Bonuses, power and inequality

Everyone seems upset by the prospect of banks paying big bonuses. What they’re not asking is: why have banks paid them for so long?
The popular answer is that banks need to attract the best talent.
Yeah, right. Eric Falkenstein and James Kwak provide the real answer. Traders must be bribed not to plunder the firm. If you don’t pay them millions, they’ll sell the banks’ assets cheaply to rival firms for which they then go and work. They are paid fortunes not because they have skill, but because they have power.
It’s not just bankers of whom this is true. Peter Skott and Frederick Guy show that it is changes in differences in power that can explain a hefty chunk of the rise in inequality we’ve seen since the 1980s.
To see why, remember efficiency wage models. These tell us that where employers cannot monitor workers directly, they might want to pay more than the market-clearing wage to bribe workers not to shirk or damage the company in some way.
Now, since the 1980s, technical change has made it easier to monitor ordinary workers. Automated production lines, bar-coding in retailing, GPS systems that follow van drivers or recorded telephony in call centres all allow bosses to measure and control less “skilled” workers. So there’s no need to pay such workers above the market rate. Their wages have therefore stagnated.
However, the efficiency wage component of  managers’ pay - the amount over the market-clearing rate necessary to bribe them - increased since the 1980s. When finance was plentiful, managers could rip off shareholders by arranging management buy-outs at low prices. To stop this, bosses had to be offered big money. And in more competitive or contestable markets, a lazy manager can more easily send a company to the wall. With the costs of shirking so large, the bribe required to induce effort must also be large.
The result of all this has been a growing gap between the pay of bosses and some professionals on the one hand and workers on the other.
You can call this a rising return to “skill” if you like. But the “skill” is an ability to demand a big bribe - and this comes from power.
Could it be, then, that one effect of this banking crisis will be to show that talk of “talent” is just an ideological veil behind which rising inequality has been the result of inequalities in naked power?

Comments

[David Heigham]

At last, I begin to see why special Board committees to decide top executives remuneration became so popular in big corporations.

Bribing people not to walk off with the assets is inefficient because you have to offer them almost as much as they could walk off with. There are usually cheaper strategies for keeping them in order. If the bosses remuneration came up at a full Board meeting, the non-executives might think of those options. But put the decision in a separate committee which is only empowered to think about remuneration, and the other, cheaper options are off the agenda.

Back that up with remuneration consultants hired by the special committee who will report independently what the market rate for the job (the bribes others have extorted) is; and talk off the record about the damage done to other firms who have tried to keep down the bosses rewards. Then you have not inequalites in naked powwer, but something more effective and durable: inequalities in veiled and well-articulated power.

[passer by]

make off book accounting go the way of the dodo, get rid of dividends, pay them in future shares, (if the share price reaches and stays at x for y time you get z. which you have to hold for 18 or so months)

we cant change human nature but we surly can build a system that take it into account.

[Ed]

Throughout the above post you managed to avoid mention of the word "law". I seem to recall that there used to be a concept called "fiduciary duty". Whatever happened to it?

[Blissex]

«the word "law". I seem to recall that there used to be a concept called "fiduciary duty"»

Are you some sort of Communist? Only Bolsheviks and terrorists want to confiscate the right of the best and brightest to do as they please, including taking as much as they want from their employers or from the State. Class hatred is disgusting, unless it is against the welfare scroungers and the lazy, parasitical working class.

:-).

[Blissex]

«we cant change human nature but we surly can build a system that take it into account.»

But this has been done: the system does take human nature into account, perhaps not in the sense that you would wish, but surely it takes into account that it is in the human nature of CEOs and other executive level management to cheat and steal as much as they can, and helps them do so.

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Those efficiency wage models also predict a higher unemployment rate, to go with the higher wages. Effectively, firms pay employees more than they need, given the unemployment rate, and use the permanent increase in unemployment to discourage their employees from shirking.

So if the banks were paying high wages during the boom years for this reason, there must still have been high unemployment amongst bankers. Was this in fact the case?

[Luis Enrique]

This is absolutely right. It's about bargaining power, because so many people in the banking industry can threaten to walk out the door and take the revenue they generate with them.

In a decentralised system, individual firms have to pay to retain these people. If the whole system is nationalised, or if there aren't enough private banks left for the individual's threat to defect to be credible, then perhaps the bonuses will fade away.

But as you ask, why does the financial sector make so much money in the first place? If the proportion of revenue going to salaries is cut, what will happen ... I guess the options are: 1. profits will rise or 2. prices will fall. Those who hate high salaries for bankers probably don't want salaries to fall only for profits to rise. Prices falling would seem to be an unambiguous good thing - what we'd call an increase in productivity in any other industry - the only complication I can think of is that banking is effectively one of biggest (the biggest?) export industry, so if rents fall in the industry, so will our export earnings.

I think most modern labour economics starts by looking at the size of the surplus created by a match (between firm and worker) and then looks at the bargaining power of the respective parties. It's not something I know too much about, but this seems a far more satisfactor explanation of earnings distribution than just thinking about skill and marginal product.

