Thursday, October 22, 2009

Wage controls are politically easier than genuine reforms

Our New Paymasters. WSJ Editorial
Wage controls are politically easier than genuine reforms.
The Wall Street Journal, page A20, Oct 23, 2009

In the annals of what used to be known as American capitalism, yesterday will go down as a sorry day: The Treasury and Federal Reserve announced wage controls on private American companies. So once again our politicians are blaming bankers, rather than addressing the incentives the politicians themselves created for bankers to take excessive risks.

President Obama cheered the pay reductions as "an important step forward" and urged Congress to "continue moving forward on financial reform to help prevent the crisis we saw last fall from happening again." The pay curbs are intended to feed the official political narrative that the bankers caused the entire crisis, and that cutting their future pay will prevent the next one. Only a politician could really believe this, or at least pretend to.

We certainly have no sympathy for bankers who've been bailed out, and the most defensible of yesterday's pay curbs are those announced by Treasury "pay czar" Ken Feinberg. He was handed the task of determining compensation for 175 executives at seven companies that are still using money from the Troubled Asset Relief Program: Citigroup, AIG, Bank of America, General Motors, Chrysler, GMAC and Chrysler Financial. These companies—and executives—owe their survival to political intervention, and the price of such taxpayer help is inevitably some populist retribution.

Mr. Feinberg thus has the impossible job of navigating between Congress's desire for revenge and the incentives needed to motivate business success at companies that still need to repay taxpayers. His strategy seems to be to slash cash compensation to $500,000 or less for most of the affected workers, while the bulk of their compensation will come in the form of stock tied to future corporate performance. This seems reasonable enough in principle. But the danger is that these pay limits will drive the most talented people at these firms to other companies without such onerous pay limits.

Far more dangerous is yesterday's announcement that the Fed plans to impose new pay guidelines on all of the banks it regulates. While the Fed imposed no pay cap, and it was at pains to say it didn't want to impose a "one size fits all" standard, the implication is that any large single-year payouts will be frowned upon by regulators. The Fed wants what it refers to as more "balanced" pay standards, which in practice is likely to mean smaller bonuses up front and longer time frames to see if "risks" pay off over several years.

The irony is that judgments about what constitutes "excessive risk" at banks will presumably be made by the same Fed regulators who let Citigroup put hundreds of billions in SIVs off its balance sheet. That certainly looks "excessive" now, though apparently it didn't amid the credit mania. The point is that Fed officials aren't likely to have a clue what kind of risks warrant tighter compensation rules. And these new guidelines may also drive the best and brightest out of the banks and into less regulated institutions.

Paul Volcker must be smiling at that one. Like Bank of England Governor Mervyn King (see below), the former Fed Chairman argued in Obama circles that a better way to regulate banks is to separate the riskiest trading activities from those that accept taxpayer guaranteed deposits. That reform would have moved the riskiest proprietary trading out of taxpayer-protected institutions. But the White House and Treasury deemed this too politically difficult, so instead they are now regulating the pay of bankers as an alternative way to diminish those risks. Good luck.

Meanwhile, the Administration still hasn't done anything to change the incentives for excessive risk-taking that are embedded in its own "too big to fail" doctrine. As long as bankers and their creditors believe they have a federal safety net, they will have a cheaper cost of capital that will encourage them to take greater risks. New pay rules will quickly be worked around or through.

As Mr. King put it this week, "The sheer creative imagination of the financial sector to think up new ways of taking risk will in the end, I believe, force us to confront the 'too important to fail' question. The belief that appropriate regulation can ensure that speculative activities do not result in failures is a delusion." The same can be said for pay curbs.

The most profound mistake in these rules is the terrible precedent they set for wage controls
across the economy. The Obama Administration will say that banks are a special case, and that is true. But once politicians feel free to regulate executive pay for one industry, it is no great leap to do it for everyone. Our guess is that these pay rules will prove to be both ineffectual and destructive—a perfect Washington combination.

Brown v. King - Politicians hate hearing their subsidies contributed to the crisis

Brown v. King. WSJ Editorial
Politicians hate hearing their subsidies contributed to the crisis.
WSJ, Oct 22, 2009

Gordon Brown gave the Bank of England its independence 12 years ago, but this week he seemed to be looking for someone to rid him of his troublesome central banker. Bank of England Governor Mervyn King gave a speech in Edinburgh Tuesday in which he said, in effect, that if a bank is too big to fail, it's just too big. On Wednesday, The British Prime Minister shot back that breaking up the largest financial institutions wasn't the answer, adding the now obligatory call for global regulation of banker pay.

One can disagree with Governor King's contention Tuesday that the banking system, and the economy, would be better served by a stricter division between investment banking and commercial or retail banking. But more important than Mr. King's solution was his diagnosis of the problem, which shows more understanding of what caused last year's panic than the usual pabulum about magic bonuses.

"Why," Mr. King asked, "were banks willing to take risks that proved so damaging both to themselves and the rest of the economy?" His answer: "One of the key reasons . . . is that the incentives to manage risk and to increase leverage were distorted by the implicit support or guarantee provided by government to creditors of banks that were seen as 'too important to fail.'" Politicians hate hearing that it was their subsidies for credit and for the biggest banks that contributed to the problem.

Mr. King wasn't done: "Such banks could raise funding more cheaply and expand faster than other institutions. They had less incentive than others to guard against tail risk. Banks and their creditors knew that if they were sufficiently important to the economy or the rest of the financial system, and things went wrong, the government would always stand behind them." He concluded: "And they were right."

On this essential point, Mr. King is on target, and it's heartening to hear an important public official put his finger on the real problem so succinctly. Mr. Brown would prefer to point to inadequate "global regulation" of finance. But show us the regulator who could have prevented the panic, even with unlimited power, and we'll show you a world without the freedom to succeed or fail.