The Importance of Compensation

In my opinion, one of the biggest contributors to the crisis we know so well was compensation schemes that gave individuals at financial institutions – from junior traders all the way up to CEOs – the incentive to take massive bets. Put people in a situation where the individually rational thing to do is take lots of risk, and they will take lots of risk – especially if they are generally ambitious, money-loving, and predisposed to think that if the market is giving it to them, they must deserve it.

Alan Blinder does a good job explaining the problem in simple terms in the first half of his WSJ op-ed.  However, I’m not optimistic about his solution: 

It is tempting to conclude that the U.S. (and other) governments should regulate compensation practices to eliminate, or at least greatly reduce, go-for-broke incentives. But the prospects for success in this domain are slim. (I was in the Clinton administration in 1993 when we tried — and failed miserably.) The executives, lawyers and accountants who design compensation systems are imaginative, skilled and definitely not disinterested. Congress and government bureaucrats won’t beat them at this game.

Rather, fixing compensation should be the responsibility of corporate boards of directors and, in particular, of their compensation committees. . . .  The unhappy (but common) combination of coziness and drowsiness in corporate boardrooms must end. As one concrete manifestation, boards should abolish go-for-broke incentives and change compensation practices to align the interests of shareholders and employees better. For example, top executives could be paid mainly in restricted stock that vests at a later date, and traders could have their winnings deposited into an account from which subsequent losses would be deducted.

Why am I not optimistic? Disney.

In 1995, Disney Chairman and CEO Michael Eisner hired his longtime friend Michael Ovitz to be president of the company. Ovitz was the founder of one of Hollywood’s most powerful agencies, but had no experience even working in a company like Disney, let alone managing it. Eisner negotiated his friend’s employment contract, which included a $1 million annual salary and 5 million options, vesting in annual increments beginning in 1998. In addition, if Ovitz were fired within his first five years (but not if he were fired for “gross negligence,” and not if he resigned voluntarily), he would be given – in addition to his salary for the remainder of the contract – $1o million, $7.5 million per year remaining on the contract, and his first 3 million options.

In 1996, one disappointing and controversial year after Ovitz joined, “Eisner and Ovitz agreed to arrange for Ovitz to leave Disney on the non-fault basis provided for in the 1995 Employment Agreement.” Brehm v. Eisner, 746 A.2d 244 (Del. Sup. Ct. 2000). As a result, Ovitz got about $40 million in cash and 3 million options.

Disney shareholders sued the board of directors, both for approving a compensation agreement that gave Ovitz an incentive to try to get fired in the first five years, and for allowing him to leave on a “non-fault basis” rather than firing him for cause (gross negligence). On both counts, the courts, in both Brehm v. Eisner and In re Walt Disney Co. Derivative Litigation (Del. Ch. 2005), held that the board was not liable because of the “business judgment rule.” The business judgment rule says, in essence, that as long as a board of directors does not have a conflict of interest, informs itself adequately, and makes a decision, it cannot be held liable for that decision, no matter how obviously stupid it is or how catastrophic it turns out to be.

The business judgment rule is not a crazy rule; it is designed to allow directors and managers to take risks that may turn out badly without worrying that they may be held personally liable. But one of its effects is to shield boards of directors from any accountability for executive compensation decisions. It’s nice to say that boards “should” implement compensation practices that align managers’ incentives with those of shareholders, but it’s hard to see why this should happen. 

Board behavior is determined by two things: power and incentives. The problem is that even though things have improved a little since Enron and WorldCom, directors are often de facto appointed by the CEO and serve at his pleasure; serving as a director is cushy enough that directors want to keep their jobs; and directors are dependent on the CEO and other managers for information. Although directors nominally represent the interests of shareholders, they can become a kind of insider, captured by the perks of the job and management’s control over the flow of information. From an individual director’s perspective, the high-percentage play is to approve generous compensation packages for the CEO and his lieutenants; that maximizes his chance of holding onto his board seat, and he has no personal accountability for his vote. Blinder describes “executives, lawyers and accountants” running rings around government regulations and regulators; today’s board of directors is an even easier mark for them. 

