Perverse Incentives

I'll admit to being a bit of a fan of Hayek, the Austrian and Chicago schools of thought, and free, unfettered markets.  That includes for labor.

So when I read that the government wants to manage their investment in bailed-out banks by restricting bonuses, I worry.  How will the government recoup its investment if people who do good work don't get paid the market rate for their work?  Maybe those employees should be paid more for adding to the bottom line at a bailout bank: those banks need money dearly and provide more difficult environments for making money.

Worse, this gets back to the same troubles: We are taxing profitable banks -- banks which had better risk management and incentive structures -- to support banks which were not profitable largely because they failed at managing risk and incentives.  Then we constrain the pay of anybody at those supported banks who makes the bank a pile of money.  This encourages the best employees to leave for unsupported banks where their pay will not be capped.

In a way, that is good because it returns some reward to the profitable banks.  However, it is bad because it effectively traps bailout banks in amber: not going broke, but losing good employees.  Why would we bail banks out only to push them into mediocrity?  It seems to be a poor use of taxpayer money.

Now I agree pay should have clawbacks and be risk-adjusted; I've been a fan of such ideas for years.  But capping salaries is not the way to achieve this.  If anything, caps treat pay so simply that they make it much harder to argue for risk-adjusted, sustainability-driven pay.

What are we doing?  We need to be working to understand the subtleties of what went wrong (and what went right) -- not reducing the issues to simple morality plays or black-and-white cartoons.  At a time when banks should be working smarter, many are being forced to take dumb actions.