Greed is good sometimes a sign of misaligned incentives

Interesting NYT blog post about banker bonuses:

Wall Street firms have always been famous for their generous bonuses to managers and traders — their so-called rainmakers. The graph above shows that employee bonuses have actually exceeded the estimated pretax profits of United States securities dealers in many years.

What is especially striking is the high level of these bonuses in 2007 and 2008, years in which profits were negative...

Now, we should expect bonuses to be relatively big at financial firms, because human capital (the knowledge and skills of bankers) is most of the capital that financial firms own. And if I'm right that bonuses are counted as costs and not paid out of profits (accountants, correct me if I'm wrong), the direct comparison of bonuses and profits doesn't mean a whole heck of a lot; it's apples and oranges.

But the correlation is extremely interesting. We see that in the 90s, even though bonuses were soaring, profits were soaring right along with them. In the 2000s, profits first stagnated and then collapsed, but bonuses kept on rocketing upward.

There's two ways for an economist to look at this. The first is to say "well, these pay decisions were made by private companies, and so the Invisible Hand must have had a good reason for dishing out huge bonuses to the employees of failing companies." The second is to invoke some basic principle of how pay should be determined - that pay should be related to value creation, for example - and then see if the facts fit the theory. The problem is, these two approaches lead to vastly different conclusions. It's hard to escape the notion that the Invisible Hand has been tied.

The blog post goes on to cite some ways this could have happened:

[But] do market forces determine pay the way most economists assume?

Many arguments to the contrary are effectively mobilized by James Crotty, the University of Massachusetts economist, in a recent working paper.

Top executives of financial firms often choose the very board members who are expected to monitor their pay decisions.

[T]he number of highly qualified graduates from top colleges eager to enter investment banking has typically far exceeded the demand. Why hasn’t the excess of supply over demand failed to drive earnings down?...The importance of personal networks and contacts gives rainmakers leverage...

[H]ighly paid employees in finance earn large premiums compared to their counterparts in other industries — pay differences that persist even when virtually all measurable differences in individual characteristics are taken into account. A recent National Bureau of Economic Research paper by Thomas Philippon and Ariell Reshef describes such premiums as unearned “rents.”

Deregulation made it easier for rainmakers to conceal risks that short-term profits would morph into long-run losses. The oligopolistic structure of the industry — now more concentrated than ever as a result of bank failures and mergers — made it easier for them to collude.

Financial firms are investing heavily in lobbying to block efforts to make the industry more competitive. Their rainmakers are still pretty good at making rain for one another.

Conclusion: There are two forces that subvert the Invisible Hand in this market. The first is that bankers use personal connections to exert pressure on board members (this is a form of "moral hazard"). The second is that bankers are often able to trick shareholders into ignoring the risks that bankers are taking (this is a form of "adverse selection"). Moral hazard and adverse selection are two very well-known, very well-studied forces that lead to a breakdown of market efficiency. We have known about these two forces for decades. There is no great mystery here.

Political lesson: The assumption that all decisions made by actors in the private sector are economically efficient is flat-out wrong. This myth has long been propagated by followers of Ayn Rand-style dogma, but it is as fantastical as any Marxist dogma. Asymmetric information - adverse selection and moral hazard - can cause markets to fail, as can externalities, public goods, and incomplete markets. This is a fact.

The next question is whether (and how) government intervention can push markets back toward efficiency. That is an open question. Randian dogma states - without evidence - that government solutions are doomed to failure. Don't buy it.