Blinder says regulation of compensation practices is likely to fail. Having lived through it, he would know better than I. But I don’t think that waiting for better corporate governance is the answer. We will still be waiting when the next crisis hits. 

If anything, I find myself more sympathetic to the views of Goldman CEO Lloyd Blankfein:

We should apply basic standards to how we compensate people in our industry. The percentage of the discretionary bonus awarded in equity should increase significantly as an employee’s total compensation increases. An individual’s performance should be evaluated over time so as to avoid excessive risk-taking. To ensure this, all equity awards need to be subject to future delivery and/or deferred exercise. Senior executive officers should be required to retain most of the equity they receive at least until they retire, while equity delivery schedules should continue to apply after the individual has left the firm.

For policymakers and regulators, it should be clear that self-regulation has its limits. We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us – especially when exuberance is at its peak. At the very least, fixing a system-wide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators.

Blankfein’s comments about regulation were not specifically addressed to executive compensation, but the references to “basic standards” in the first sentence and “elevating standards” in the last imply that he would not see compensation as off limits for regulation.

By James Kwak

47 responses to “The Importance of Compensation

  1. http://www.nakedcapitalism.com/2009/05/guest-post-goldman-sachs-principal.html

    .
    fact is it aint noones money till its robbed G… you can transplant-graft 3 different rose stems and its still a rose… with 4 heads

  2. High marginal tax rates on income of any kind above a certain amount, no exceptions, at least the government can redistribute the greed incomes

  3. James,
    You and Alan are obviously risk adverse individuals who have not experienced the thrill of working on large trades or deals in a financial firm.

    Some people are greater risk takers than others. Just as some people drive faster or ski down the expert slopes, people with a greater risk taking profile, take jobs where they can engage in greater risk taking. Trading ranks as one of the most stressful jobs with a high degree of risk.

    Lowering the compensation will not change that part of the job profile. Risk seeking individuals will still take these jobs.

    Lowering the compensation and incentive pay structure will change the types of people who take these jobs along other measures but it will not stop their risk taking.

    People self select for jobs using many attributes of the job as their criteria. Compensation is just one of a job’s characteristics. People who enjoy jobs where there is stress and thrills will always seek to be traders and deal makers. They will always push the envelope.

    Just as incentive pay is not the defining difference between test pilots and regular pilots, lowering the compensation and incentives will remove those applicants who self-select based on total compensation, but it will not remove thrill seekers as applicants.

    Yes, a lower compensation without bonus incentives will change the types of individuals in financial firms, but not along the qualities that you want to eliminate. It will not prevent a reoccurrence of excessive risk taking, just as it was not the cause of the excessive risk.

    Blaming incentive compensation is equivalent to blaming a high performance sports car for a driver’s speeding instead of blaming the driver. Drivers who speed choose fast cars and not vice versa.

  4. Until the total compensation is linked someway to the ultimate success or failure of these complex transactions, these traders aren’t taking any risk at all. And the compensation formulas and plans should be disclosed. Now that would be interesting.

  5. Although I agree that compensation is out of hand, David Einhorn puts his finger on a more tractable solution. It would be tricky (un-American?) to impose laws on compensation limits, but Einhorn points out that by limiting leverage, you will eliminate outsized returns on the way up, which would directly impact compensation.

    The moral is that if you want to reign in compensation, a sensible way to do so is to simply reign in leverage.

  6. So Alan Blinder is still spouting the Bush line of voluntary self-regulation over real regulation, even as it has been proven beyond a shadow of a doubt that self-regulation simply does not work. Charming.

    Blankfein is much better in that at least in theory he concedes the obvious. (Though what he supports in practice may be very different. After all, many politicians say basically the same thing. But how many of them are trying to do anything about it.)

    The Disney example is instructive. Regardless of the conscious intentions of the players (which are basically irrelevant), the fact of the case is that Eisner and the board looted the company on behalf or their crony Ovitz. It was literally a raid.

