Government interference, unintended consequences, and Wall Street bonuses

World leaders are now gnashing their teeth over bank bonuses, and discussing ways of getting involved in dictating compensation at banks and other firms.

This story, which aired on NPR yesterday, seems to think that would be a good idea.

Making a parallel with professional basketball and players whose compensation may be tied to their individual scoring statistics, the announcer declares, "A selfish basketball player can cost his team a shot at the playoffs; but bankers who play for themselves can put the whole economy at risk."

The outrage centers over the heavy use of enormous bonuses in the compensation of those who work at banks, particularly at Wall Street investment banks. As one member of the Institute of International Finance said on the NPR broadcast, "Banks' profits were illusory, but the bonuses were real."

At yesterday's G20 confab, President Obama said he wanted to use the government to change compensation structures "so that executives are compensated for sound risk management and rewarded for growth measured over years, not just days or weeks."

Far be it from us to defend Wall Street bonuses: we have written before in criticism of the short-term mentality at Wall Street firms which allowed the pursuit of short-term profits (and the short-term cash bonuses associated with short-term profits) to sacrifice the long-term good of their shareholders. Our opinion is firmly with those who believe that Wall Street ruined itself and caused significant collateral damage with its profligate bonuses.

However, with all this high-level criticism of these bonuses among politicians and the media, a very important fact is being deliberately ignored -- the role that government interference played in creating this infamous bonus structure in the first place.

This insightful article published in Forbes on February 04 of this year explains how 1990s agitation against large salaries for executives led to severe limits on how much executive salary could be deducted for tax purposes.

Normally, a company pays taxes on what it earns -- after it pays its employees and other expenses. But IRS revenue code rule 162(m) said that publicly-traded companies could only deduct $1 million of the salary paid to each of the top five executives at the firm. If a firm payed the CEO $2 million in annual salary, then it would be taxed on the second million dollars as if those dollars had gone through to the bottom line instead of payed out as a cost of doing business.

Note that this interference is analogous to the government telling you how much you are allowed to spend on your children's birthday presents. It is really outside of the boundaries of government to be dictating what citizens do with money that they earned in the private sector.

Additionally, unlike birthday presents that private citizens choose to buy for their children, salaries that businesses pay to their executives are not given in order to be generous: they are given in order to obtain the kind of talent they feel is necessary in order to obtain profits in the extremely competitive and complicated corporate world, where other firms are actively trying to put their competitors out of business.

As Professor Emeritus of Economics for Pepperdine University George Reisman has noted, if you needed brain surgery someday, you would want your surgeon to be the best one that money could buy. From the perspective of a corporation, including a Wall Street firm, their executive is as critical as a brain surgeon. The success or failure of their business in the competitive arena has a huge impact on their lives and the lives of every single employee and shareholder at those firms.

Predictably, the attempt to tell companies how much they could pay did not actually lead to a freezing of executive salaries, as the Forbes story explains, but rather to an increase in the use of other forms of compensation for critical executives, including stock option grants and the now-infamous bonuses.

In other words, the social engineering intended by the legislators only led to consequences that they did not foresee. As the article explains, the increase in stock option use may also have led to a general decrease in dividends by companies that use stock options as compensation -- yet another unintended consequence lost on the legislators who enacted the limits in the first place. Additionally, as the NPR radio program correctly points out (and as we pointed out last year), the use of cash bonuses may also have played a role in creating incentives for short-term behavior that was detrimental to the long-term health of those firms.

It is extremely important that people understand the role that government meddling (in areas of private economic activity in which it had no business meddling) played in creating these unintended consequences.

The news media is completely ignoring this enormous story. Similarly, politicians are not rushing to the microphones to admit the blame that their own political legislation played in creating the bonus structure that has infuriated people around the world.

Because this link is not understood, we now face the prospect of even more government interference, which is what caused the problem in the first place! As we have written before, "economic ignorance hurts."

For later posts related to this same subject, see also:

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