In defence of bonuses

Everyone’s moaning about “bonus culture.” So I will too. You know what the problem with “bonus culture” is? There ain’t enough of it.
Now, I’m not defending bankers’ multi-million bonuses - they were just legalized extortion. What I mean is that a bonus should be a larger part of ordinary workers’ salaries. I say so for four reasons:
1. The problem with fixed wages is that they generate unemployment in bad times. If a firm pays a fixed wage and suffers a fall in demand, the marginal product of some workers fall below the wage, and so the firm has to sack them. If, however, wages comprised a more variable element, demand shocks would lead to varying wages, but with more people keeping their jobs.
This point was made forcefully by Martin Weitzman and James Meade in the 1980s, though for some reason it never caught on. However, now we know that the psychological costs of unemployment are large (pdf), it’s time to revive interest in the idea.
2. Bonuses would allow firms to hire otherwise discriminated-against workers. Imagine two equally qualified 20-somethings, a man and a woman, apply for a job. The employer, fearing the woman will take maternity leave, hires the man. But what if the job comprises a lowish wage and variable bonus? Then, the risk of hiring her is partly shared with her - in the form of a lower wage. So our employer might be tempted to hire the woman, and if she doesn’t take maternity leave he can pay her a decent bonus.
3. There’s good evidence (pdf) that some forms (pdf) of profit-related pay can improve (pdf) productivity quite significantly. Bonuses can be effective incentives.
4. Bonuses can be a paternalistic way of encouraging savings. If people regard their base pay as normal, and bonuses as windfalls, they are likely to save at least some of the latter. This is what I did when I had a job with a big(ish) bonus element.
Now, there are two obvious objections here, both of which have easy solutions.
You might object that a mix of lower pay plus a bonus would merely be a way for employers to screw workers’ pay down.
But this can be solved by giving workers greater control of their workplace.
Or you might object that variable pay exposes more people to economic risks. This problem can be overcome by ensuring that people have an out-of-work income that helps smooth such fluctuations a little - such as a citizens’ income.

Comments

[ChalrieMcMenamin]

Why would bonuses be better for the workforce than agreed short-time working in times of downturn ? Surely, in most adverse trading situations, sharing out a smaller number of available hours would allow less risk to be transferred to the individual than routinely being uncertain of the size of a bonus?

Or is this just another of those 'I've-got-my-tongue-in-my-cheek-here' moments from you Chris?

[ChalrieMcMenamin]

Why would bonuses be better for the workforce than agreed short-time working in times of downturn ? Surely, in most adverse trading situations, sharing out a smaller number of available hours would allow less risk to be transferred to the individual than routinely being uncertain of the size of a bonus?

Or is this just another of those 'I've-got-my-tongue-in-my-cheek-here' moments from you Chris?

[Chris]

The problem with point 2 is that you implicitly assume that it is rational (and legal) for an employer to discrimate.

I think it works better for younger workers where there is more risk to hiring them (lemons problem) but when they gain more experiance that problem becomes smaller so the employer takes less risk

[Luis Enrique]

These are all good arguments - I think the most serious problem is the measurement of the performance for which bonuses would be paid. Not all jobs suffer from this problem to the same extent, so your proposals are probably more applicable to some jobs more than others, as I'm sure you know already. There's a large contract theory literature on this - I think the main result is that the less observable performance is, the lower is the optimal bonus, but there are also issue with team work. I have been trying to find a nice paper to link to, with a title something like "the stupidity of paying somebody to do X when you really want them to do Y" but I can't find it.

It's not obvious that employers would be able to use bonuses to screw down wages - you could make the argument that it could work in the other direction, and help workers bargain for a larger share of the gross value add.

[Steve]

Luis has it spot on. Nice idea in theory, works very well for some jobs, counter-productive for other jobs. First hand knowledge of this effect working for a very large global IT corporation.

for an alternative take on this
http://joelonsoftware.com/articles/fog0000000070.html

[chris]

Thanks for that link Steve, but it just corroborates a different point I've made before - that small incentives can be counter-productive.
I was vague about how bonuses should be calculated, and it's obvious that some types of bonus (such as those tied directly to precise individual targets?) can sometimes backfire. The right bonus structure will of course vary from firm to firm. But isn't it possible, in theory, that there might occassionally be a half-competent manager who might once in a while design a bonus scheme that isn't entirely half-assed?
@ Charlie - the virtue of bonuses is that they allow workers to share in the upside in good times.

[Dipper]

The furore over bonuses at RBS shows the government at its worst. The FX business has made large profits in a business with well marked prices and risk under one year. Yet the government seems intent on ensuring the staff will be paid less than the market rate for the job.

- the government is treating bonuses as though it is a trough which everyone sticks their snout in, not a performance for individual performance.

