Limiting the compensation of a handful of employees at a handful of firms can't have any effect except to benefit the firms' competitors by making them more attractive places to work. The limitations are a form of scapegoating designed to appease public anger over the high incomes of financiers who precipitated an economic collapse that has caused widespread suffering, much of it to people who, unlike financiers, bumbling or inattentive government regulators, macroeconomists, members of Congress, and improvident homebuyers and home-equity borrowers, bear no share of blame for the collapse.
There is a slightly better, though still unconvincing, case for regulating (2) compensation structure, as distinct from the level of compensation, of (2) all financial institutions. Since the market for financiers is global (in part because even a very small country can become a major banking center, given the mobility of capital and of financial personnel and the absence of any need for elaborate infrastructure, physical resources, or a large domestic market), effective regulation of compensation structures would require agreement among all major and many minor nations. If that obstacle to effective regulation could be surmounted, the case for regulation would come down to the fact that front-loaded compensation of financial executives can increase macroeconomic risk.
To explain, the risk of the kind of financial collapse that occurred in 2008 was reasonably perceived as small; had it been perceived as large, the banking industry would have reduced its leverage and other sources of risk. The risk of the kind of financial collapse that occurred in 2008 was reasonably perceived as small; had it been perceived as large, the banking industry would have reduced its leverage and other sources of risk. That small-seeming risk was produced by individual risky transactions, and the object of compensation reform is to discourage such transactions. Suppose the transactions were the purchase of triple-A tranches of mortgage-backed securities at an attractive price, but carried a correlated annual risk of 1 percent that the investments would turn out to be worthless and bring down the firm. A financial executive paid salary or bonus based on the expected profit of such a deal would have an incentive to make it despite the slight chance that it would blow up eventually. Merely requiring, say, that a portion of his salary or bonus be placed in escrow for a few years would not deter him; the reduction in his expected compensation would be too small. Suppose 50 percent of the bonus he received on the deal was placed in escrow and the duration of the escrow was five years. Then he would face a 5 percent chance of losing half his bonus. That would be too small an expected penalty to dissuade him from making the deal. The penalty could not be made sufficiently heavy to disuade him without depriving him of most of his current income.
So I think regulating financial compensation is a mistake. At the same time I think financial executives probably are overpaid from a social perspective. The reason is that their high incomes are generated mainly by speculative trading of stocks and bonds and other financial assets. Speculative profits are not net additions to economic welfare, because they are offset by the losses of the speculators on the other side of successful speculators' trades. That is not to say that speculation has no social value. It generates great social value by bringing about improved matching of prices to values, which encourages investment in productive activities. But the amount of profit that a speculator makes is not the measure of the social value of a successfl speculation. The increase in social value is probably only a small fraction of the speculator's profits.
If financial speculation involved a lot of career risk, in the same way that becoming an actor does, then the high incomes of successful speculators, like those of successful film actors, would be compensation for the risk of failure. But financial executives, while they do sometimes lose their jobs because of bad trades, generally experience a soft landing because their training and experience equip them for a variety of good jobs in business, government, or academia.
Recipients of Harvard Ph.D.'s in physics are said to have two career tracks open to them: academia and Wall Street. No doubt many are attracted to Wall Street by the much higher incomes they can expect there. Yet their social value might well be greater in academia.
Higher marginal income-tax rates, or a stiff tax on financial transactions, might go a slight distance toward correcting the financial brain drain, but probably it is a problem that we shall just have to live with.