Should We Cap Bankers' Bonuses?

George Osborne’s move to reject the bonus cap proposal is a brave one. Brave but correct. He will receive a lot of stick from a banker-bashing electorate, but by not succumbing to public pressure, he has voted with the UK’s best interest at heart. A banker bonus cap is purely political. Whilst it would win a lot of public approval, it would severely damage the UK in the short, medium and long run. The only problem is that that UK is isolated. Out-voted 26-to-1, a bonus cap is almost a formality unless Osborne can gain some allies before the vote in April.

The bonus cap proposal is a result of the European parliament trying to assert some authority as we move one step closer to a banking union. The idea is to cap banker bonuses at 100% of base salary or 200% if shareholders agree. It is perhaps quite convenient that the news of a bonus cap was quickly followed by RBS’s announcement of a £607m bonus pool despite £5.2bn losses. Is it fair that a bank, which is 81% owned by the taxpayer, should reward their staff handsomely for a 400% increase in losses?

Most of the EU says absolutely not, hence the proposal’s overwhelming support. The UK however, whose financial sector makes up 10% of its GDP and is the biggest hub within Europe, can see past the political support to the catastrophic unintended consequences that will result. So much so that the UK is even considering the ‘Luxembourg compromise’ from EU law, which allows a member state to block a majority decision if it is against national interest.

Why cap bonuses?

A common mistake is to think that a bonus cap is about fairness and equality. Many would argue that obscene banker bonuses need capping simply because they are unfair or need to be brought down in line with the rest of the economy. This is simply not the case. Nations have voting, taxation and redistribution at their disposal to alter income inequality and to determine how rich the rich can be. If the reason were purely political then this is an entirely different ‘Hayek vs Marx’ debate. Neo-Keynesian economics and capitalism urge the state not to intervene in competitive markets unless there is a market failure, especially with a draconian policy such as a salary cap.

The reason for the cap proposal is because there was a market failure. One of the reasons for the financial crisis was too much risk-taking. As explained before, it is the state’s role in a capitalist society to step in to correct market failures. In this case, to prevent future recessions. The idea is that extreme bonuses, many multiples of a base salary, lead to a short-termism that encourages banks and employees to take on too much risk. CEOs have very short life spans and bonuses distort their incentives. It is thought that this short-term outlook and the search for better returns at the expense of higher risk was a key factor in the collapse of the financial sector.

So the argument follows that capping bonuses would reverse these incentives, create longer-term goals and reduce risk-taking. There is also the accountability argument that links back to RBS. Bonuses are paid out even though the company is mostly state-owned and has performed poorly. In this case, it seems sensible that the shareholders should be able to prevent extreme bonuses. Until the bank is returned to private hands or to profitability, there is an argument to say that bonuses are simply not morally acceptable.

These arguments are fair. I do believe that bonuses are extreme and sometimes ironically unjust. But a bonus cap is still a bad idea….

Avoid a Cap

Vehemently opposing a bonus cap is the only option the UK has. A bonus cap should only be introduced if it makes the residents of the UK economy better off. If your arguing it should be done because it involves some sense of retribution or punishment towards banks then you’re a biting your nose off to spite your face. The reason being that a cap will make the UK economy worse off and no more protected from a financial crisis. (Also while we are at it, we should probably be punishing the regulators, state, rating agencies and indebted consumers).

The reason for too much risk-taking in the financial services industry is because banks are “too big too fail.” The security of a bailout leads to a moral hazard that encourages too much risk-taking. The bonuses in itself are not enough to create a risk culture and are in fact a result of and not a cause of the moral hazard. 

The lead up to the financial crisis was a period of low interest rates and a savings glut. In the search for better returns, banks looked for new ideas. Securitisation was one of them. Securitisation on its own is not a bad thing. In fact it allows companies to reduce and hedge risk. However, this new invention was coupled with two other factors. The first is a dangerous lack of knowledge of the products being created from governments, consumers and even banks. The second is the protection of a bailout. This lead to excessive risk-taking without any true understanding of what was happening until ex-post. The point is that the risk-taking in the financial sector is not originating from high bonuses. High bonuses are just another result of moral hazard.