    I don’t doubt that this was perfectly legal. (in Delaware, of course.) Which just proves how utterly corrupter and inadequate the law itself has become.

    (Regarding Delaware, today’s NYT story on the subject is apropos:

    http://www.nytimes.com/2009/05/30/business/30delaware.html?ref=business

    I especially like the part where the crooks are represented as saying “business doesn’t like Delaware because it set up a tax scam; they like it because it has overthrown the rule of law.” I’m sure they like both.)

    As in most other things, the basic problem here, as diagnosed in the post, is the nature of corporations themselves. Their goals are explicitly sociopathic, and they are empowered with legal rights while being absolved of legal or social responsibilities. Where acting as corporate officers, individuals as well are absolved of all such responsibilites. Therefore the Nuremburg defense is explicitly sanctified for today’s corporate criminals.

    Therefore no problem (such as warped pay incentives and scams) which stems from this demented existential circumstance can ever be solved until the circumstance itself is changed. That means fixing the grotesque wrong turn modern society took with corporations, and restoring their original place, function, and life cycle.

  7. Milton – in your post, you ignore the fact that the risk-loving folks in finance have brought down the economy with their risky behavior.

    There is nothing wrong with people pushing the envelope. There is nothing wrong at all with people being rewarded extremely well for outstanding performance.

    However, as Blinder notes in his WSJ piece, a “go-for-broke” compensation structure that rewards executives excessively no matter what the outcome of their bet is one of the reasons why our economy is a mess right now. If the CEOs and executives and traders win big, they get paid big. If they lose big, they get paid big. There is no downside for the risk taker who engages in stupid behavior.

    The downside is absorbed by everyone else.

    That’s what needs to be stopped – having other people pay the price and the risk taker reap a reward for his extremely poor performance.

    Kind of a no-brainer, actually – to link a “bonus” with performance, not as a contractually obligated fee to be paid regardless of the financial condition of the company.

    And frankly, I’d love it if risk-seeking individuals used that trait to engage in the risky business of inventing something great or developing a cure for cancer – not just fattening up their wallets.

  8. Amazing, these same people are constantly complaining that America can not compete because we pay our workers too much. Social Security and Medicare cost too much. Union workers make too much. We must offshore.

    Where is the analysis of the Corp’s true costs of their behavior, lavish compensation packages, huge tax benefits? What was the cost of loading Chrysler and other corps up with debt for LBO’s and then taking out huge bonuses. The cost of their bailouts. The total cost of the harm to the rest of us.

  9. markets.aurelius

    V good analysis. Thank you, James.

  10. markets.aurelius

    This is a very good point, Ella. There is a model waiting to be built that explains the full-cycle cost of public policies. A very good example of this would be e.g. the consequence of keeping gasoline prices relatively low by not imposing taxes that would, were they imposed, send a price signal that rewarded conservation over consumption. The cost of such a policy is massively back-loaded in the form of military expenditure — i.e., the trillions of dollars that must be spent to secure access to hydrocarbons in remote reserviours, typically falling within the borders of “governments,” if that’s not too generous a term to describe the cliques that run these provinces, that loot the coffers filled with petro-dollars. This, of course, introduces its own set of limiting constraints, but that’s for another reply.

    Likewise the true costs of the laissez-faire corporatist capital-markets model that so dominated the American landscape for the past 30 years or so. Initially, the model worked brilliantly: Capital was allocated to highly productive use — bio-tech, micro-tech, etc. A true wave of innovation that transformed life as we know it (… as I adjust the screen of my Mac, sitting on the deck streaming Pandora wirelessly) was unleashed. This reversed decades of government-induced atrophy in the previous 20 years, a result of the recklessly profligate Vietnam War + the so-called War on Poverty. Unwinding the inflation, waste and ungodly tax burdens of that era imposed real costs on the US economy and its citizens. Given the size of the US economy, these effects extended into every economy on the planet. US voters ultimately rose up in an anti-government backlash with Ron Reagan at its vanguard.

