Against the Pay Caps--Posner

The government has decided to impose a $500,000 ceiling on the senior executives of banks and other financial institutions that accept bailout money. This is a bad idea, though politically inevitable because of public indignation at financiers, thus illustrating a point I make in my forthcoming book about the depression--for I insist that it is a depression, and not a mere recession, that the country is in--that a depression is a political rather than just an economic event. (The book is entitled A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, and will be published early in April by the Harvard University Press.) It is a bad idea for three reasons. First, it directs attention away from the really culpable parties in the depression, who are not the financiers. They were engaged in risky lending, that is true; but the fact that a risk materializes does not prove that it was imprudent. A small risk of bankruptcy--a risk that almost every business firm assumes--can be, when it is a risk faced by most firms in an industry and the industry is financial intermediation, catastrophic. But the responsibility for preventing catastrophic risks to the economy caused by a collapse of the banking industry lies with the Federal Reserve, other regulatory bodies, and the Treasury Department. A banker is not going to forgo a risk that should it materialize would wreck the economy, because his forbearance would have no consequence, as long as his competitors continued running the risk; it is a classic case of external costs, requiring government intervention. Because the Federal Reserve under Alan Greenspan pushed interest rates too low and kept them low for too long, and because regulation of financial intermediaries had over the years dwindled and became especially lax during the Bush Administration, the bankers were allowed, and competition forced them, to take risks that could have and have had disastrous results. If the government thinks that shaming the bankers and capping their pay will prevent future banking disasters, it will be distracted from making the regulatory changes that are necessary to restore effective public supervision of a vital industry. Second, the pay cap contributes nothing to getting us out of the depression. That can be done only by an active monetary policy, by recapitalizing the banking industry, and by a stimulus program (because the first two policies are not working well)--that is, by trying to stimulate demand for goods and services by putting unemployed or underemployed labor and other resources to work, as by a public-works program, the idea being that if private demand falls below supply, the equilibrium can be restored by substituting public demand for the missing private demand. The pay ceiling does nothing along any of these lines. One reason it does not is that the problem of overcompensation in the banking industry is more serious at the trading level than at the senior management level, since it's the traders who make the transactions. I give an example in my book of how it can pay a trader to make an extremely risky trade. The pay cap doesn't reach down that far in the corporate hierarchy. Third, and worst, the pay ceiling will retard the recovery of the banking industry. Not, I think, because it will drive the ablest executives into other fields; for the demand for their services in other fields is apt to be weak, though some may retire early rather than work for what they are apt to regard as a derisory salary. But some will be hired by banking firms to which the pay cap does not apply because they do not want bailouts. And those who remain in their present jobs and are subject to the cap will be distracted from their work. They will have to make changes in their personal finances to adjust to their lower salary, and, human nature being what it is, they will spend time seeking ways to evade the ceiling--efforts that no doubt will be met by bureaucratic regulations designed to foil them. Their time and attention will be deflected from the challenges facing their companies. The pay ceiling will be more than a personal distraction, however. It may cause senior management at some banks to refuse a bailout, to the detriment of recovery from the depression. Worse, it will increase the volatility of the political and regulatory environment of the banking industry (a term I use broadly to include financial intermediaries in general, since the traditional barriers between banks and other such intermediaries have largely been taken down). Critics of the bailouts complain that banks aren't lending the money that the government has given them, but instead are putting it in the pockets of their executives, in the form of high salaries, bonuses and perks. All that money that is going to the executives, however, is just a drop in the bucket. The banks are not lending the capital the government has given them not because they've squandered it on their executives but because the demand for loans is weak in a depression, because loans in a depression are at a high risk of default, and because the banks are still undercapitalized. Having railed against the banks for taking too many risks, the government now wants them to take more risks! A compelling criticism of the bailout programs is that their erratic administration has left the banking industry uncertain as to what is coming next. Are the banks going to be taken over by the government? Or subjected to new forms of regulation? What strings will be attached if they need additional capital? Will they be forced to lend money even though they are undercapitalized? If so, and they get into trouble, will the government bail them out again? Will they be made scapegoats for lax regulation? All else aside, a firm operating in so uncertain an environment is apt to hunker down and hoard its cash, for it must be prepared for anything. The pay ceiling adds to the uncertainty of their environment by suggesting that they are to be subjected to populist regulation as well as to regulation singlemindedly concerned with getting us out of the depression as quickly as possible. All this said, I don't deny that there is such a thing as executive overcompensation, owing to the weak incentives of boards of directors to police compensation. But that's a long-term problem, rather than anything to do with fighting a depression.

