The Economics was Fake, but the Bonuses Were Real

posted by Frank Pasquale

Gar Alperovitz and Lew Daly’s book Unjust Deserts: How the Rich are Taking our Common Inheritance and Why We Should Take it Back is at the top of my reading list this Christmas season. That’s not just because, as Patrick S. O’Donnell reminds us, social justice is at the core of Christian identity.* It’s also because I fear that if we don’t start seriously rethinking our entire approach to finance, the foundation of trust necessary for even basic economic order will erode.

Anyone trying to understand the current financial crisis should take a look at the NY Times series The Reckoning, a blow-by-blow account of a deep rot at the core of American finance and politics. An article on Wall Street bonuses clinically describes the outrageous incentives at the heart of it:

In 2006 . . . Merrill handed out $5 billion to $6 billion in bonuses . . . . A 30-something trader with a $180,000 salary got $5 million. But Merrill’s record earnings in 2006 — $7.5 billion — turned out to be a mirage. The company has since lost three times that amount, largely because the mortgage investments that supposedly had powered some of those profits plunged in value. Unlike the earnings, however, the bonuses have not been reversed.

Lucian Bebchuk of Harvard Law School said investment banks like Merrill were brought to their knees because their employees chased after the rich rewards that executives promised them. . . . “They were trying to get as much of this or that paper, they were doing it with excitement and vigor, and that was because they knew they would be making huge amounts of money by the end of the year,” he said. “What happened to their investments was of no interest to them, because they would already be paid,” said Paul Hodgson, senior research associate at the Corporate Library, a shareholder activist group.

What’s more, some of the principals are not merely enjoying their tens of millions of dollars in bonuses now, but are still being recruited to head other ventures–a quick profit being the expertise Wall Street apparently values most. Given this mentality at the banks we are now collectively bailing out, we need a fundamental rethinking of the anti-regulatory dogma that has informed policy for so long. As a shaken Richard Posner has recognized, “This is troublesome for economics. You can have rationality and you can have competition, and you can still have disasters.”

I’ve been following Robert Skidelsky’s responses to this crisis, and found them compelling. This most recent article provides the broader perspective we need as we rush to respond to emergency after emergency:

[T]he crisis is global, and . . . [t]here were three kinds of failure. The first, discussed by John Kay, was institutional: banks mutated from utilities into casinos. However, they did so because they, their regulators and the policymakers sitting on top of the regulators all succumbed to something called the “efficient market hypothesis”: the view that financial markets could not consistently mis-price assets and therefore needed little regulation. So the second failure was intellectual. The most astonishing admission was that of former Federal Reserve chairman Alan Greenspan in autumn 2008 that the Fed’s regime of monetary management had been based on a “flaw.” The “whole intellectual edifice,” he said, “collapsed in the summer of last year.” Behind the efficient market idea lay the intellectual failure of mainstream economics. It could neither predict nor explain the meltdown because nearly all economists believed that markets were self-correcting. As a consequence, economics itself was marginalised.

But the crisis also represents a moral failure: that of a system built on debt. At the heart of the moral failure is the worship of growth for its own sake, rather than as a way to achieve the “good life.” As a result, economic efficiency—the means to growth—has been given absolute priority in our thinking and policy. The only moral compass we now have is the thin and degraded notion of economic welfare. This moral lacuna explains uncritical acceptance of globalisation and financial innovation. Leverage is a duty because it “levers” faster growth. The theological language which would have recognised the collapse of the credit bubble as the “wages of sin,” the come-uppance for prodigious profligacy, has become unusable. But the come-uppance has come, nevertheless. [emphasis added]

The current crisis exposes the fragility of markets generally. They are built on mutual reciprocity, and as more opportunism from trusted intermediaries is exposed, the weaker our faith in other market actors becomes. Both Francis Fukuyama’s work on trust and Robert Putnam’s on the “social capital” it reflects bode ill for our economy. Putnam describes a southern Italy mired in corruption and fraud, and a northern Italy whose economic success is built on its long history of civic associations and mutual endeavor. Can anyone doubt that our economy is exposed (with each passing day) as more Sicilian in its “winners’” casual acceptance of fraud, more Russian in its oligarchic tendencies, more Brazilian in its inequality? After the Madoff scandal, what are investors to do–personally spot-check their broker’s office and assure that trades are actually being made? As Joseph Grundfest noted in a recent NPR “Planet Money” segment, the SEC simply does not have the resources to do the kind of policing necessary when basic bonds of trust break down.