    As is always the case, particularly in a society pre-disposed to minimal government and maximal individual freedom, the individuals running the firms that became wealthy spend greater and greater sums securing access to and control of the rules-making process. This money-fueled process is a more subtle version of the ham-fisted seizure of the rules-making process (and the requisite means of enforcing the rules) on display in, say, Russia or pre-WW2 France, but the end result is the same: Cartels gain effective control over society’s resources and direct the bulk of wealth generated by their society toward their own enrichment. This wealth then is stored in forms inaccessible to the government — in tax-advantaged investments (under tax laws written by and for the benefit of the various cartels), or in off-shore havens that exist primarily to shield wealth from governments. Restarting the economy after it’s been sucked dry during this part of the cycle, and unwinding the excess and destruction induced by the reckless behavious of these cartels imposes trillions of dollars of cost on the economy and its citizens, most of whom have had their savings and wealth destroyed by the recklessness of the cartels.

    The success of the unwinding process is never a given, as France demonstrated in the 1920s, ’30s and ’40s. Just because the US has been able to work its way out of past excesses is no assurance it will do so this time around. Then the full-cycle costs will be epic: It’s Pascal’s wager vis-a-vis society: a small clique wagers it all against the extremely low probability event the entire system breaks down. And we all lose.

  11. What you are seeking is retribution. You, Alan Blinder and many others are angry and outraged at the behavior of the financial services industry. The public feels that financial workers were unjustly compensated and instead should be punished. They look at past and future finance industry employees as identical. A common way to punish is to take something away, such as high wages. However, good that feels, it will not prevent a reoccurrence, nor was it the cause.

    Additionally, the employees with the huge bonuses are as much a part of this economy as anyone else. They lost money in investments, lost home equity value, lost jobs, lost prestige, watched companies where they spent their whole lives disappear, watched restricted stock go to zero, etc. On the streets, in the playground with their children, in the grocery store, etc., they are just like everyone else. Did these employees really want this economic outcome?

    If you give a Porsche to someone who likes to speed, he will drive 90 mph in a 55 mph zone. If you give him a Ford Taurus, he will drive 50 mph in a 35 mph zone.

    Many jobs attract risk seekers, including financial industry jobs, but not solely because of incentive compensation.

    Yes, we need to try to prevent a return to the concentrated, highly leveraged investment positions that brought down the banking and securities industries, but compensation structure was not the cause. Changing compensation will not solve the underlying problems that created the mess. If we ban securitization, as some propose, the risk takers will invest somewhere else, such as foreign currencies, commodities, etc.

    One fundamental question has not been openly discussed. Why were all the large banks and investment banks invested in similar products? The firms’ employees could have just as easily put many other types of equivalent risk investments on their balance sheets, instead of mortgage securities and mortgage derivatives, and made the same bonuses. Investment failure would not have then led to all the banks suffering at the same time.

    The real problem, the “systemic risk”, is that all the large banks and investment banks went down together. When the politicians, the economists and all the other pundits figure out why each bank was a copy of the others, we will have a solution to prevent a reoccurrence. I would venture a guess it has a lot more to do with capital structure, it measurement, and existing regulatory and legal restrictions on financial institutions than on employee compensation. The regulators and Congress are more likely the cause than any other factor.

  12. markets.aurelius

    Taxpayers are being forced to absorb the ultimate cost of the recklessness the risk-takers you so admire produced. Comparing a 25-year-old MBA’s hormone surge following a correct guess on the direction of interest rates or the value of MBS derivs to the life-preserving adrenaline surge produced by the brain of a test pilot, which brings mental and physical acuity to its highest state, is laughable.

    The trading companies populated by young MBA’s sought and received cart blanche to lever themselves to the hilt, engage in reckless behaviour and ultimately destroyed the capital markets and trading markets. When they’re wrong they want a galactic do-over in the form of a government bailout. When a test pilot, downhill skier, heart surgeon, …, fails people die. There are no do-overs.

