Why are big bonuses are paid in the first place? Unpleasant as they may be, the reasons described by Chris Dillow cannot simply be wished away. Individual bankers generate huge quantities of revenue, and if they walk out the door they take the revenue with them, giving them bargaining power that (partially) explains their incomes.

We – the taxpayer – own some banks now, and our interests will not be served if the revenue generators walk out the door and take the business with them. The general impression appears to be that big bonuses exist simply because bankers are greedy and like paying themselves lots of money, as if people in other industries wouldn’t pay themselves lavishly if they could.

Please do no confuse this with a “defense” of big bonuses – I’d love it if bankers were paid less. That would amount to an increase in productivity – more output at less cost. I would also love it if footballers were paid less – that would mean we’d have to pay less to attend games and to watch the games on television. But what popular opinion appears to be pressing for now is the equivalent of nationalising Manchester United and imposing a £500,000 annual salary cap. And then asking Arsenal and Barcelona not to poach our star players. Everybody knows that to make that work, we’d need a global cap on footballer salaries. The co-ordination problem is the same in banking.

This is not to dispute the corrosive effects of big bonuses that rewarded short-term performance – the existence of “perverse incentives” is one of the strongest explanations for the crisis. We’d all like to see a system where the incentives in banking are better aligned with society’s interests, and where salaries and bonuses in the industry are lower. A lot of people are asking why the bankers didn’t foresee the consequences of their actions; all I am trying to do is foresee the consequences of ham-fisted attempts to cure the bonus problem.

One response to this argument is that as things stand, even the “rainmakers” won’t be able to find work, if they respond to bonus cuts by walking out. I don’t think that’s correct, but even if it is, it’s beside the point. Reforms to bonus systems need to work when the banks are making money again (which we want them to do, because we own some of them) and when the “reasons” why banks found themselves having to pay so lavishly, will be as strong as ever. It’s quite common in banking for entire trading desks or analyst teams to quit en mass and go elsewhere, and these guys will have no problem finding seed capital to set up new shops if they can escape the salary caps imposed on the banks that have received tax payer investments. They can get around wage and bonus legislation by setting up partnerships and paying themselves dividends.

Fixing this problem is going to take some carefully designed, far reaching legislation that will also require global co-ordination (to prevent the banks simply relocating to countries with lax legislation, and carrying on blowing bubbles as before). Either that or we solve co-ordination problems via state monopolies[2]. The bottom line is that we must not be satisfied with some legislation that caps salaries and bonuses in banks that have received tax-payers’ assistance; that’s just not good enough.

[1] Why are the sums involved so high? Why don’t banks compete on price, like say supermarkets? How can they charge so much for what they do? Here’s part of the answer: imagine you are a company looking to sell yourself on the stock market. One investment bank charges £500,000 in fees, but another, staffed by “star” corporate brokers, analysts, and traders, charges £2,000,000 but can add 10p to the price your shares will sell at, raising an additional £10m[3].

[2] Chris suggests nationalised banks existing alongside private competitors. I don’t think that would work for investment banking, for the reasons given above.

[3] One big weakness of this piece is that I fail to distinguish between retail banking, business lending, mortgage provision and investment banking. Most of what I say really applies to the investment banks, which is where I reckon the seat of the problem lies. I don’t know why retail bank directors get paid so much – probably just because they set their own pay. See here.

The crisis will be slotted effortlessly into the existing left-wing narrative about the evils of capitalism, neoliberalism, and the ‘myth of free markets’. The bailouts will be commonly referred to as hand-outs to the greedy bankers who created all the trouble in the first place [1], and the headline figures (say the $85bn to AIG) will be spoken of as if this is money taken from taxpayers and given to banks/insurers [2]. We will see lots of talk of parasitic financiers who produce nothing and indulge in nothing but speculation.

There will be calls for bankers to return their bonuses (to whom?). Oh, and the left-wing story of ‘how this happened’ will be hopelessly garbled, and will generally get no further than blaming aforementioned greedy speculation in opaque financial instruments. You can see examples here, here and to an extent here [3].

So what should the left’s response be?

Well, I don’t know for sure, because I don’t really know what’s gone wrong (perhaps the first thing the left should do is find out). The general picture on the left appears to be that the banks took speculative trading positions (in opaque financial instruments) that went wrong (much like one might borrow money to buy a stock that you expect to rise). But I struggle to believe either of these is enough to explain what’s happened [4].

