Passion is always the enemy of reason. This is true in politics as in everything else, and helps to explain why we have all got so excited about cracking down on bankers’ bonuses. “Wait a second,” I hear you say: “Bonuses paid out to greedy City boys fuelled the boom and bust and should therefore be capped, right?” That, after all, is the new consensus in Westminster and a view that resonates with a public thirsty for revenge.
Yet the trouble with all received wisdom is that it tends to be wrong — and it is no different in this case. There is very little rigorous academic evidence (as opposed to glib assertions by regulators or commentators) examining whether CEO pay helped exacerbate the crisis. But the little that exists suggests that bonuses and stock options played no role in the crisis. If you don’t believe me, take a look at a new paper by Rene Stulz and Rüdiger Fahlenbrach, both dispassionate economists with no axe to grind.
Their findings — based on a forensic, scientific examination of the performance of banks — demolish the claim that badly-designed or excessive bonuses made banks focus too much on the short-term and take exaggerated risks. They reveal that it didn’t really matter what banks’ pay structure was. Whether bonuses were low or high made no difference to their firms’ performance or to the degree of risk-taking they chose to engage in.
Their conclusion: bank CEOs misjudged the state of the world and made stupid mistakes. They would have failed whether or not the bonus and stock option system was in place. If CEOs had taken risks they knew were excessive, they would have sold shares ahead of the crisis. This did not happen.
In fact, CEOs increased their stakes and options in their banks in the run-up to disaster and were subsequently hammered. On average, the research reveals that bank CEOs personally lost $30m each in 2008.
Don’t get me wrong: I don’t feel sorry for failed CEOs. They made devastating errors. But the underlying cause of their madness was excessively loose monetary policy, idiotic international rules and a series of misconceptions, shared by the entire global establishment, about the way the economy works. Virtually everybody thought you could abolish risk by using complex derivatives and mathematical models. Most people were convinced US house prices would never fall. Regulators encouraged banks to reduce reserves to a bare minimum. All of this turned out to be dangerous nonsense.
There are plenty of important lessons to be learnt from this crisis. We must reform our economies and financial system to avoid another bubble. But we shouldn’t obsess with bonuses: banker-bashing makes good politics but useless economics.