Bankers’ Giant Bonuses (Opinion piece in the NYT)

[TheTodd]

On the Origin of Bankers’ Giant Bonuses

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By EDUARDO PORTER
Published: March 8, 2009

If you’re still having trouble understanding big-time bankers’ huge paychecks — and who isn’t? — try thinking of the problem in more primitive terms. Like, say, the lives of elephant seals.

Bull seals put on flab for competitive reasons: the bigger the bull, the greater its chances of thrashing other males on the beach to win a harem of cows.

The problem is that while each bull may be happy with his success, the competitive dynamic has a cost to elephant seal society. When the fattest seals always win, they will be more successful in passing their genes to the next generation —which will lead to a fatter population over time.

Elephant seal bulls can weigh 8,000 pounds. As the Cornell economist Robert Frank has pointed out, the social costs come clear when you consider that at 8,000 pounds it is pretty difficult to out-swim a great white shark.

Which brings us back to Wall Street. There are competing hypotheses about why top bankers and corporate chief executives are paid so much. Some researchers suggest a form of theft, exercised by coaxing, cajoling or browbeating pliant boards of directors to hand over more and more company money.

Bankers prefer the elephant seal theory: the humongous bonus packages are essential to attract top executives who otherwise would be nabbed by a rival. Bailed-out bankers grumble that the pay caps imposed by the Obama administration will allow better-financed hedge funds to swoop down and poach the best from their ranks.

This theory of capitalist evolution conveniently omits the part about the social costs. It is doubtful whether this executive superstar system adds any value to firms.

One study by Ulrike Malmendier of Berkeley and Geoffrey Tate of U.C.L.A. suggested that when C.E.O.’s are anointed as superstars by the media, shareholders suffer: C.E.O. performance declines relative to what it was before and to that of other C.E.O.’s. They start writing books, serving on boards and doing more work outside the company. And they become more active in tinkering with corporate earnings. Of course, the C.E.O.’s themselves get a raise.

Today we are all bearing the costs of bankers’ lopsided remuneration. The arms race in financial-sector pay that started with financial deregulation in the 1980s has grossly distorted economic incentives. Not only did handsomely compensated financiers engineer the dot-com bubble and the housing crisis, but bankers’ pay is reshaping the economy and society in other perilous ways.

Between 1980 and last year, the financial industry’s share of the nation’s corporate profits rose from 19 percent to 30 percent, government figures show. Wages followed. Research by the economists Thomas Philippon of New York University and Ariell Reshef of the University of Virginia found average remuneration in the financial industry rose from about par with wages in the non-farm private sector in 1980 to about 1.7 times today.

In the face of such odds, more of the nation’s pool of talented students decided there was no point in becoming a doctor or an engineer, when one could be a banker. In a recent research paper, the Harvard economists Claudia Goldin and Lawrence Katz reported that the share of Harvard graduates who took jobs in finance increased from 5 percent of the 1970 class to 15 percent of the 1990 class. The share going into law and medicine fell from 39 percent to 30 percent.

Perhaps the current crisis will end this trend. Finance is unlikely to recover quickly from this debacle, which has caused shares in financial companies to slide almost 60 percent in the last year. That means pay packages might return to earth, where the rest of us live. Banks could start competing for talent on the scale of hundreds of thousands of dollars, rather than in the millions.

Elephant seals don’t know that they would reduce their odds of becoming lunch if they all cut their tonnage by half — a move that would leave the competitive field unaltered. But people are smarter, we hope, and can understand that if we rein in all bankers’ pay we might be able to protect society from the fallout of their mating habits.