Out Of Alignment: Wall Street Bonuses And The Public Good

Our financial system failed to perform the key roles that it is supposed to perform for our society: managing risk and allocating capital. A good financial system performs these functions at low transaction costs. Our financial system created risk and mismanaged capital, all the while generating huge transaction costs, as the sector garnered some 40 percent of all of corporate profits in the years before the crisis.

The sector is also responsible for running the payments mechanism, without which our economy cannot function. But so badly did it manage risk and misallocate capital that our payments mechanism was in danger of collapse. So deceptive were the systems of creative accounting that the banks had employed that, as the crisis evolved, they didn’t even know their own balance sheets, and so they knew that they couldn’t know that of any other bank. No wonder then that no bank could trust another, and no one could trust our banks. No wonder then that our system of credit—the lifeblood on which the economy depends—froze.

We may congratulate ourselves that we have managed to pull back from the brink, but we should not forget that it was the financial sector that brought us to the brink of disaster.

While the failures of the financial system that led the economy to the brink of ruin are, by now, obvious, the failings of our financial system are more pervasive. Small- and medium-sized enterprises found it difficult to get credit, even as the financial system was pushing credit on poor people beyond their ability to repay. Modern technology allows for the creation of an efficient, low-cost electronic payment mechanism; but businesses pay 1 to 2 percent or more in fees for a transaction that should cost pennies or less.

Our financial markets not only mismanaged risk—and created products that increased the risk faced by others—but they also failed to create financial products that would help ordinary Americans face the important risks that they confronted, such as the risks of home ownership or the risks of inflation. Indeed, I am in total agreement with Paul Volcker—it is hard to find evidence of any real growth associated with the so-called innovations of our financial system, though it is easy to see the link between those innovations and the disaster that confronted our economy.

Underlying all of these failures is a simple point, which seems to have been forgotten: financial markets are a means to an end, not an end in themselves. If they allocate capital and manage risk well, then the economy prospers, and it is appropriate that they should garner for themselves some fraction of the resulting increases in productivity. But it is clear that pay was not connected with social returns—or even long-run profitability of the sector. For many financial institutions, losses after the crisis were greater than the cumulative profits in the four years preceding the crisis; from a longer‐term perspective, profits were negative. Yet the executives walked off with ample rewards, sometimes in the millions. Most galling for many Americans was the fact that even when profits were negative, many financial institutions proposed paying large bonuses.

Market economies yield growth and efficiency when private rewards and social returns are aligned. Unfortunately, in the financial sector, both individual and institutional incentives were misaligned. The result of the flawed incentives, perhaps even worse in the aftermath of the crisis, can be called ersatz capitalism, with losses socialized and profits privatized; it is an economic system that is neither fair nor efficient.

But in some critical ways, incentives are actually worse now than they were before the crisis. The way the bank bailout was managed—with money flowing to the big banks while the smaller banks were allowed to fail (140 failed in 2009 alone)—has led to a more concentrated banking system. Incentives have been worsened too by the exacerbation of the problem of moral hazard. A new concept—with little basis in economic theory or historical experience—was introduced: the largest financial institutions were judged to be too big to be resolved. We saved not just the banks, but also the bankers, the shareholders, and the bondholders.

The bankers have been criticized for their excessive greed. First-time homebuyers were deliberately exploited. Similar criticisms can be made about the exploitive behavior of credit card companies. I don’t think that those who went into finance are greedier or more deficient in moral scruples than others. But the incentive structures led them to behave in the way that they did. Economists have an expression: “everyone has their price,” and in finance, for too many, the rewards were simply too great to resist.

The system even affected how they thought. In most professional jobs, one takes pride in one’s work; one gives one’s all. We don’t pay heart surgeons on the basis of success, arguing higher pay will provide an incentive to exert more effort to save his patient. What kind of person says to his employer, “If you only pay me $5 million, I’ll give you only half my effort? If you want me to really exert my energies, you have to pay me more if I succeed in increasing profits.” But for those in finance, this kind of reasoning became not only acceptable but also became the conventional wisdom—with little thought, as we have seen, to the relationship between these “measured” profits and either long-term firm performance or, more importantly, societal returns.

There is another misallocation of resources that resulted from the sector’s compensation policies, one whose effects are graver and longer lasting, and one that, as a teacher, I have felt intensely. There was a misallocation of scarce human capital, as some of America’s most talented young succumbed to the lure of easy money—brilliant minds that, in another era might have made real discoveries that enhanced our knowledge or real innovations—that would have enhanced societal well-being.