In fact, banks pay high bonuses in order to stay competitive and attract the best talent. After all, the firm’s capital is their staff’s ability. Whether you like it or not, this is the culture of the industry. Unless a bonus cap is global, it will be hugely detrimental to the UK.

Here is what it will do... It will drive away talent in something called a brain drain. Over time, new financial hubs will flourish such as Singapore, Hong-Kong, China and the US. As the best talent moves away from London, the EU banking sector will lose competitiveness and restrict EU growth. Are we really considering damaging our true comparative advantage? We will be simply handing our competitors the golden snitch.

The only way UK firms would be able to keep their staff is by enlarging base salaries many times over (allowing for bigger nominal bonuses in turn). This is what happened with RBS. Restricted by the taxpayer, a graduate joining RBS could earn up to £60K, much more than the going rate at bulge bracket firms. So bonuses may not even reduce the amount a banker will be paid. In fact, bankers will go home at yearend with the same six-figure salary but with fewer incentives to do well. With pay a lot less related to performance, you divert incentives in the complete opposite direction. Bonuses also allow for flexibility which large base salaries do not. We have to remember that banks are in the business of risk management. We do not completely want to strip banks of the incentive to search for risk and return. It is this search for risk that allows banks to loan to small and medium-sized companies.

Here is another key factor. Even if bonuses do encourage risk-taking, we are not immune to financial meltdowns from outside of Europe as proved by this recession. If banks paying large bonuses outside the EU cause excessive risk-taking and a global meltdown then that will hit the UK. The world is far too globalised to believe that individual trading blocs alone can prevent a global recession.

What should be done instead?

What needs to be done is to align the incentives of bankers and the general economy. This can be done through regulation. We need to remove the moral hazard of a ‘too big to fail’ mentality. This involves installing a set of rules that mean banks can cover their losses and will find it hard to take on enough risk in the first place.

This is already happening. Basel III is the new regulatory framework that has come down from the G20 (a global level). It is currently being implemented in the EU. It involves increasing Tier 1 capital level, improving liquidity and leverage. It has banned proprietary trading (Volcker rule) and has proposed to ring-fence retails arms. Whilst I believe the regulation may have gone too far, this is the sort of regulation that will make banks robust enough to cover the losses of a recession or prevent it in the first place.

If the EU cannot overcome the urge to alter salaries within the industry, then there are methods other than a damaging salary cap. For example, the remuneration code in the UK ensures banks must pay at least 50% of bonuses in shares (or options), which creates a longer-term employee view. It mandates that 40-60% of bonuses must be deferred for 3-5 years and also allows banks to legally claw back bonuses preventing future negligence and inducing accountability.

These rules and the Basel III regulation will prevent risk-taking over the new few years, perhaps even by too much. Robust banks are less likely to fail and capital buffers mean banks will absorb a lot more of the losses. The legislation is already in place and being processed. An additional bonus cap is purely political. It will damage the UK economy, restrict growth and make everybody worse off.

In a period where the UK is desperately looking for growth, let’s not implement rules that will push talent away and destroy our comparative advantage.

Spend Your Way out of Debt

Moody’s downgraded the UK’s credit rating one notch from AAA to Aa1 on 23 February.  This can now be added to the long list of sovereign downgrades made by the major credit rating agencies since the start of the recession (which includes the US). This decision mainly stems from a combination of rapidly growing public debt and a poor growth outlook. UK Debt stood at 70.7% of GDP at 31 December 2012, which is equal to £1,111bn. The threshold level for countries entering the Eurozone is 60%.

George Osborne has pledged to use austerity measures to curb the national debt. I will argue that austerity is not the answer. Growth is an automatic stabiliser. The best way to reduce debt within the UK is to spend our way into growth and then consolidate.

Who cares about the Debt?

Why does reducing national debt actually matter at all? The main reason revolves around investor confidence. If investors fear that the UK may not be able to meet their debt repayments, they will demand higher interest rates on UK gilts. This leads to a vicious cycle whereby an increase in interest rates (larger interest payments) increases the national debt thus further increasing interest rates required by investors and so on. If not careful, debt can rise exponentially in an explosive fashion. A high debt therefore leads to a risk of a fiscal crisis and makes conducting fiscal policy very difficult.