[Luis Enrique]

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I think you can think of the efficiency wage argument as needing to pay workers a premium over their "outside option", not necessarily over unemployment. I'm not clear on this - if you are looking at things on a macro level, and asking why wages are higher than the market clearing level, you can say that the existence of 1. some unemployment and 2. wages higher than reservation keeps everybody working hard. But for highly skilled individuals who do not face unemployment, then the efficiency wage just means paying them enough to stop them buggering off.

[Bob B]

"we cant change human nature"

The notion that "human nature" is settled, the same everywhere and unchanging is demonstrable nonsense.

Why was crime so low in the 1930s, despite pervasive poverty because of the depression, but is so much higher now despite much greater affluence on average?

How come drunkeness and sexual promiscuity are on the rise? Why does Britain have one of the highest rates of teenage pregnancy in Europe?

In Nepal: "This is rigorous work, but Kundol has a little extra manpower at her disposal. She has two husbands, Tsering Yeshi and Pema Tsering, who are brothers."
http://news.bbc.co.uk/1/hi/world/south_asia/4461196.stm

By many accounts, wife-sharing was a traditional practice among the Inuit.

On the evidence, "human nature" is very adaptable.

[tbrrob]

Excellent post. You could well be right on this one.

[passer by]

Bobb, where did I say that human nature was settled, it is not and never has been otherwise evolution would be a dead duck.

But behind the flux human nature takes massive events to change it quickly and takes eons to change when it is adapting.

The idea of humans are a blank state, born to malleable by the rest of society has pretty well be junked by Chomsky, Pinker and MRI brain scanners.

we have a small margin of error to work with (not against)

[Tom James]

@Bob b:

"Why was crime so low in the 1930s, despite pervasive poverty because of the depression, but is so much higher now despite much greater affluence on average?"

Maybe if there is more wealth around there is more stuff to steal?

Also I think you're mistaking transient cultural and social trends for underlying human nature.

[Bob B]

"Also I think you're mistaking transient cultural and social trends for underlying human nature."

How else do we ascertain what "human nature" is and whether it's the same everywhere, unchanged and unchanging, unless we observe how humans behaviour, especially in groups? How do we distinguish the transient elements from the bedrock and fundamental except through observation with clinical objectivity?

Experimental evidence consistently shows surprising and unpleasant features of human behaviour in groups and Edward Bernays was hugely successful in manipulating public behaviour - as Adam Curtis's TV doc shows. At any rate, Bernays made a lot of money doing it.

A series of experiments by Elton Mayo and his team exploring how changes in (real) working conditions affect productivity arguably disrupt economists' preconceptions profoundly - see this account of the "Hawthorne experiments":
http://www.personneltoday.com/Articles/2004/10/19/26126/Staff+under+the+microscope.html

As the Hawthorne experiments were conducted over many years and in a real-world context, the findings can hardly be dismissed as mere role-play.

The disturbing findings of the original Milgram experiment were confirmed in a recent re-run:
http://en.wikipedia.org/wiki/Milgram_Experiment

What happened at the Abu Ghraib prison in Iraq rather confirmed Zimbardo's grim Stanford prison experiment of 1971.

I go by the evidence - and btw, from personal experience, colleagues were remarking to me about characteristic herd-like behaviour of agents in finance markets c. 20 years ago. But then, perhaps, that is what is included in human nature. If so, are we to take it that the current crisis in financial markets was programmed to happen? At least that would be some improvement on Stanley Jevons's sunspot theory of the trade-cycle.

[John Freeland]

I thought the big executive pay packages were a simple matter of risk-reward. The top execs are at risk of going to jail, therefore they can demand higher compensation.

[reason]

John Freeland,
pick someone at random on the street, and ask them if they would be willing to be a CEO for say 1 million a year.
Besides, do you have any evidence that CEO have any more chance of ending up in jail than anybody else.
(I'm not saying your wrong, but your argument sounds so unlikely, I think you need to made a prima facae case for it.)

[Tom James]

"How do we distinguish the transient elements from the bedrock and fundamental except through observation with clinical objectivity?"

So we can categorise common cognitive biases common to all human beings of whatever cultural background as parts of "human nature". The Milgram experiments and how people respond to authority have (as you say) remained constant over time and may also be constant across cultures - therefore they are part of human nature.

Any other behaviour, in groups or otherwise, that differs between cultures and over different times would be classed as "cultural factors."

So to return to your original point:

"The notion that "human nature" is settled, the same everywhere and unchanging is demonstrable nonsense."

Human nature IS the same everywhere and can be assumed to be fairly constant over historical time.

The example that comes to mind is the ultimatum game where people behave in an "economically irrational" way in response to perceived injustice:

http://en.wikipedia.org/wiki/Ultimatum_game

(see also Camerer, Thaler (1995) here http://irving.vassar.edu/faculty/sf/333/camererthaler1995.pdf).

The recent response of the media and politicians to banker's bonuses strikes me as the ultimatum game played out in a wider context.

