Wolf and Mankiw on What To Do Now

Martin Wolf, one of the doyens of free-market orthodoxy, says it is time for public regulation of bankers' pay (link):

No industry has a comparable talent for privatising gains and socialising losses. Participants in no other industry get as self-righteously angry when public officials – particularly, central bankers – fail to come at once to their rescue when they get into (well-deserved) trouble.

Yet they are right to expect rescue. They know that as long as they make the same mistakes together – as “sound bankers” do – the official sector must ride to the rescue. Bankers are able to take the economy and so the voting public hostage. Governments have no choice but to respond.

Nor is it all that difficult to understand the incentives at work. …

It is the nature of limited liability businesses to create conflicts of interest – between management and shareholders, between management and other employees, between the business and customers and between the business and regulators. Yet the conflicts of interest created by large financial institutions are far harder to manage than in any other industry.

That is so for three fundamental reasons: first, these are virtually the only businesses able to devastate entire economies; second, in no other industry is uncertainty so pervasive; and, finally, in no other industry is it as hard for outsiders to judge the quality of decision-making, at least in the short run. This industry is, in consequence, exceptional in the extent of both regulation and subsidisation. Yet this combination can hardly be deemed a success. The present crisis in the world’s most sophisticated financial system demonstrates that.

I now fear that the combination of the fragility of the financial system with the huge rewards it generates for insiders will destroy something even more important – the political legitimacy of the market economy itself – across the globe. So it is time to start thinking radical thoughts about how to fix the problems.

Up to now the main official effort has been to combine support with regulation: capital ratios, risk-management systems and so forth. I myself argued for higher capital requirements. Yet there are obvious difficulties with all these efforts: it is child’s play for brilliant and motivated insiders to game such regulation for their benefit.

So what are the alternatives? Many market liberals would prefer to leave the financial sector to the rigours of the free market. Alas, the evidence of history is clear: we, the public, are unable to live with the consequences. . . .

No, the only way to deal with this challenge is to address the incentives head on and, … the central conflict is between the employees (above all, management) and everybody else. By paying huge bonuses on the basis of short-term performance in a system in which negative bonuses are impossible, banks create gigantic incentives to disguise risk-taking as value-creation.

We would be better off with Jupiter’s 12-year “year”, since it takes about that long to know how profitable strategies have been. The point is that a year is an astronomical, not an economic, phenomenon (as it once was, when harvests were decisive). So we must ensure that a substantial part of pay is better aligned to the realities of the business: that is, is made in restricted stock redeemable over a run of years (ideally, as many as 10).

Yet individual institutions cannot change their systems of remuneration on their own, without losing talented staff to the competition. So regulators may have to step in. The idea of such official intervention is horrible, but the alternative of endlessly repeated crises is even worse.

The big points here are, first, we cannot pretend that the way the financial system behaves is not a matter of public interest – just look at what is happening in the US and UK today; and, second, if the problem is to be fixed, incentives for decision-makers have to be better aligned with the outcomes.

Meanwhile, Harvard’s most popular economics professor says we’d better be chary about proposals to give more food stamps to the poor. Might not be doing them a favor says Greg Mankiw (link):

Marty Feldstein may well be right that those on food stamps have a higher-than-average marginal propensity to consume. Nonetheless, I wonder if we really want to target such cyclical measures on the poorest members of society. That is, for any mean level of food stamps, wouldn't the poor be better off with a constant stream of benefits than with a benefit that fluctuates over the business cycle? Using food stamps as a cyclical tool seems to risk destabilizing some families' food consumption in an attempt to stabilize the overall business cycle.

If we are going to use fiscal policy to smooth out the business cycle on a regular basis, then we should think harder about improving the economy's automatic stabilizers. For example, imagine we enacted an investment tax credit, the size of which was a function of the unemployment rate. Firms would have an incentive to time their investment projects toward those periods when the economy was weakest and most needed a shot in the arm.

I can more easily imagine, when the economy starts to overheat, telling corporations that their investment credit has shrunk or disappeared than telling poor families that their food budget has been cut.

So far as I can tell, Mankiw has not weighed in on the question whether the president of Countrywide Financial, the poster-child of irresponsible mortgage lending, should receive a $84 million payday (link).