- presumably the government is prepared to wave goodbye to the FX business and other profitable businesses. Why have they not formally announced that this is their plan? Why is this in the taxpayers' best interest?

- most traders view their working career as a life on hold until they have enough money to follow their interests elsewhere. Without the opportunity of earning bonuses they will put considerably less effort into the job, and keep risk and hence profits down to a minimum.

[Ben]

I agree with all of your points, and certainly the structure of such a scheme would differ between different jobs. Though there are a few problems I see with this, other than those mentioned above:

How would said bonus schemes be applied? I can't see a way of preventing firms from setting unrealistic targets. Furthermore, how are the unemployed to distinguish between jobs with completely different pay structures? This would likely cause a fall in competition within the labour markets.

[CharlieMcMenamin]

Chris: no, bonuses are not how (most)workers share in the upside in the good times. Bonuses are about, for most people, making part of their basic (in the sense of 'relied upon') wage discretionary - or at least it is if the bonus is significant in relation to the 'core' wage.

In the good times workers can, perhaps, get higher wages or shorter hours or better benefits or all three. In the bad times - and hopefully only when the workers as well as the management have agreed that they are bad times - they can take short time working. This is better that a system of undependable bonuses. It's about how risk impacts on people with few resources. Magicking up a Citizen's Income to offset the personal risk involved in a generalised system of bonus payments is an advanced case of special pleading I'd say, even if I do support the concept on other grounds. ...

[ad]

"I was vague about how bonuses should be calculated"

If the firms motive is point 1) they could probably tie the bonus to the companies performance. Or simply announce a lower than usual bonus when the economy is doing badly.

I think the reason this is rare is fear of revengeful employees around the workplace. The firm need have no fear of revengeful ex-employees.

[Matthew]

I realise this piece is half-joking, but is there really an attack on bonuses per se? Or the specific examples of bonuses as in banking where they encourage excessive risk-taking due to their one-sidedness? Your points are valid, but they all point to not paying bank bonuses at this moment, which is the point I think people might (mistakenly) think you are making.

[Luke Lea]

I remember Weitzman's book, "The Share Economy." I once proposed (in my youth) something similar, and wrote a paper on it. The gist was that instead of paying workers (or managment for that matter) a set wage (or salary + bonus) you give them a share of the net product, defined as the difference between all their costs (except labor and salaries) and all their revenues. In other words, of the value added.

One nice thing about it would be that firms could reduce their prices in a downturn without having to bear the full brunt on their bottom line: wages and salaries would decline proportionately. Ergo, the price system would be much more flexible than it is today.

Of course I'm just an amateur, though Milton Friedman once said I was a good one!

[Phil]

The reason we don't do this is that most people wouldn't take jobs that have highly fluctuating salaries. People are naturally risk-averse, so a business would have to offer a higher average salary to get people to accept a job with the possibility of significant year-to-year salary changes. Especially low income people would be very vulnerable to these types of changes. Indeed, the jobs where you do see a lot of large bonuses, like in the financial sector, tend to be high-paying jobs.

[reason]

Phil
to channel Chris on this - citizens income! Part of the package.

[Keith]

I am sure you are all intelligent and well enough informed to know that the proposal to replace a large fraction of wages with 'bonus' is a charter to exploit. It would certainly result in poverty, aggression, mass bullying and crime - is that what you want? The reason we have fixed wages and employment law (!) is to protect, yes - protect workers from their bosses. This is self-evidently necessary and you are suggesting doing away with it. Have you thought this through? If yes, then I must conclude that you care only for the promotion of unbridled greed and its accompanying human misery. Happily, previous posts suggest otherwise.

[michael punzet story]

Von Raivo Pommer

Der Dax ist am Donnerstag etwas höher in den Handel gestartet. Der Leitindex notierte wenige Minuten nach der Eröffnung 0,4 Prozent im Plus bei 4222 Zählern. Vor allem Finanztitel lagen in der Anlegergunst vorn. Deutsche Bank, Commerzbank und Allianz tendierten knapp 2 Prozent fester.

In Reaktion auf die Vorlage von Geschäftszahlen für 2008 zogen MAN-Titel um 0,8 Prozent auf 33,15 Euro an. Der Lkw- und Maschinenbauer hat mit seinem operativen Gewinn die Analystenerwartungen weitestgehend erreicht. Der Ausblick für 2009 erscheine allerdings etwas zu optimistisch, schrieb DZ-Bank-Analyst Michael Punzet in einem Kommentar.

[Luis Enrique]

Keith,

Why do you think employers are less capable of exploiting workers when paying fixed wages, than they would be paying variable wages? Are workers getting paid piece rates known to fare worse than workers getting paid flat rates for similar jobs? Can't employment laws be written for variable pay regimes?

