On debt-fueled consumption, rising inequality, education, and service sector pay

Raghuram Rajan, the former IMF economist who was one of the first to finger banks' pay structure as a key cause of the financial crisis,(in Jan. '08)  has an  interesting essay out: How Inequality Fueled theCrisis (h/t Chait).  In developed countries, only the educated can thrive in a global economy. Delivering effective, broad-based education reform is hard and slow; encouraging debt-fueled consumption is a readily available palliative. So politicians of both parties have turned to the latter:

In the US, though, there have been strong political forces arrayed against direct redistribution in recent years. Directed housing credit was a policy with broader support, because each side thought that it would benefit.

The left favored flows to their natural constituency, while the right welcomed new property owners who could, perhaps, be convinced to switch party allegiance. More low-income housing credit has been one of the few issues on which President Bill Clinton's administration, with its affordable-housing mandate, and that of President George W. Bush, with itspush for an "ownership" society, agreed.

A Wolf whistle on bankers' pay

Almost two years ago, FT economics columnist Martin Wolf surprised himself (rhetorically, anyway) by seconding a proposal by Raghuram Rajan, former chief economist of the International Monetary Fund, that regulators force banks to tie bonus pay to long-term performance:

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

Today, Wolf further surprises himself by calling for a windfall tax on bankers' bonuses. Here's how his case begins:

Windfall taxes are a ghastly idea. They are a sop to prejudice, a burden on risk-taking and a form of arbitrary confiscation.

So Wolf once again casts his stance as a Nixon-to-China moment. But the logic seems incontrovertible:

“Windfall” support should be matched by windfall taxes.

And in a bit more detail:

Fourth, ordinary people can accept that risk takers receive huge rewards. But such rewards for those who have been rescued by the state and bear substantial responsibility for the crisis are surely intolerable. What makes them yet more so is that the crisis has devastated the prospects of tens, if not hundreds, of millions of innocents all over the globe. The public finances will be devastated for decades: taxes will be higher and public spending lower. Meanwhile, bankers are about to reap huge rewards. This damages the legitimacy of the market economy.

Fifth, it is hard to argue in favour of exceptional interventions to bail out the financial sector at times of crisis, and also against exceptional interventions to recoup costs when the crisis is past. “Windfall” support should be matched by windfall taxes.

If a nonideological free marketer like Wolf can make this case seem watertight, there ought to be ample cover for a large Democratic majority badly in need of landing a populist blow. But then, Wolf presumably doesn't take campaign contributions.

B.F. Skinner haunts the banks

A year after first Raghuram Rajan and then Martin Wolf, both writing in the FT, fingered bankers' bonuses as a prime cause of the financial meltdown, Nassim Nicholas Taleb redoubles the attack. The point is not hard to grasp. The banking industry runs on a heads-I-win-tails-you lose incentive structure: take huge hidden risks, reap the rewards of resulting outsized gains, and give up nothing (except perhaps your job, multimillions later) when those gains give way to huge losses.

But Taleb does end with an arresting dictum that's worth a thousand words:

never trust with your money anyone making a potential bonus.

Take that as as a rule of life. Are you listening, education reformers? It translates: never trust with your child anyone making a bonus. There are buried risks in juicing children's apparent performance, too. Skewed incentives also pervert education from the other end. As an opponent of behavior mod programs once said, give children pizzas for reading books, and you'll end up with a lot of fat children who can't read. Incentives focus people's attention on the reward rather than on the act required to get the reward.

I'm also reminded of a wise woman's watchword: never trust what you hear from any man with an erection. Broadly, then: beware of anyone dazzled by overwhelming incentives, by the prospect of immense gratification.

Obama realigns bailout bankers' incentives

Today, Obama made headlines for capping executive pay at banks that accept "major" bailout funds at $500,000. Here, though, is the real news in his statement:

Finally, these guidelines we’re putting in place are only the beginning of a long-term effort. We’re going to examine the ways in which the means and manner of executive compensation have contributed to a reckless culture and quarter-by-quarter mentality that in turn have wrought havoc in our financial system. We’re going to be taking a look at broader reforms so that executives are compensated for sound risk management and rewarded for growth measured over years, not just days or weeks.

That promise gets at the core problem, nicely framed last January in the FT by Raghuram Rajan, former chief economist at the IMF:

True alpha [the value the investment manager's abilities contribute to the investment process] can be measured only in the long run and with the benefit of hindsight – in the same way as the acumen of someone writing earthquake insurance can be measured only over a period long enough for earthquakes to have occurred. Compensation structures that reward managers annually for profits, but do not claw these rewards back when losses materialise, encourage the creation of fake alpha. Significant portions of compensation should be held in escrow to be paid only long after the activities that generated that compensation occur.

