Why is there still a row about bankers’ bonuses? What I mean is that the issue should by now be settled against them. There’s abundant evidence that large bonus “incentives” are not only not justified (pdf) by efficiency considerations, but can actually backfire, with the result that intelligent observers are demanding an end to them.

If we were serious about designing high-powered incentives, we’d consider abandoning bonuses and instead simply killing under-performing bankers. After all, the threat of death works perfectly well in motivating airline pilots or soldiers. So why not apply it more generally?*

Let’s be clear. Bankers’ bonuses have less to do with rational incentive mechanisms than with the fact that bankers have power. It’s a form of legal extortion.

Which raises the question; why is this not more clear? It’s because any power structure is sustained by ideology – a set of cognitive biases which might have a grain of truth but which serve to defend vested interests. In the case of bonuses, there are four such biases:

1. The fallacy of composition. If any one banker doesn’t get a big bonus, it’s possible he might flounce off in a huff to another firm. But it’s not possible for all bankers to do so; only a tiny handful of British bankers could get good jobs in New York or  Switzerland. In this sense, a blanket nationwide ban on big bonuses wouldn’t do much harm.
What’s true for an individual needn’t be true for a group.

There’s a parallel here with one of the errors that got us into this mess – what Keynes called the “fetish of liquidity”. An asset might be liquid from the point of view of an individual, but there is no such thing as liquidity for al investors.

2. Mental accounting. Last year’s banks’ losses seem to have been put into a separate mental box, and are regarded as an exceptional item now that business is back to normal. But this shouldn’t be the case. Those losses vindicate Nassim Nicholas Taleb’s point that banks, on average, don’t make money because occasional huge losses wipe out years of profits. Which suggests bankers don’t have the skill they pretend to.

3. The fundamental attribution error. The belief that banks’ profits come from skilled individuals is in part due to the common error of attributing to individual agency what is in fact the result of situational or environmental factors. It’s trivially true that today’s banks’ profits are due to cheap money, government guarantees and state bail-outs. But it’s always been the case that profits have risen and fallen according to environmental forces such as monetary policy, waves of takeovers and general investor sentiment.

4. The impossible/difficult conflation. Throughout history necromancers, witch-doctors alchemists and ju-ju men have extracted high incomes. They’ve done so because their patrons have believed their job to be very difficult, demanding supreme skills. But in truth, the jobs of foretelling the future, controlling the weather and turning base metals into gold  haven’t been difficult ones. They’ve been impossible.

So it is, perhaps, with banking. Making high risk-free returns isn’t difficult, but impossible. In failing to see this, we give bankers the fortunes our ancestors gave other charlatans.

* Of course, the same reasoning applies to politicians, as they too can make huge errors which cost society dearly. This probably explains why they are not proposing the idea.