Comments

[Jeff]

Judge, I think that you should define your idea of stimulus. It is too vague.

Stimulus in the form that Congress passed is not my idea of stimulus, and I wonder, is it your idea of stimulus?

There are many ways to stimulate the economy. Keynesian methods almost never work for the long run.

[Jeff]

There are many good points in the comments on this blog on control for pay.

My fundamental problem with controlling pay by a centralized government is that the market doesn't set the pay rate. As soon as centralized government gets involved, there are distortions. Black markets ensue. In the bankers' case, they will find a way around the regulation. Goldman issued non-restrictive stock to their employees.

The free market always works the best. The ivory tower is right about that. However, you have to ask yourself if the market we had was truly free with perfect competition.

[Liam]

You want a a really free market? Eliminate corporate shields from liability. Watch what the privilege of such shields is worth.

Also, people seem to labor under the idea that the government and people in their capacity as voters are somehow outside the market - wrong. Consumers, producers, labors and shareholders are all voters - their voting is part of their participation in the marketplace.

The main benefit of the pay cap is that it will triage firms that don't really need it to survive. That's really the point of it - it has the added bonus of being politically popular, but it has a function (albeit one J. Posner says he fears rather than welcomes).

[Barbyrah]

Two words: credit unions.

[PT]

Are there seriously people who still think wage & price controls work???

And wage controls during WWII were most certainly did distort labor markets. They prevented firms who had more productive uses for labor from hiring them away from the firms who had less productive uses since they could offer higher wages for the higher productivity. In short, the economy was less efficient than potential.

Another wonderful consequences of WWII era wage caps that is still costing all of us 60+ years later is the wonderful employer-based health insurance system. Firms tried to get around wage caps by offering incentives such as generous health insurance and America's employer-based health insurance system was born. Without those distorting caps on workers' pay, maybe a more more flexible and productive way of providing health care would have evolved, and people would live in slightly less fear of losing their jobs b/c of the fear of losing health coverage...not to mention the rigidities employer-based health coverage imposes on job mobility.

[truthynesslover]

I thought bonuses were based on performence.
And I thought an economy was more than a vast ponzi scheme.
Gee what do I know huh?

[Alan]

Billionaires for Bush, you're ignorant. Posner is not a Friedmanite. In fact, when Friedman died, Posner admitted that he hadn't read all that much of Friedman's work--which I thought scandalous, but less scandalous than the fact that Posner, having read little of Friedman's work, nonetheless considered himself qualified to write a post mostly critical of Friedman's philosophy which Posner had barely read.

[truthynesslover]

Heres what their thinking of doing in britan.
David Cameron has stressed that no cash bonuses over £2,000 should be paid to any employee of a bank which has a significant taxpayer shareholding.

Thats from the conservatives.
Thats what a teller makes.
Thats justice,no?

[Rob Swanson]

Judge (and Prof. Becker):

You're under-analyzing. Falling prey to the very type of micro thinking that can lead to a macro collapse, by analogy.

We want to simplify the banking system (as FM Scherer at Harvard and I have discussed). In brief (longer discussion), we do not need "foxes" as bankers, but rather simple, average "hedgehogs," who not only do not want to maximize expected value, but can't, and so keep it simple (and thereby systemically we end up with lower risk in the system).

True, brilliant bankers - Einstein brilliant, which really don't exist in a real world - might be able to minimize risk as part of their objective function. But merely smart ones, as the last few years show, even very smart ones, aren't going to engage in the type of game theoretic reasoning that makes their competitive responses truly ideal. That's unrealistic, and one dimensional economics (no offense, but you must admit it upon reflection).

That means (hope you read this, since your readership is much broader) that we need average, "within the box" bankers.

And then the macro guys can create incentives without having to game the too smart bankers - too smart for their own good.