  13. Doen’t it seem that a nationalization of the insolvent banks that completely cleans out equity holders is really the answer here?

    How can it be the responsibility of anyone other than the owners of the bank to police the bank’s operation?

    Brad deLong said that we had decide between fixing the economy and punishing bankers, that we couldn’t do both. This seems backwards, seems that actually we can’t do one without the other.

  14. Milton – to defend the compensation format of the financial community, you say:

    “If you give a Porsche to someone who likes to speed, he will drive 90 mph in a 55 mph zone. If you give him a Ford Taurus, he will drive 50 mph in a 35 mph zone.”

    Yes, speeders like to speed, no matter what car they drive. That’s why cops stop speeders and issue tickets. There is actually a downside to speeding.

    And when speeders end up out of control, they crash whatever car it is they’re driving – but then they are held accountable for the crash. They get injured and injure others. Their insurance rates go up; they can be subjected to a criminal trial, etc. and so on.

    And sometimes, Milton, they lose the privilege of driving because the state takes their license away because they’ve been deemed “too risky” for the roads.

    In calling for compensation that is tied to performance, I am absolutely not seeing retribution. I’m seeking a fair compensation for risky behavior that has potential to destroy the economy. People who seek risk certainly should reap big big rewards when their bet hits big. But when their bet turns up a losing hand, it should be as in Vegas, they lose whatever THEY’VE put on the table. House doesn’t pick up the tab when risk takers lose in Vegas; the player does.

    You cannot have it both ways – you can’t say that an industry must have risk takers to thrive, but the rest of the country must pay big when the risk takers fail AND get the bonus.

    I agree that compensation is not the only factor in the fall, but it is a biggie. Encouraging risk without any kind of check on the kinds of risks to take is a terrible way to run a business – as we see today, with a financial community in tatters and alive thanks to trillions in a federal bailout.

  15. Yup, this is the simplest and best solution. Increase marginal rates gradually, starting with Obama’s 39% on income over 250K, until it hits 90% at all income over 1 million. Someone wants to earn more than $!,000,000 per year, fine. Let them keep 10% of it. It’s not about money at that point anyway, but about ego.

    Incidentally, this may seem like socialist madness, but it was the top marginal rate under the administration of Republican president Dwight D. Eisenhower during the 1950s — hardly a time when America was particularly favorable to socialism. Indeed, this period now seems like a golden age of American capitalism.

    It’s only the mindless conformity of today’s conventional wisdom that keeps such ideas from legitimate public discourse.

  16. I have yet to hear an advocate of nationalization, including their poster child Paul Krugman, describe, specifically, how they will unwind nationalization, and what will be the benefit above the current plan. In fact Krugman gurgled helplessly on this exact point a few weeks ago on one of the talk shows.

    They wave hands and describe a separation of assets into bad and good entities and a public market flotation, but leave some important features bare. Who values the assets? Who buys the assets after you have effectively screwed providers of capital in countless cases (ok, a bit harsh – lets just say the government has not been clear in its rule making)? What do you, the government now do with the “bad” assets?

    But just really simply, can someone please quantify the benefit of nationalization?

  17. There are plenty of places that would welcome extreme risk takers – here are two – hedge funds and private investment partnerships (think Wall St. before they all went public). The common thread – there is inherent self regulation through having your own capital at risk (and yes, the hedge funds have a lot of partner capital).

    If Wall St had not gone public, we would not be having this conversation now…..

  18. Whatever happened to Milton Recht & his goofy Porche anology?

  19. “I’m seeking a fair compensation for risky behavior that has potential to destroy the economy.”

    However, neither any single bank nor employees at any individual bank had the power to destroy the economy. The potential for destruction came about because all the banks had similar investments that suffered losses. Did “unfair compensation” make employees at different banks buy the same investments?

