Posts filed under “Wages & Income”
Originally published December 4th, 2008,
Our different views prove that hindsight is often myopic. Larry White’s take is that Clintonian regulations perverted private incentives.
The boom and bust happened in a system with … extensive legal restrictions on financial intermediation. Nor have we had banking and financial deregulation since … 1999.
(One can’t explain an unusual cluster of errors by citing greed, which is always around, just as one can’t explain a cluster of airplane crashes by citing gravity. Anyway, the greedy aim at profits, not losses.) [T]o explain industry-wide errors we need to identify policy distortions capable of having industry-wide effects. The actual causes of our financial troubles were unusual monetary policy moves and novel federal regulatory interventions. Regulatory distortions intensified in the 1990s.
Perverse Compensation Systems are the Key
I disagree with Larry’s theses, but have space to demonstrate only an alternative perverse incentive. What went wrong is that modern compensation systems did not “align” interests, but rather created perverse incentives to engage in accounting “control fraud,” where the CEO uses an apparently legitimate firm as a “weapon” to defraud creditors and shareholders.  No regulation forced any lender to make a bad loan. Larry misses the key dynamic: “The greedy” do not “aim at profits, not losses” when compensation schemes are perverse. They maximize short-term accounting “profits” in order to increase their wealth. Making bad loans, growing rapidly, and extreme leverage maximize “profits.” Bad borrowers agree to pay more and it is impossible to grow rapidly via high quality lending. Lending to the uncreditworthy requires the CEO to suborn controls, maximizing “adverse selection.” This produced an “epidemic” of mortgage fraud, particularly in the unregulated nonprime sector. The FBI began warning in September 2004 about the mortgage fraud “epidemic.”  Fraudulent loans cause huge direct losses, but the epidemic also hyper-inflated and extended the housing bubble, and eviscerated trust, causing catastrophic indirect losses. When we do not regulate or supervise financial markets we, de facto, decriminalize control fraud. The regulators are the cops on the beat against control fraud—and control fraud causes greater financial losses than all other forms of property crime combined.
The most relevant economic works for understanding these crises are by Akerlof and Romer, Galbraith, and Minsky. Akerlof and Romer explain why “looting” (control fraud) can occur and the fraudulent steps looters take to optimize short-term accounting profits (which destroy the firm).  Note that they are writing about a form of a “market for lemons” in which the CEO maximizes information asymmetry. The failure of economists discussing the ongoing crises to cite the work of a Nobel laureate writing in the core of his expertise demonstrates why we have failed to learn the proper lessons from prior financial crises. James Galbraith extends Akerlof and Romer’s analysis to show why the state aids fellow control frauds.  Minsky describes the “Ponzi” phase of a crisis and why financial instability reoccurs. 
Modern executive compensation systems suborn internal controls. (Control frauds do not “defeat” controls—they turn them into oxymoronic allies.) The Business Roundtable’s spokesman, Franklin Raines, Fannie Mae’s former CEO, explained in a Business Week interview what caused the epidemic of accounting control fraud that became public in 2001 with Enron’s failure.
> The Bloomberg chart above compares year-to-year percentage changes in labor costs and consumer prices – from 1950 to present, for the past six decades (data source: Labor Department). These indicators had a high correlation — 0.82 during the period — according to Brian Belski, chief investment strategist for Oppenheimer & Co. Labor costs have…Read More
The Finance sector is back to record revenue, and of course, record bonuses and pay. I was surprised to see how much greater the Commercial Bank revenue and comp was versus Wall Street totals. When you think about it, they have many more assets, transactions and commercial activity than Wall Street does, so it makes…Read More
A report prepared by the Regional Plan Association confirms that local house prices on Long Island are increasingly elevated relative to incomes. And, residents are nervous about what this means for them: Long Islanders are ever more anxious about how they can maintain their lifestyle, the report found. An affordable home — defined as costing…Read More
A pair of fascinating NYT/Census/Google map mash ups from the NYT this morning. Using US Census data, they look at a variety of data points: Race & Ethnicity, Income, Housing and Families, Education. Click the link, then select View More Maps, choose topic: click for full interactive versions > Median Household Income Change in Median…Read More
Have a quick look at yesterday’s post: Wedbush: Cheap as a Fox. There was a robust discussion in comments — and the general take that resonated with me was summed up thusly: Being judicious about expenses is one thing, but being ultra cheap can be counter-productive and myopic when you figure in the opportunity costs….Read More
Back in October, a friend at Merrill told me about an arbitration award that could rock Bank of America. It was circulating via email from desk to desk, and was causing some consternation amongst the troops. It seemed that two former Merrill Lynch brokers had bolted for Morgan Stanley after the Bank of America acquisition…Read More
Want to pull down the big bucks? Floyd Norris advises you to get a job on the street of dreams: “Wall Street incomes are surging back. The government reported this week that the real wage and salary income of finance industry employees based in Manhattan rose nearly 20 percent in the first quarter of this…Read More
Category: Wages & Income
We interrupt the George Bush reputation rehabilitation tour for this brief reminder: “For most of the past 70 years, the U.S. economy has grown at a steady clip, generating perpetually higher incomes and wealth for American households. But since 2000, the story is starkly different. The past decade was the worst for the U.S. economy…Read More