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.

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