Knowing and Making

I intended to mention this little tussle between Felix Salmon and John Carney a couple of weeks ago. As it happens, it's provoked an idea on a solution to the eternal problem of bankers' pay. Carney points out that we don't actually want traders to take the minimum possible risk in all circumstances. If they did, they would never make any returns at all. Instead, we want them to take the right level of risk...at the scale of the whole economy, this is the socially optimal level; at the scale of an individual company, it's the optimal level of risk for shareholder value. He says that without guaranteed bonuses, traders will take less risk than shareholders want them to, because they will need to retain some amount of guaranteed upside to pay their mortgages. Felix's argument against this is interesting, because he doesn't quibble with the theory. As various people have pointed out, because shareholders have limited liability, they have an incentive to get th...

Robert Peston reveals a report by MPs on bankers' bonuses. Of course they are calling for reform. But what should that reform look like? Here are a couple of odd things about such bonuses: Behavioural economic theory indicates that it's not so much the absolute amount of money that acts as the reward, but the relative amount - if I get £5m to your £3m, it's just the same as me getting £500k and you £300k. The 'reward' seems to be the ego boost of being at the top of the tree. But unfortunately it's also not the amount of money that has led to the risk-taking behaviour. Even if banks had only paid their employees 1/10 of the bonuses, they would still have acted the same way. So how to change behaviour, if that's what we want to do? Certainly tying bonuses to long-term results instead of short-term is one option. But for motivational purposes, people should still receive performance bonuses relatively quickly, as this is how their mental association between a...

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...