From what I can gather, the truth is closer to banks having unwittingly built their balance sheets on assets that they thought were solid, but have turned out not to be, and this sparked off some sort of market failure, rather like the classic market for lemons story. Here used car prices fall because nobody can be sure the cars aren’t wrecks (lemons) so only owners of lemons are prepared to sell at the going price and, knowing that, nobody wants to buy a wreck, so the market collapses. Something similar has happened in the money markets. Another dynamic is that if everybody is doing it at the same time, selling assets to raise capital depresses asset prices and falling asset prices increase the need to raise capital.

Market failures are well-known phenomenon, and addressing them is not the preserve of the left. But right-wingers have a tendency to pretend they don’t happen, so one left-wing response is to lay claim to being the bunch best relied upon to identify market failures and find ways of curing them. The market for lemons story isn’t very realistic (it’s only a parable), because you can get a reasonable idea of a car’s quality by looking at it, and remedies are fairly obvious – some independent auditor of quality (say, the AA) and some mechanism for buyers being able to return cars that turn out to be wrecks. The long-term solution to the current problem will look different to that (the finance industry already has an AA – the credit rating agencies – and that didn’t help).

Fixing this market failure will probably entail keeping some financial functions under state control (the short-term solution certainly does) and in the private finance sector, constraining who can do what, and building some fire-breaks into the system.

A related idea is looking at the incentive structures within banking that encourage the system to inflate bubbles and build up concentrations of risk in such a way that periodic crisis are inevitable. Again this is not an exclusive preserve of the left – Martin Wolf has written about regulatory reform of salary and bonus structures in banking (here’s that column, he’s also worth reading here, here and here) – and everybody from The Economist leftwards knows more regulation is needed [5]. In this sense, how the left ought to respond need not differ from how everybody else responds.

What does the crisis tell us about free markets?

Yes, a “free market” in finance has self-destructed, and millions of people who played no part in it, are going to suffer because of it. But the free market in finance failed in a fashion that hasn’t much to do with the popular left-wing anti-market story (other than it involves ‘greed’). The left-wing anti-markets story is usually applied to markets that are working healthily (at least as far as an economist would consider). Here we have a market that has collapsed. Nobody foresaw exactly this (although plenty of people were worried about the housing bubble and derivatives) but anybody familiar with market failures ought not have their world view turned upside down, even if they are surprised at the scale. Nor does this crisis tell us much about the wisdom of appropriately regulated free markets in most goods and services, and labour.

Of course, the left has different priorities from the right, and although this crisis is in great part a technical problem with a technical solution, even technical solutions involve trade-offs, and different priorities can mean different choices. What does a distinctly leftish solution look like? The answer should follow from what the left wants from capital markets. I think capital markets are there to facilitate investment and improve asset allocation in the economy, to spread ownership, to enable citizens to protect themselves against risk, save and borrow at the best possible rates. But again, that’s not really a left or right answer. So I have to end with restating the question – what does the left want out from capital markets?

It may just reflect my centrist, left-capitalist inclinations, but I can’t think of much that’s distinctly left-wing. Brad De Long and Paul Krugman are heavyweight centre-lefties (the takes on this question can be read here and here and here – the last mentioning pay caps for bankers) De Long channels Marx on financial crisis here. Ah, here is a resounding left-wing response – a fund to help workers who lose their jobs because of all this. That’s something I had omitted, having been thinking directly about responding to the narrow capital markets problems. I favour temporary government job creation, such as heavy investment in renewable energy and transport infrastructure (which will have the added bonus of cutting long run energy costs). And finally, as ever, Chris Dillow is vital reading on this question. 

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[1] When a business blows up, let’s say there are 3 sets of people who could be bailed-out: the owners, the company directors and the workers. In the main these bailouts have seen the owners lose everything, the directors paid according to their pre-existing, regrettably absurdly generous, employment contracts, and many of them fired and their stock options/holdings wiped out, and some workers losing their jobs and others keeping them. It makes almost no sense to think of these bailouts and handouts to the bankers themselves – other than that because the bailouts are intended to limit the collateral damage of this mess, which involves trying to keep some of these banks afloat, so hence keeping some bankers and workers in their jobs. Of course it may turn out that the terms of big bailout are too generous; it make equally turn out they are too miserly. UPDATE – although it looks like the actual plan being drawn up, sucks. See here for why, and links to further critical commentary by economists.

[5] Another simplification to be avoided is that this happened because bankers had too much freedom, and the solution is thus “more regulation”. Frannie Mae and Freddie Mac were about as regulated as regulated gets. Sometimes regulation can have the peverse effect of encouraging the use of derivatives, that end up concentrating risks and creating crisis. Also, it’s wrong to assume that state provision is necessarily less risky – governments can get themselves into a mess, and face some screwy incentives too. It’s a commonplace that capitalism entails booms and busts, but crisis may be a feature of any system of economic organisation.