“I have no idea why I was offered a contract with a bonus in it because I promise you I will not work any harder or any less hard in any year, in any day because someone is going to pay me more or less." So says John Cryan, the new CEO of Deutsche. This has prompted Merryn Somerset Webb to claim that bonuses "can have an almost infinite number of negative effects" to which Brooke Masters replies that a well-designed bonus system can do some good.
I side with Merryn here. A well-designed bonus system is like a fully-fit Arsenal squad - a theoretical possibility rarely observed in the real world. More likely, bonuses encourage bubbles and short-termism - what John Kay calls "I'll be gone, you'll be gone" thinking - and crowd out intrinsic motivations (pdf).
This debate, however, misses an important point. AFAIK, there wan't an investment bank which paid zero bonuses, saw its staff slacking and so decided to introduce a bonus system.Instead, the original intention behind bonuses was completely different.
Before Big Bang, stockbrokers and merchant banks were mostly owned by partners. They didn't need to pay bonuses to incentivize staff simply because they worked alongside them and so could oversee them directly: I'm old enough to have worked in one, and some of the partners were quite scary.
Instead, they paid bonuses because revenues were volatile, being dependent upon share prices or M&A activity. Such volatility would have meant either big risks to the partners or to employees as bad years led to mass sackings. Bonuses were paid not to motivate employees but to stabilize the business.
In this sense, bankers' bonuses are a legacy of a different era; the idea that they are necessary to motivate staff is a justification tacked onto a system which came into being for different and better reasons.
This is by no means the only example in economics of a legacy idea - an idea or institution that that made sense once but no longer does so. Here are some others:
- Taxing profits or income is less sensible in a globalized world where these can easily shift - or be made to appear to shift! - overseas. Taxing land, which can't move, would be better.
- Corporate hierarchies made sense in capital-intensive firms with lots of unskilled labour. They might be less sensible in firms where human capital is more important and physical capital less so.
- Bashing trades unions might have been a good idea (at least from capitalists' perspective) when squeezed profit margins in the 1970s and 80s were deterring investment. But it doesn't make sense when the barriers to investment lie elsewhere, when wage-led growth (pdf) is feasible, or when the alternative to unions is tighter regulation.
- High-charging actively managed funds were tolerable many years ago, but are less so now that we know that most of them, on average over the long-run, under-perform the market.
Edmund Burke urged us to be conservative because existing institutions and ideas embodied the wisdom of the ages which could be greater than our own bounded rationality.However, as Niels Bohr once said, the opposite of a great truth is also true. And sometimes, ideas continue to exist even after the circumstances that gave them validity have disappeared.