    You and I probably agree about most things about this crisis except whether the compensation structure was a cause. Yes, bank risk must be control, but I do not believe the cause of excessive risk taking was compensation. I am also not trying to justify the compensation structure. It is an unimportant artifact of this crisis. It is a problem for another time.

    By the way, habitual speeders get many speeding tickets and many continue to drive even after they lose their licenses. Most people are naturally law abiding. Tickets do not solve the problem of speeders. It is just a revenue source that on occasion also picks up the occasional, normally law abiding speeder along with the habitual speeder. The law abiding driver normally does not speed with or without the police issuing speeding tickets.

  20. Yes, bring back the progressive income tax. :)

    But 90% at $1,000,000 is steep. You get to keep only $100,000. If you make only $250,000 you get to keep $152,500 at 39%.

    How about something like this? If you quadruple your income you double your takehome. E. g.,

    70% tax on $1,000,000, $300,000 takehome

    85% tax on $4,000,000, $600,000 takehome

    92.5% tax on $16,000,000, $1,200,000 takehome.

    Above a certain level, pay is largely for scorekeeping, anyway.

  21. Does anyone really think you can tax your way out of our income disparity? I grant it is a terrible problem, but you are seriously delusional if you think this will fix the problem. It might scratch your “someone has to pay” itch, but solve the problem. Never.

    Why do the states with the highest marginal tax rates – NY and CA – have the highest, or close to the highest, unemployment rates? Coincidence? I don’t think so. Jobs flee high taxation areas. So now you want to structure it so the jobs will flee the country, not just the states…

  22. Milton Recht: “However, neither any single bank nor employees at any individual bank had the power to destroy the economy. The potential for destruction came about because all the banks had similar investments that suffered losses. Did “unfair compensation” make employees at different banks buy the same investments?”

    No single institution or individual got us into this mess, nor is there any single determining factor. The compensation structure for risk-takers was one factor, lack of diversification was another.

    The two are not unrelated, I think. For the sake of argument (only) assume that the risk taker’s income depends upon how much money he brings in, but it is capped. Will the risk taker go for broke on one very risky deal that will make his yearly salary? Perhaps so, depending on his psychology. However, if he is fairly rational, he will improve his expected income by controlling risk. And, of course, one way of doing that is to diversify.

    OTOH, suppose that there is no limit to his payoff. Then he may seek the riskiest deals, because they have the highest payoffs.(And besides, it’s other people’s money.) This will especially be so if others are doing so as well. Herd mentality aside, he has an excuse if things go bad. “Everybody was doing it. Who knew?” Striving for the maximum return leads to concentration, not diversification. The compensation structure was a factor in the lack of diversification. And that, as you point out, increased systemic risk.

  23. Economic Darwinism: “The moral is that if you want to reign in compensation, a sensible way to do so is to simply reign in leverage.”

    When I was a kid I was taught that one thing that caused the Great Depression was 10:1 leverage. What have we seen recently? 30:1, 40:1 and up!

  24. i think regulating pay is really a futile effort and though they are with good intentions, the ultimate result will be very poor. having been a peasant from vietnam and having experienced the “american dream” (family has a few houses, i went to college, etc….and it’s not all that it’s cracked up to be), i think that many americans forget the privilege of experiencing the right to freedom with transparent laws that have meaningful recourse. i will probably get railed on my last statement, but i ask that everyone live in a third world and you will see how much less freedom with less transparent laws that have little or no recourse that these third world people (majority of the world experiences. nothing is perfect and we should look at everything through a spectrum of extremes where we’re somewhere in between. remember that no one forced anyone to purchase disney stock. also, is it too much to ask to save for a rainy day? or to have bonds with your family and neighbors where they are the first to offer help and the government the last resort? i feel that american society has forgotten this. yes, we need to fight corruption. and it’s a great ideal to have pay be commensurate with performance. but implementing this in reality is extremely difficult, if not impossible, and the side-effects will be very damaging and highly probable.

  25. winstongator

    You do not understand our current taxation system. The 90% bracket would only be for income > 1M. For someone making $1.1M, they get to take home $10k instead of $61k with a 39% top bracket.