A week later, FT columnist Martin Wolf elaborated:

the only way to deal with this challenge is to address the incentives head on and, as Raghuram Rajan, former chief economist of the International Monetary Fund, argued in a brilliant article last week ("Bankers' pay is deeply flawed", FT, January 9 2008), the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter's 12-year "year", since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

The big points here are, first, we cannot pretend that the way the financial system behaves is not a matter of public interest - just look at what is happening in the US and UK today; and, second, if the problem is to be fixed, incentives for decision-makers have to be better aligned with the outcomes....

All bonuses and a portion of salary for top managers should be paid in restricted stock, redeemable in instalments over, say, 10 years or, if regulators are feeling generous, five. I understand that the bankers will not like this. Yet one thing is surely now quite clear: just as war is too important to be left to generals, banking is too important to be left to bankers, however much one may like them.

For bailout recipients, that kind of long-term tie-up begins today. In addition to the $500,000 salary cap, Obama announced:

And if these executives receive any additional compensation, it will come in the form of stock that can’t be paid up until taxpayers are paid back for their assistance.

Incentive pay for reducing your bank's contribution to the national debt. Will anyone collect?

UPDATE: Some timely further perspective on distorted pay incentives today from Thomas Frank, lone liberal on the WSJ op-ed page:

...Wall Street's compensation system isn't just aesthetically displeasing to liberal snobs. It is the very heart of the problem. According to Bill Black, a professor of economics and law at the University of Missouri-Kansas City and an authority on dysfunctional financial systems, "It is the compensation system that has proved to be the weak point in everything critical that went wrong, that has produced a global catastrophe."

At each stage of the disaster, Mr. Black told me -- loan officers, real-estate appraisers, accountants, bond ratings agencies -- it was pay-for-performance systems that "sent them wrong."

The need for new compensation rules is most urgent at failed banks. This is not merely because is would make for good PR, but because lavish executive bonuses sometimes create an incentive to hide losses, to take crazy risks, and even, according to Mr. Black, to "loot the place through seemingly normal corporate mechanisms." This is why, he continues, it is "essential to redesign and limit executive compensation when regulating failed or failing banks."

Footnote: Obama ought to keep the malign effects of distorted pay incentives in mind when the subject of pay for performance for teachers comes up. Otherwise, our kids' diplomas may have all the value of an AAA mortgage-backed security.

Down girl, down! Dowd sics herself on Wall Street

Oh dear. Maureen Dowd's gone demagogue, as she occasionally does when her rhetorical weaponry is set loose in a target-rich environment.

On Wednesday she unloosed a fearsome smart-bomb barrage against banking mogul excess. Today, she carpet-bombed Wall Street. Making money from money "must unhinge you." Those who awarded bonuses should be prosecuted, the money disgorged.

Reality check:

1) Done right, allocating capital efficiently is as important as making good widgets. You don't get good new widgets made without the capital. The problem was regulation gone awry (or AWOL), not the existence of people whose function is to make money from money. Like lawyers, they're unpopular but useful. You could argue that poor regulation made the field so lucrative that there's too many of them, but that's different.*

2) Dowd quotes Barney Frank without comment: "Paulson let the cat out of the bag...and it can't be gotten back." Frank's right. You can't claw back, let alone prosecute, unless someone broke a law. TARP was riddle with holes. The Obama Administration and Congress can fix the second half but not siphon back what's been pissed away.

3) Dowd ridicules Rudolph Giuliani for saying that cutting Wall Street bonuses would mean less spending in restaurants and stores. Restaurants, schmestraurants. The bonuses constitute a huge chunk of New York's decimated tax base.

There's a balance to be struck with regard to bonuses. They're more than half of a lot of financial people's yearly compensation, they're supposed to be based on the money you make, and some people did make money for their firms. Yes, TARP should radically limit them, particularly for those with 7-figure compensation and more. More to the point, as first Raghuram Rajan* and then Martin Wolf (hardly a pair of flaming radicals) wrote in the FT a year ago, the bulk of bonus money should be tied to long term performance -- locked up for up to 10 years and clawed back if today's bets wreak mass destruction tomorrow. But the whole system can't be obliterated at a stroke.

*As an index investor, I find them only indirectly useful, as there'd be no indexes without paid professional investors vainly trying to beat them.

**Former chief economist, IMF