Fortunately, realist scholars of inequality have been ahead of the curve in recognizing the social bases of individual success, and we can look to their work as we begin to think about how to rebuild the trust necessary for a thriving economy. The first imperative is ending the pattern of skillful elites wielding exceptional power by leveraging economic into political capital, and vice versa. Next, we need to realize the social bases of our common wealth, and how important it is to tend to it. As Alperovitz and Daly argue, the worship of wealth that is the ultimate rationale for tax cuts for billionaires ignores the real bases of prosperity:

The problem we see is a society whose wealth is commonly created, by and large, but very unequally distributed and enjoyed. The largely collective way we produce our wealth is morally out of sync with the individualistic way we distribute the wealth and also justify the resulting vast inequalities. So we’re not saying to the Bill Gateses of the world: you don’t deserve anything and we’re going to tax it all away. What we’re saying is that our society should be more equal than it is if we truly believe, first, that people should be rewarded according to what they contribute, and second, that society should be repaid for the large contributions it makes, which enable everything else. These are common beliefs or, at least, reasonable ideas, so that is not the problem. The problem is a mistaken view of wealth-creation, which distorts how these common ideas are applied.

Alperovitz and Daly have a number of misconceptions to dispel. But we can all hope that the wisdom of former fund manager John Bogle will inform future policy on these matters:

At a party given by a billionaire on Shelter Island, the late Kurt Vonnegut informs his pal, the author Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch 22 over its whole history. Heller responds, “Yes, but I have something he will never have . . . Enough.” . . .

[T]he more that our financial system takes, the less our investors make. Yet the financial field is where the money is made in modern-day America, the breeding ground for the wealthiest of our citizens. (If you made less than $140 million dollars last year, you didn’t make enough to rank among the 25 highest-paid hedge fund managers.) When we add up all those hedge fund fees, all those mutual fund management fees and operating expenses; all those commissions to brokerage firms and fees to financial advisors; investment banking and legal fees for all those mergers and IPOs; and the enormous marketing and advertising expenses entailed in the distribution of financial products, we’re talking about some $500 billion dollars per year. That sum, extracted from whatever returns the stock and bond markets are generous enough to deliver to investors, is surely enough.

As Krugman stated, “In recent years the finance sector accounted for 8 percent of America’s G.D.P., up from less than 5 percent a generation earlier. If that extra 3 percent was money for nothing — and it probably was — we’re talking about $400 billion a year in waste, fraud and abuse.” Enough.

*O’Donnell paraphrases and quotes major points of Catholic Social teaching, and I will take the liberty of reposting relevant parts here:

Common Good and Community: The human person is both sacred and social. We realize our dignity and rights in relationship with others, in community. Human beings grow and achieve fulfillment in community. Human dignity can only be realized and protected in the context of relationships with the wider society.

How we organize our society — in economics and politics, in law and policy — directly affects human dignity and the capacity of individuals to grow in community. The obligation to “love our neighbor” has an individual dimension, but it also requires a broader social commitment. Everyone has a responsibility to contribute to the good of the whole society, to the common good.

Option for the Poor: The moral test of a society is how it treats its most vulnerable members. The poor have the most urgent moral claim on the conscience of the nation. We are called to look at public policy decisions in terms of how they affect the poor. The “option for the poor,” is not an adversarial slogan that pits one group or class against another. Rather it states that the deprivation and powerlessness of the poor wounds the whole community.

The option for the poor is an essential part of society’s effort to achieve the common good. A healthy community can be achieved only if its members give special attention to those with special needs, to those who are poor and on the margins of society.

Role of Government and Subsidiarity: The state has a positive moral function. It is an instrument to promote human dignity, protect human rights, and build the common good. All people have a right and a responsibility to participate in political institutions so that government can achieve its proper goals.

The principle of subsidiarity holds that the functions of government should be performed at the lowest level possible, as long as they can be performed adequately. When the needs in question cannot adequately be met at the lower level, then it is not only necessary, but imperative that higher levels of government intervene.

Economic Justice: The economy must serve people, not the other way around. All workers have a right to productive work, to decent and fair wages, and to safe working conditions. They also have a fundamental right to organize and join unions. People have a right to economic initiative and private property, but these rights have limits. No one is allowed to amass excessive wealth when others lack the basic necessities of life.

Catholic teaching opposes collectivist and statist economic approaches. But it also rejects the notion that a free market automatically produces justice. Distributive justice, for example, cannot be achieved by relying entirely on free market forces. Competition and free markets are useful elements of economic systems. However, markets must be kept within limits, because there are many needs and goods that cannot be satisfied by the market system. It is the task of the state and of all society to intervene and ensure that these needs are met.

Global Solidarity and Development: We are one human family. Our responsibilities to each other cross national, racial, economic and ideological differences. We are called to work globally for justice. Authentic development must be full human development. It must respect and promote personal, social, economic, and political rights, including the rights of nations and of peoples It must avoid the extremists of underdevelopment on the one hand, and “superdevelopment” on the other. Accumulating material goods, and technical resources will be unsatisfactory and debasing if there is no respect for the moral, cultural, and spiritual dimensions of the person.

 December 19, 2008 at 2:18 pm   Posted in: Economic Analysis of Law    Print This Post

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