How obscene Wall Street salaries are proof of market failure

The right-wing says government interference in private sector compensation is evil socialism. But the real problem is that capitalism isn't working as advertised.

Published April 27, 2009 7:46PM (EDT)

Who didn't feel their hackles rise at the mere sight of the headline in the Sunday New York Times business section, "After Off Year, Wall Street Pay Is Bouncing Back"? The notion that "workers at the largest financial institutions are on track to earn as much money this year as they did before the financial crisis began," is obscene. While the U.S. economy continues to shed up to 700,000 jobs a month, and with trillions of dollars of taxpayer funds keeping the entire edifice of capitalism afloat, those bankers who still have jobs are rolling in the dough, again.

Paul Krugman rages against the Wall Street machine in his Monday New York Times column, making the sensible points that a) the vaunted financial innovations that these high-priced whizzes cooked up did not end up creating net benefits for the U.S. economy and b) that "given all that taxpayer money on the line, financial firms should be acting like public utilities, not returning to the practices and paychecks of 2007."

The public-utility line sounds like the socialism that the Republicans are always going on about. I don't disagree with it, but I think it's more provocative, and perhaps useful, to explicitly argue that outsize banker salaries are a failure of capitalism as it has been practiced in the United States. Viewed thusly, caps on compensation can't be demonized as "class warfare" but instead are more correctly seen as crucial upgrade to the operating system.

Which is exactly what John Thanassoulis, a university lecturer at Oxford, argues in the fresh-off-the-digital-presses issue of the Economist's Voice. Excessive banker compensation is proof of market failure, which thus requires government intervention to set things right.

What is missed by much of the outrage is that these bonuses and the pay system that leads to them is integral to the incentive system that created the mess. The payments are not a Wall Street conspiracy. The problem is that poor corporate governance cannot rectify a market failure created by the competition for trader talent between two very different types of institutions: hedge funds and investment banks.

Thanassoulis sketches out the basic forces at work. Whether a trader bets 5 million or 50 million, the worst that can happen to her if she loses the bet is that she'll lose her job. But upside compensation is tied to performance, so if she wins bigger bets, she makes bigger money. The incentive is clear: Make bigger bets whenever possible.

Banks might normally be inclined to restrict the size of trades to protect against devastating -- to the bank -- losses, in part because their other businesses outside of investment bank-style trading require specific amounts of capital to be held in reserve against potential losses. Hedge funds do not generally suffer such constraints, and so they're able to offer traders the lure of big trading positions with their big rewards. So the banks, in order to keep the best traders, have to allow them to make larger and larger bets -- with, as we have seen, disastrous consequences for the whole global community.

Wall Street has long wanted us to believe that its best and brightest deserve their huge salaries, and even now, there are politicians who, even as they rail against taxpayer money being shoveled at Wall Street traders, still believe that in the normal order of things government should have no role in determining compensation in the private sector. But when the market screws up, government always has to step in to clean up the mess, and that's exactly what we have here.

This is a market failure which individual banks acting alone cannot correct. The Global Financial System is currently dissolving from trader-induced losses on countless banks' balance sheets. The problem of bank bonus systems creating risk is too important to be left unresolved. The solution is not that Government should micro-manage an individual's pay, or that incentive contracts are bad. Rather the forces pushing banks to take on risk need to be understood and appropriate checks and balances instituted. As Government steps in to bail out the Financial System, now is the time to confront the market failure in bankers' pay and accompanying risk-taking.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

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