Tuesday, November 5, 2013

My Kingdom for a Rational Compensation System ...

Brad DeLong has a review of Alan Blinder's book on the financial crisis  After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead (New York: Penguin, 2013).  He includes the following interesting argument:  (1) we need to strictly regulate finance to fix the economy, (2) but we can't regulate finance because with the current income inequality finance finds it easy to buy Capitol Hill, (3) shareholders of financial corporations finance could alter the highly unequal compensation system to a more rational system that would then permit Congress to regulate fianance, but (4) shareholders of financial corporations would rather not, so (5) we are lost .....

Here's Brad:  
[T]he United States ... ought to obey Blinder's three commandments to the government and strictly regulate finance, in the interest of avoiding excessive leverage and hold financiers strictly... liable for misrepresentations and omissions....However, accomplishing it is a political task.
 One point of view is that this political task will be easy for at least the next generation: even people who are twenty today remember the orgies of near-fraud and outright fraud committed in the housing, mortgage, mortgage-backed securities, and derivatives markets; not until they retire in 2060 will it be possible to pull the same type of tricks again on the same scale.  
The second point of view is that this political task will be impossible. According to this point of view, times like these in which income inequality are high are times in which finance finds it easy to buy Capitol Hill, and that although finance has a collective long-run interest in being regulated so that it does not overspeculate [fiananciers do not] recognize this collective interest--or [they] expect to make their financial pile, and take an [attitude of] apres moi le deluge. 
Certainly the root-and-branch Republican opposition in the Congress to the very existence and functioning of the relatively innocuous Consumer Financial Protection Board is a strong piece of evidence for the second point of view. And if that point of view is indeed correct, we are in awful trouble: only ... sharply reduc[ing] the education salary premium coupled with a severe strengthening of the progressiv[ity] of the tax system could then create a politics and a Capitol Hill that would support the kind of financial regulation that 1929 taught us that we needed, and that 2008 taught us that we needed again.  
...Perverse compensation systems--systems that provide financiers with enormous incentives to run very large risks in the belief that you can make your pile and, before the time the crash comes, have moved on to philanthropy or politics or art collecting-- exist for a reason. And it is these perverse compensation systems that provide financiers with the incentives to forget that shareholders are their real bosses, to deliberately un-manage risks, to assume excessive leverage, and to treat the balance sheet as a toy.   
Moreover, there are three ways to make money in finance. The first is to have better information, and so buy low and sell high: this is nearly impossible. The second is to match risks  that need to be born with people for whom it makes sense to bear extra risk: this is difficult. The third is to match risks that need to be born with people with money who do not understand what the risks really are: this turns out to be easy. And this is especially easy when there is less information in the financial market--when securities are complex, when trading is proprietary and secret, when bespoke rather than standardized is the order of the day, and when balance sheets are toys rather than accurate representations of firm positions.  
Fixing perverse compensation systems would fix all these problems. But with perverse compensation systems, all these problems are intractable. The right organization of finance is one in which financial professionals lead middle-class lives but get to be rich at 60 if, when they reach 60, people look back and see that their judgment has been very good and their clients have received good value for their fees. Shareholders of financial corporations could impose such a compensation system if they organized themselves and so wished. They aren't organized. They do not so wish.
 


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