As post-mortems of the financial crisis proliferate, it's helpful to keep an eye on some foundational causes. Michael Lewis recently commented that "the people who squandered the most money paid themselves the most" -- and continue to do so. We’ve all heard about agency problems, but rarely are they as crisply illustrated as in this post by James Kwak:
[The hedge fund] Magnetar made the Wall Street banks look like chumps. [In] one deal . . . Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.
But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan's bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers' pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)
I was recently at a conference on "Too Big to Fail" banks organized by Zephyr Teachout, and several experts explained how the tail of massive compensation was wagging the dog of societal capital allocation. William K. Black’s theory of "control fraud" is one of many efforts to illuminate the persistent conflicts of interest between banks, bankers, and investors, but one needn't designate any of these conflicts "fraudulent" in order to see how socially destructive they have become. Rather, pulling back to see the big picture -- from the lens of political economy -- illuminates the key drivers of the crisis. As Kwak notes, "the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself." Thinkers across the political spectrum -- from Arnold Kling to Robert Kuttner -- can recognize the critical role of political connectedness in driving bankers' compensation.
This dynamic is more than an American story. It explains economic developments in many parts of the world where close ties between political and financial elites exist. When writers like Zachary Karabell and Niall Ferguson talk of the “superfusion” of China and the US into Chimerica, they usually emphasize the complementarity of the two partners: China’s “savings glut” fuels US consumption. But I can’t help but think of growing similarities between the two powers, and the “fusion” of public and private interests in each. For example, consider this passage on Shanghai from Perry Anderson's review of Yasheng Huang's book, "Capitalism with Chinese Characteristics: Entrepreneurship and the State":
Huang demonstrates how little average households in the city benefited from its glittering towers and streamlined infrastructures. Amid a 'forest of grand theft', officials, developers and foreign executives prospered while private firms were stunted and ordinary families struggled to get by, in 'the world’s most successful Potemkin metropolis'. Nationwide, in 20 years, officialdom -- raking in four successive, double-digit increases in its salaries between 1998 and 2001 alone -- has more than doubled in size.
America's "officialdom" may not have grown that fast, but the revolving door between “Government Sachs” and the executive branch continues to turn. Having just endured a decade of zero job growth, many Americans are struggling to get by. While their material struggles are of an entirely different order than those of the poor in China, both countries face growing public concern about corruption.
I hope that Simon Johnson and James Kwak's book, "Thirteen Bankers", can help the U.S. avoid the Chinese scenario, where political and economic power are hopelessly intertwined. But if we fail to adequately insulate financial firms from government (and vice versa), we'll have to grope for a second-best solution. Whether that involves matching Chinese grand strategy in resource procurement, reshaping defense spending as industrial or innovation policy, or some other plan, remains to be seen. But it is clear that the U.S. is seriously endangering its future as a global power if, as Keynes put it, the "capital development of [the] country becomes a by-product of the activities of a casino."