    Taxes at that rate would produce even more evasion than we have today.

  26. winstongator

    There is accounting funny business in financial firms. What were Lehman, Bear, Merrill, Countrywide, AIG, Citi’s cumulative profits from 2001-2008?

    This particular problem can be tied to how banks book profits. They booked large profits today, based on the assumption long term loans were worth par, without acknowledging the huge risk that the loans would not keep paying as they did. If you can book 5-10% instant revenue on the initiation of a 30 year term, two things happen. You take all that income stream today, and you ignore any possibility for loss. This is a lot like how Enron abused mark-to-market accounting, but they were marking phantom gains instead real losses.

    No institution should go bankrupt at the speed that Bear or Lehman did. They were abusing accounting rules to show that they were healthier than they were, and had used them to show profits when they were hopeful profits. If the bank does not have profits, it does not pay bonuses. If instead of a $3Bln profit this year, you spread it out over the life of the loan, $100M/yr, you don’t have a trader making $30M, he’s making $1M. You also have them making better long term bets because their continued compensation is based on continued operation of their original loans/trades/bets.

    Take a large amplitude sine wave, positive profits, negative losses. Employees will work to maximize the amplitude because they know their personal compensation is rectified – they get the integral of the positive portion. Has there been any claw-back? The full sine wave has zero mean, but the bigger amplitude causes larger disruptions, but also has the bigger rectified value.

  27. winstongator: “You do not understand our current taxation system. The 90% bracket would only be for income > 1M. For someone making $1.1M, they get to take home $10k instead of $61k with a 39% top bracket.”

    Actually, I do understand it. I just presented something that was conceptually simpler. :)

  28. Tippy Golden

    A former Bank of Canada governor David Dodge has said: the global recession will be long and deep and will —fundamentally alter capitalism. — Maybe compensation for financial piracy will get altered along the way.

    On another matter: In January 2008, Mark Carney was appointed as the new Bank of Canada governor. Carney spent 13 years at Goldman Sachs. (Let’s not forget where Hank Paulson came from.) What’s this all about ! Unfortunately, it’s most likely another example of the cozy relationship between government and corporations.

  29. Tippy Golden

    Delete the qualifier “most likely” from above.

    Let’s hope Dodge is right. And he is a very smart man.

  30. markets.aurelius

    great post. thank you.

  31. It’s ironic to see Kwak approvingly quoting the same (eminently sensible) Lloyd Blankein op-ed that his co-blogger Simon Johnson inexplicably found so offensive.

    (One wonders if Johnson ever actually read Blankfein’s op-ed, or if he just assumed — based on his zero years of experience in the financial markets — that any op-ed by a financial services executive MUST be arrogant and offensive.)

    In any event, I’m glad to see that Kwak isn’t as comically dogmatic as Johnson. If he keeps it up, maybe this site won’t typify the blind leading the blind anymore. We might even get some factually accurate and reality-based commentary!

  32. Over compensation did not cause this financial crisis, and it did not lead to the risky behavior that inflated the problem.

    Fannie and Freddie, when they chose to lend trillions of dollars to people who could not afford those loans are the principal culprits in this mess . F &F essentially created a new welfare program for mortgages, which at some point had to destroy a considerable amount of wealth in our financial system. They created a situation that was unsustainable, and had to fail spectacularly. To make matters worse, many of the financial instruments created by Fannie and Freddie were either guaranteed by our government or were marketed with the allusion that they were guaranteed.

    To many on Wall Street, these mortgage backed securities and the derivatives of them carried little risk because these securities were thought to be guaranteed. These instruments were more often than not, triple A rated. So how can you blame the traders? Sure, some of Wall Street committed fraud, while others with their quant formulas used pathetically poor judgement. There’s no denying Wall Street has culpability in this financial mess, but the heart of the problem was at Fannie and Freddie. That’s where the risky behavior was at it’s apex.

