.
And while one consequence of any restriction on income is that it discourages income seeking behavior, I can’t help but suspect that somehow discouraging the best and the brightest from going into finance wouldn’t be a good thing. Do we really need such a large finance sector, if it has shown itself to be incompetent at the one thing of social value it provides: the spreading around of risk?
Of course, there’s a backdoor way of changing the incentives for people going into finance. Just raise marginal income rates on rich people, or better yet, create more brackets at the tippity top of the income scale. It is by no means guaranteed that, once (and if) the crisis is over, we will have the same income distribution that we had before. But it’s worth remembering that much of the growth in inequality, and specifically the assent of the hyper rich (the .1,.01,.001 percentiles) was attributed to people making a lot of money in the financial sector. So, if we had made it so that those risk-fed, bubble-based bonuses based on work that had little social value were highly taxed, maybe we would have gotten the double social benefit of more generously funding government programs that people use while discouraging this bad risk taking.
