Knowing and Making

What issue has such purchase on the public imagination that it - at least in the UK - just keeps coming back, again and again, as people's top concern about the financial crisis and the recession? Of course, it's the bonuses paid to bank employees . The psychology of this conversation is revealing. Nobody really notices if RBS makes £6 billion in profits. But when one RBS employee gets a $10 million bonus - that's about 1/1000th of the amount - suddenly it's a big deal. We can relate much better to (relatively) small numbers with people attached to them than we do to huge figures. Clearly the government has a political problem: it doesn't want to be seen to be allowing high bonuses to be paid when the public has paid for the banks to be rescued. But it also has a commercial problem: the rescue is a sunk cost, and the bonuses are part of the bank's strategy to incentivise  future  behaviour. If RBS doesn't pay any bonuses, perhaps their top people wil...

Oddly enough, given Robert Peston's latest post , I met some people from RBS today. They seemed to have a decent understanding of, and commitment to, their job. I imagine they were - as Peston suggests - completely uninvolved in any of the high-risk decisions that put the bank's capital at risk. Having said that, they have no doubt benefited along with the rest of the staff when the bank was profitable for the last few years. But no matter - the proper economic reason for a bonus is not primarily to reward past performance but to incentivise future performance. The reason it's typically calculated on past performance is to reinforce the notion (from game theory) that sequential games are linked; to create an ongoing narrative of one event flowing from another, credibly tying together present-self and future-self so that people invest today's time and effort for tomorrow's reward. This is how the interests of employees and owners are aligned. If this is made explicit...