Enough with the 'smartest guys' in the room arguments. You're, with all due respect, thinking one dimensionally and not about the iterative application of the logic you suggest, in a market where people game, and smart people think they are better at gaming.

Finally, I strongly suspect that what is needed most are not "smart" bankers but "honest" ones. What does this mean - in realistic terms, not theoretical ones, it means those who value reputation for honesty more than wealth - i.e., honesty over greed (greed being the real problem of people who are overly competitive, because lots of people, as Prof Becker points out in other contexts, maximize a utility function that includes inputs other than wealth, not a wealth function).

And I strongly suspect that there is a high correlation between greed and very high (top 1/2 of 1% compensation), as well as propensity for honesty (having taken the deposition of one of your former colleagues at Lexecon, it was quite obvious that he was honest, until it seemed it might start to hurt his compensation - as is true in my experience with many people who are highly competitive - honesty is sacrificed for reputation or wealthy or other factors).

You're a bright man. A clerk of Justice Marshall's and I were discussing you the other day, as it happens.

Do a little better. Your capable of more.

(Which is not to say we want the government regulating anything like exec comp, but to say the reasons you give for no intervention - your point about recovery and the correlation with intelligence and ability - is not a very good model of reality here.)

[neilehat]

PT - and if Hilary had gotten a much needed Health Care reform package through a Republican dominated Congress, perhaps we wouldn't be in this fix today. But, it's all "water over the dam". so the question is, "What are we going too do Today"?

[Jack]

PT you seem to be fairly good at identifying a few of the unintended consequences and blowing them up at close range so that they obscure the intent and success of the original policy.

WWII Wage and PRICE controls: GIVEN: The extreme shortage of labor (remember that we drafted 12 million men of prime working age out of a population of just 150 mill) and the extreme shortages of consumer goods, a free "supply and demand" model would have done nothing by light off massive inflation and even MORE distortions. (The blatant profiteering of H-burton and Blackwater provide only a hint of what would have taken place during a world war.

Healthcare? We might have gotten off on the wrong foot with employer based H/C though in those days there wasn't much a Doc could do anyway and what they did do was not financially crippling whether one had "insurance" or not. Where we REALLY went wrong was third partying the costs to "insurance" companies that have done a miserable job of containing costs. How miserable?

Arguably France and Germany provide first rate H/C for 10% of GDP with better outcomes than we do for 18% or our larger GDP.

I agree completely with your last suggestion that our H/C system often distorts our labor market by indenturing middle aged folk at the peak of their productivity with "pre-existing" conditions. Those considering going off to incubate a new biz are often surely chilled by the prospect of having to add the tremendous costs of individual H/C to their start-up costs.

Well, as Neil wisely suggests the time is here to create an efficient universal H/C system.

[Jack]

Rob: You have me thinking about the "smartest in the room" in terms of the lobster traps my grandfather used to use.

The bait of increasing loan ratios from 5 to 1 out to 32 to 1 (as Goldman admitted before Congress) is pretty smart in one sense. Say you one unit to lend that costs 3% the "non-banks" have done well at lending it 5 times for a gross return of 25% and going out to 30 times would be so profitable that losing a few loans wouldn't hurt the profits much at all.

But Ha! they diced these things up such that when one went bad they couldn't reach out to the consumer to do a workout or anything. Trapped! Like lobsters in a trap!

I'm sure that had they been able to reach out to their individual borrowers using common sense to rejigger loan terms that there would have been far fewer foreclosures and that the predictable contraction would have taken place over a longer term with a somewhat softer landing.

[Kurt]

Neilehat, you ought to check your facts. Hillary's health care reform proposals didn't fail with a Republican-controlled congress. Republicans certainly led opposition to her proposals, but at the time, the Democrats controlled congress. The party in charge didn't switch until the 1994 election.

[Jack]

Kurt I think that's right and that the credit should go to the Harriet and Louise ad campaign put on by the "insurance" companies and the wholesale But! to be fair, though H/C reform would have been timely and beneficial in 1994, or in Nixon's day, things were not nearly as dire as they are today. Looks like the stars are finally aligned!

[john]

Salary capping is just a headliner to smoothen the go-ahead of the bailout plan. Just a slap on the wrist.