    What is shocking reading so many of the previous comments, is how ignorant such intelligent people are of the destructive effects of confiscatory taxes. Much of the pain and duration of the Depression can be blamed on the egregious tax hikes in top marginal rates; to 63% in the Hoover Administration, 90% in the Roosevelt. Those tax hikes worked out well, didn’t they! There was still 17% unemployment in 1939! Only when a huge chunk of the population was conscripted into the Armed forces did unemployment fall.

    And on the other hand, every boom since the 20’s has been preceded by a tax cut; the Andrew Mellon cuts in the 20’s, Kennedy cuts in the 60’s, Reagan cuts in the 80’s, Capital gains cuts in the 90’s, and the tax cuts in the Bush II years.

    High taxes have consistently shown to discourage economic growth and job creation. Higher taxes are exactly what we don’t need right now, no matter what illusionary social engineering benefits some think they might have.

  33. I think that the best way to approach compensation problems is indirectly. First of all, there are tax code issues (I believe they are still around, though it has been a few years since I followed this closely) left over from when congress was worried about empire building and conglomerates. I believe that executive salary above a relatively low level is punitively taxed unless it is “performance related.” It was this tax change that led to the flowering of options, etc. and increased significantly the payoff to risk-taking. It seems to me that congress should stay out of the nature of the exact contract being written. Higher tax rates are fine as long as they apply to income regardless of source.

    More importantly, I think that there should be a big push to improve the transmission of information about a company’s performance. If it were clearer how well a company was doing, executives would have more incentives to actually do well, rather than engage in financial engineering to make their financial statements look prettier. I study the economic effects of accounting information for a living, so this may be a case of everything looking like a nail because I have a hammer, but I think that reporting has been an under-discussed issue in all of this.

  34. Donald Thieman

    James Kwak’s analysis is spot-on. I would add that boards are even more unlikely to rein in compensation for executives, because they are themselves drawn from the same business stratum–they are accustomed to feeling entitled to large sums of money per unit of useful work, so it’s very hard for most of them to see the “problem” with outsize compensation for senior executives in the companies they serve.

  35. Daniel Colascione

    Your comment is factually incorrect. According to http://www.bls.gov/web/laumstrk.htm New York has a middling unemployment rate. California has its own issues that are unrelated to a progressive income tax.

    Yes, you really can tax your way out of income disparity. It worked fine for 40 years before the Reagan “revolution”.

  36. Paul: “And on the other hand, every boom since the 20’s has been preceded by a tax cut; the Andrew Mellon cuts in the 20’s, Kennedy cuts in the 60’s, Reagan cuts in the 80’s, Capital gains cuts in the 90’s, and the tax cuts in the Bush II years.

    “High taxes have consistently shown to discourage economic growth and job creation. Higher taxes are exactly what we don’t need right now, no matter what illusionary social engineering benefits some think they might have.”

    Absolutely right. Now is not the time for high taxes. The time for high taxes was a few years ago, to counteract the incipient bubble. No bubble, no crash.

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  38. Make it nationwide. If they leave, then don’t trade with whoever they go to.

    Keep the jobs and businesses here. Get rid of the greedy people at the top. Replace them and watch as the country does NOT fall apart contrary to what the “people” at the top think!

  39. “Does anyone really think you can tax your way out of our income disparity?”

    Partially. The best thing to do is tighten the labor market so middle and lower income people can get raises NO MATTER how much the fed and the spoiled and the rich do NOT like it.

  40. “Jobs flee high taxation areas.”

    Is it more like spoiled, rich people want to flee high marginal tax areas and want to take the jobs with them?

    Let them leave. Keep the jobs!

  41. Min, did too much consumer debt and too much financial speculation debt cause the Great Depression?

    Did those two things just happen again?

  42. The real problem is wage and job suppression in the high wage countries that lead to low interest rates that lead to borrowing for the purposes of financial speculation.

    Force up wages and raise some prices somewhat. Watch interest rates go up and financial speculation with debt go to almost zero.

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