What sort of relationship between nominal wages, prices and the real wage are you assuming, when you talk about poverty? To borrow an argument out of a 1st year Macro text book, if the 'mark-up' (profit margin) is constant, then lower nominal wages mean lower prices, leaving the real wage unchanged. So if you think variable pay would see wages fall, a corresponding decline in prices would see real wages unchanged. Whatever view you take as to the extent to which competition between firms constrains profit margins, why would you think that the efficacy of competition between firms would be lessened by moving to variable pay?

[Keith]

Thanks for the questions, Luis.
First, I think employers are less capable of exploiting workers when paying fixed wages, than they would be paying variable wages because the employment law covering the first case is more complete and effective - I suppose that answer tends towards your second question, to which I want to say, yes, employment laws can be written for variable pay regimes, but they have not been yet and I don't expect them to be as robust (and not at all easy to make).

Your next questions indicate a difference in direction of thinking more than anything else. I was not considering such a naturally equilibriating model, just this - that employers will grasp the opportunity to reduce wages by denying people their bonuses and thereby *increase* their profit margins. You may think competition for labour will stop this, but I don't believe that a) since the transaction between employer and employee is far from symmetrical (employers are have far more negotiating power) and b) competition can easily be overcome by formation of cartels among employers - such a routine behaviour that a long line of labour activists have spent their lives enshrining resistance to it in the law. In other words, employers are greedy, the market is insufficient to balance this with employees interests, so we have to rely on the law, which is not ready for the change suggested. That's my thinking, anyway.

[Investors times]

Bonus even though it seems imoral is the best way to improve productivity. While we the tax payers may see it as unacceptable we ourselves would not work at our best with a measly pay. May be we should just have to accept the fact that these people deserve a bonus even though we may not agree with it. After all these are highly qualifies people have can have better pay elsewhere. With all our moralising we may not be half as good as them to do their job. So quit the whining about bonuses.

[Bob B]

Could it be that the real problem with RBS and HBOS was not the bonuses paid to executives for making high-risk deals after all?

"Scotland is in the grip of a health crisis after research revealed that more than half of men and 30% of women drink to excess."
http://www.guardian.co.uk/society/2009/feb/22/scotland-alcohol-crisis

The head offices of both RBS and HBOS are in Edinburgh.

[depfa]

Raivo Pommer
[email protected]

Depfa Bank Krise

Es handelt sich dabei um eine nachrangige Anleihe über 500 Millionen Euro. Die für den 21. März geplante Zinszahlung falle nach einem Beschluss des Verwaltungsrats der Depfa aus.

Eine Entscheidung zu ähnlichen Papieren der Depfa stehe noch aus. "Diese Nachricht könnte das Vertrauen in das Marktsegment erschüttern", kommentierten Anleihenhändler.

"Das ist ein politisches Debakel", sagte Bankenprofessor Klaus Fleischer von der Fachhochschule München. Schließlich seien die Garantien und Hilfen des staatlichen Rettungsfonds Soffin in Höhe von mehr als 102 Milliarden Euro in die HRE-Gruppe geflossen, "um Schaden vom Kapitalmarkt abzuwenden".

Nach Angaben der HRE hat die Bankengruppe vier Nachranganleihen im Volumen von insgesamt 1,55 Milliarden Euro ausstehen. Zinstermine sind im März, im Juni und im Oktober. Der Analysedienst Dealogic gibt den Gesamtmarkt vergleichbarer Nachranganleihen in Europa mit 300 Milliarden Euro an.

[Worldwide Distribution]

Why would bonuses be better for the workforce than agreed short-time working in times of downturn ? Surely, in most adverse trading situations, sharing out a smaller number of available hours would allow less risk to be transferred to the individual than routinely being uncertain of the size of a bonus?

Or is this just another of those 'I've-got-my-tongue-in-my-cheek-here' moments from you Chris?

[Richard]

Attempting to clap down on a "bonus culture" is a big mistake. A good bonus system rewards people for creating value.

A bad bonus system is one that rewards people for failure. Some banker's bonuses merit criticism because they rewarded profit that were contingent on continued easy money. If, instead, booked profits had been correctly discounted to reflect systemic risk, the bonuses themselves would have been considerably lower. Another way of saying the same thing is to say that bank's weighted average cost of capital was applied in computing profits - they should in theory and in practice have applied a CoC reflecting the risk of each project, transaction and investment. The booked profits would then have been considerably lower, leading to lower bonuses.

It's farcical, on the other hand, to attack the bonuses of traders in bank divisions that have remained, and continue to be, profitable throughout the downturn. Some business divisions have made profits that have supported their group balance sheets, and without which they would have needed even more taxpayer support. Their continued profitability, as well as paying tax, increases the value of bank assets that we collectively own. Damn right those people can be rewarded, and I hope they stay in the country.

[patek philippe 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