Society as a whole is rejecting the perceived greed of CEOs and bankers, as we have evolved to punish greed even if we personally lose out in doing so.

But I guess it's fairly clear that there has been a divorce between talent and compensation in some areas.

[Tom James]

"How do we distinguish the transient elements from the bedrock and fundamental except through observation with clinical objectivity?"

So we can categorise common cognitive biases common to all human beings of whatever cultural background as parts of "human nature". The Milgram experiments and how people respond to authority have (as you say) remained constant over time and may also be constant across cultures - therefore they are part of human nature.

Any other behaviour, in groups or otherwise, that differs between cultures and over different times would be classed as "cultural factors."

So to return to your original point:

"The notion that "human nature" is settled, the same everywhere and unchanging is demonstrable nonsense."

Human nature IS the same everywhere and can be assumed to be fairly constant over historical time.

The example that comes to mind is the ultimatum game where people behave in an "economically irrational" way in response to perceived injustice:

http://en.wikipedia.org/wiki/Ultimatum_game

(see also Camerer, Thaler (1995) here http://irving.vassar.edu/faculty/sf/333/camererthaler1995.pdf).

The recent response of the media and politicians to banker's bonuses strikes me as the ultimatum game played out in a wider context.

Society as a whole is rejecting the perceived greed of CEOs and bankers, as we have evolved to punish greed even if we personally lose out in doing so.

But I guess it's fairly clear that there has been a divorce between talent and compensation in some areas.

[Tom James]

"How do we distinguish the transient elements from the bedrock and fundamental except through observation with clinical objectivity?"

So we can categorise common cognitive biases common to all human beings of whatever cultural background as parts of "human nature". The Milgram experiments and how people respond to authority have (as you say) remained constant over time and may also be constant across cultures - therefore they are part of human nature.

Any other behaviour, in groups or otherwise, that differs between cultures and over different times would be classed as "cultural factors."

So to return to your original point:

"The notion that "human nature" is settled, the same everywhere and unchanging is demonstrable nonsense."

Human nature IS the same everywhere and can be assumed to be fairly constant over historical time.

The example that comes to mind is the ultimatum game where people behave in an "economically irrational" way in response to perceived injustice:

http://en.wikipedia.org/wiki/Ultimatum_game

(see also Camerer, Thaler (1995) here http://irving.vassar.edu/faculty/sf/333/camererthaler1995.pdf).

The recent response of the media and politicians to banker's bonuses strikes me as the ultimatum game played out in a wider context.

Society as a whole is rejecting the perceived greed of CEOs and bankers, as we have evolved to punish greed even if we personally lose out in doing so.

But I guess it's fairly clear that there has been a divorce between talent and compensation in some areas.

[Bob B]

I'm seriously tempted to ask what, if any, manifestations of human behaviour would be incompatible with the proposition that human nature is settled, the same everywhere and unchanging?

Apparently, no observable human behaviour is incompatible with that proposition, not even inconsistent behaviour. Ah well !

This will present continuing problems as bankers as well as propective war criminals will both have the perfect defence.

Perhaps Edouard Balladur, the former French [Gaullist] prime minister - and one of those reviled ENARCs mentioned above - was on to something after all when he asked: "What is the market? It is the law of the jungle, the law of nature. And what is civilisation? It is the struggle against nature."
http://www.wired.com/wired/archive/3.05/culture.html

IMO this looks worth reading on what to do about the bonus culture of Wall Street - and much else to fix financial markets. The writer is CEO of Goldman Sachs.
http://www.ft.com/cms/s/0/0a0f1132-f600-11dd-a9ed-0000779fd2ac.html?nclick_check=1

[John Freeland]

reason:
Here's a link to a WSJ article called "A Short history of Wall Street Jail Sentences."

Fell on their swords on behalf of the firm, perhaps.

http://blogs.wsj.com/deals/2008/05/30/a-short-history-of-wall-street-jail-sentences/

[reason]

John Freeland
Anecdote is not data.

[Joe Otten]

Chris, I agree with your analysis. Or to put it another way, bosses are workers too - they just happen to have leverage that unions can only dream of.

Otoh, the little power unions have is of much the same kind - to demand a bribe not to wreck the company.

Poor shareholders.

[breitling watches]

This is just one idea, and perhaps displays no more than my limited imagination. If there are better ideas out there, that amount to more than "implement something called "market socialism" and then - alacazam! - full employment!" then I'd love to hear them. http://www.watchgy.com/ mostly bank deposits, fell by £143.2bn in Q1. And of course there’s no guarantee such buying will continue.
http://www.watchgy.com/tag-heuer-c-24.html
http://www.watchgy.com/rolex-submariner-c-8.html

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And in more competitive or contestable markets, a lazy manager can more easily send a company to the wall. With the costs of shirking so large, the bribe required to induce effort must also be large.

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Automated production lines, bar-coding in retailing, GPS systems that follow van drivers or recorded telephony in call centres all allow bosses to measure and control less “skilled” workers.

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