A policy idea

Incentives matter. Brad DeLong points out that one reason America finance companies have done so much worse than our tech companies is that the finance companies use worse incentive structures:

The engineers of Silicon Valley startups are significantly smarter and work a lot harder than do the traders of Wall Street. Some of the engineers of Silicon Valley make fortunes: they are compensated with relatively low salaries and large restricted equity stakes in the startup businesses they work for, and so if the businesses do well they do very well indeed--in the long run, in the five to ten years it takes to assess whether the business is in fact going to be a viable and profitable going concern. And the engineers of Silicon Valley have every incentive to use all their brains and all their hours to make their firm viable and successful: they get their cash only at the end of the process...

The traders of Wall Street, by contrast, get their money largely up front. If the mark-to-market position is good, they get paid--even though it is almost surely the case that nobody has tried to actually sell the entire position to somebody else. If the strategy produces short-run profits, they get paid--even though not nearly enough time has passed for anybody to be able to assess what the risks involved in the strategy truly are...

The failure of the major institutions of Wall Street to adopt Silicon Valley compensation schemes in the 1980s and 1990s was always a great worry to regulators and policymakers. The strong view was that the venture capitalists of Silicon Valley knew what they were doing and were acting as prudent and responsible agents of their investors when they insisted on SVCS for their startups. So why didn't the shareholders of the major banks do the same with their traders, quants, and strategists? The decisive argument in regulatory and policymaker bull sessions about this issue was that this was the shareholders' business--that if the shareholders of these companies thought that there was good reason to elect board members and CEOs who did not impose SVCSs, the government should be cautious about stepping in. And the argument that "maybe the shareholders know of some good reason not to adopt SVCSs" no longer applies: we are the shareholders, we know of no reason, and we see no reason not to align the interests of our employees at AIG and at TARP-receiving companies with the long-run interests of the U.S. Treasury.

Basically, some compensation schemes encourage long-term planning, and some encourage short-term planning...and short-term planning is a lot more likely to result in fraud, waste, and bubbles, because it's a lot easier to trick people for 6 months than it is to trick them for 10 years.

This raises a question: Why don't we encourage long-term compensation schemes by giving them favorable tax treatment? There seems to be a substantial externality here; when one company decides to use a stupid short-sighted compensation scheme, it's mostly only that company that gets hurt, but if everybody does it, the entire economy can suffer the effects of a devastating bubble. Extenalities mean there's a good reason for the government to get involved.

Giving tax breaks for "SVCS" and other similar "patient" compensation might increase our economic security and boost shareholder returns all in one stroke. It's something we should think about.