On legacy ideas

“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.

Comments

[nick ford]

I believe an interesting legacy policy is the issuing of long dated government bonds. Governments act as if they were companies when they do this, as if there are circumstances in which they would be unable to meet their obligations.
This is a legacy of previous currency arrangements, such as the Gold Standard or Bretton Woods. However, when the currency is freely floating, and issued by its own central bank, the government can always meet its obligations. If the UK government only issued short term debt it could save itself billions over the cycle.
You don't have to believe in the rest of Bill Murray's more dubious assertions (give everyone a job picking up litter, print an infinite amount of money) to see this is true.
Bob is on holiday on the beach in Zimbabwe, so I think I can safely post this today.

[Phil]

Daniel Davies wrote an interesting piece explaining bonuses a bit back, but he lost me when (in subsequent discussion) he talked about bonuses being needed to motivate people whose entry-level salaries had been screwed down to the bare minimum, and it then turned out the bare minimum was £50K. I pointed out that as a time-served academic I was two competitive promotions away from £50K (and will in fact be lucky to be on that kind of money by the time I retire), with nary a bonus in sight. Then the conversation got diverted onto academics being underpaid and London weighting and stuff, and we never got any further with bonuses. But I like your explanation better.

[An Alien Visitor]

The problem with banking is that no 'decent' person would ever want to work in one. It is on a par with joining ISIS.

In order to get decent people into such an unreputable and undignified business they obviously feel they have to pay way way over the odds.

[Luke]

"I'm old enough to have worked in one, and some of the partners were quite scary."

I've spent most of my working life employed by partnerships. It's pretty much a requirement of being a partner that you should not just be "quite scary", but absolutely terrifying. I have no views on whether that's a good thing. Just saying.

[nick ford]

An alien visitor may have stumbled and mumbled onto the solution to the problems in Syria. Offer the jihadis jobs in the financial services industry, with the opportunity to trade in financial weapons of mass destruction. On large bonuses that lock them until the conflict is over.

[chris]

@ Phil - ta. One point where Dan might be right is that there's vast variation in salaries, based on negotiating ability when joining the bank, and bonuses can be a way of rectifying these - levelling out the pay of the guy who's not the "star" you thought he was and the lower-paid one who turns out to be good.

[Nicholas Shaxson]

Yes to most of this, but one thing:

"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."

Not so.

1. Why is it an either/or situation? Tax both.
2. Profits can be taxed in a globalised world. E.g. via unitary tax / formulary apportionment system for corporate income taxes.
3. Stop taxing profits, and clever people will soon turn their "income" into profits. whole tax system becomes suppressed.
4. Lots more here: ten reasons to defend the corporate income tax.
http://www.taxjustice.net/2015/03/18/new-report-ten-reasons-to-defend-the-corporate-income-tax/
5. The Land Value Tax campaign, in my opinion, is done a great disservice by those (whom most people would regard as fanatics, and extremists) who advocate LVT as the only tax, replacing all others. LVT should be part of a comprehensive tax system.

[Nicholas Shaxson]

'suppressed' should've read 'compressed'