[Paul]

This would be an actual problem if the salary where too high, but given the poor performance of the bankers cricque, I don't think the level is too low. If they don't want to earn such a low amount, then they can refuse taxpayers money, or split the banks and get multiple salaries.

[Ryan]

The focus of government should be on regulating precisely that which triggerred the economic crisis: the practice of mortgagees selling mortgages in bundles and creating mortages for the sake of selling them. The fact is that lenders were giving away mortgages to borrowers who could not afford them because mortgagees did not care about the creditworthiness of the borrower: the original mortagee's intent was merely to get the mortgage, then sell it to the highest bidder. This financial arrangement, encouraged by a booming housing market back in 2004 and 2005, created incentives for borrowers and "lenders" to take action devastating to the national economcy: borrowers wanted nice homes and therefore were eager to purchase the same if it "appeared" affordable and lenders could care less if borrowers could afford to pay back the loans because they intended only to sell the mortgage to someone else for a profit. The lender who intends to sell the mortgage the moment a mortgage is created has no incentive to self-regulate in a booming housing market because his profit-margin is not tied to the creditworthiness of the borrower. This, the governmnent must remedy.

[Hypesiaheiree]

Create pure drinking water with our Atmospheric Water Generators
http://tinyurl.com/dz2c5q

[Jack]

Ryan: you bring up a good point and one very suitable for regulation; ie. that a mortgage is not and never can be a simple bond, one the same as the next. There SHOULD be a means of contacting the mortgage issuer, or a surrogate with the same rights and interests as the initial underwriter.

There has been a lot of discussion about bankruptcy courts being able to rejigger loan terms so as to best meet the terms of the existing contract. That seems about the only option available when these things are chopped up like confetti with only a "servicer" who can not speak for the principle(s) but things should not have to go so far as to end up in BR court if the holder of the loan can be ....... found? and rational work-outs made in many cases.

Geez! Imagine if commercial loans were scattered in the same way and a company had no one to contact when the business climate changed. Yikes! perhaps they are!

[Jim]

Suddenly I can't pay my mortgage and I pulled a muscle while I was grocery shoping today and I just found out I can get extended unemployment if I quit my part time job at the post office. Whoopee, I am rich on someone else's Taxes and law suit money.

[neilehat]

Kurt, I didn't say "Controlled" as in the numbers sense, I said "Dominated". There is a difference you know. Perhaps part of the solution to the Health Care problem of today, is the instituting of Price and Wage Controls. Hmm ...

[neilehat]

As for the problems incurred by the privatized banking system now in operation, or should I say inoperative, perhaps it's time too return to the establishment of a "National Bank". Instead of waiting for the private interests to get their acts straight and create a solution to the Crisis of their own making.

[Jack]

Jim: Sorry to hear your bad news and am wishing you luck in finding a good pulled muscle attorney. On the one hand; I'd hope you'll rethink quitting your part time job even if the unemployment check is higher, as you'll then be listed as unemployed with the risk of adding to the pessimism and the momentum of the downward spiral. On the other hand if you can keep body and soul together while withholding your talents from the market the scarcity could provide a much needed uptick in wage rate, assuming, of course, a scarcity of labor.

~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

Ha! Neil, it looks as though we'll get a number of "National Banks" in the coming weeks as the taxpayer seem to have been fleeced in buying assets with no control. Laately, I've been trying to recall just why we deregged S&L's and let Podunk bankers go play in the commercial sector with the bigs and getting themselves fleeced in the process.

In thinking about the "old fashioned" state chartered banks and why they weren't "competitive", Ha! I suppose one aspect is that of spreading local risk throughout the system, surely one attraction of derivatives, resulting in the judgment of local bankers being rendered useless as they could all, complacently sell their risky to the broader pool where their somewhat flaky portfolio would be "protected" by the "stability" of the whole.

What does tuition at Wharton cost these days????

[neilehat]

Jack, As for the cost of tuition, books, room&board, and mis'c. at Wharton or any of the other "Business Schools", from what I've seen as of late due to the "Crisis", certainly the "Education" received hasn't been worth the price. Has the MBA become the new "Basket Weaving" major? ;)

[wow gold]

sdfwerwer