What really matters?

The key point to remember is that the raw debt figure is not the important statistic. More important is the ratio of debt to GDP. This tells us whether a government can afford its debt. In others words, we want to know whether national debt is rising too fast relative to the economy’s ability to repay it. This ratio fundamentally depends on the growth rate and the real interest rate. If growth exceeds the real interest rate then, the Debt to GDP ratio can decrease (even with a small budget deficit).

My argument that we should spend our way out of debt revolves around the concept of an “automatic stabiliser”. This is a logical concept. When a country goes into a recession, the budget deficit automatically increases. As unemployment increases, tax receipts falls and government expenditure increases to meet larger welfare demands. Conversely, in a boom period, budget deficits automatically fall. The rule of thumb is that a 1% decrease in output leads to an automatic increase in the deficit by 0.5% of GDP.

Fiscal policy is an important policy and vital to governments experiencing a recession. However it must be used correctly. A cyclically adjusted deficit (CAD) is the annual deficit, adjusted to remove the effect of the “automatic stabiliser” I just described. Over the medium-term we want our CAD to equal zero to maintain a non-increasing debt level. In order to do this and prevent an explosion of debt, a government must run surpluses in a boom and deficits in a bust. In fact, a government can even run a cyclically adjusted deficit in a recession as long as it runs the opposite in periods of high growth. By running a deficit now (spending more than is received), we will certainly increase our debt stock further. However, expansionary fiscal policy can help create growth and growth automatically decreases a deficit. The time to run a surplus is when the economy returns to sustainable growth. 

The problem with trying to run a surplus now is simple. A surplus will NOT reduce our debt to GDP ratio (our important statistic). Austerity decreases an already negative growth rate. The effect of a decrease in growth far outweighs what would be a small (if possible) budget surplus, decreasing our ability to pay our debt and pushing us into a downward spiral.

The NICE decade and Labour’s Moral Hazard

NICE stands for non-inflationary consistent expansion. It relates to the period of high growth, over a decade, prior to the financial crisis. As explained above, in a period of high growth, the government must attempt to run budget surpluses to maintain a constant debt level in the long run whilst allowing for deficits in a bust. Labour was in power from 1997 to 2009. Of the 13 years in power, Labour only ran four budget surpluses (1998 to 2001). More importantly, in real terms, the largest surplus in this period was less than the smallest deficit. Up until 2007, before the first signs of the financial crisis, the Labour government should have done more to curb an increasing debt level. This would have allowed future governments to use expansionary fiscal policy in a downturn without a long run effect on debt.

There is a problem with moral hazard here. No party will choose to run consistent (large) budget surpluses.  Government terms are too short to reap the benefits of being financially astute in the good times. In others word, Labour had no incentive to fix the roof while the sun was shining. The budget should follow the business cycle. Labour certainly did follow this rule and reduce deficits from previous years. The mistake was running deficits in the early noughties.

What’s the solution?

There is a harsh reality in the solution. If we use austerity measures to decrease our debt now, growth will fall leading to lower tax receipts and larger welfare spending. The ability to repay our debt will spiral off into the distance.

However, if we push further and continue to use expansionary fiscal and monetary policy along with quantitative easing, debt will obviously rise but so will growth. Growth leads to an automatic stabiliser. As people move into employment, government expenditure falls and tax receipts increase. The government can finally afford to reign in spending. Only then should the state attempt to run a surplus. More importantly, the state must then run a surplus, many surpluses.

The harsh reality is that eventually taxes will increase and spending will have to be reduced. Then the debate ensues as to whether is it fair that future generations must bear the cost of the recession. It’s not fair but that is the nature of the business cycle that Gordon Brown infamously claimed his party had defeated. The same generation that pays the higher taxes will be enjoying a period of growth. When the next recession comes and it will, future generations after that will bear the cost. The point is, you bear the cost of a recession after the recession.  Given the negative growth outlook and the fourth quarter contraction, we are by no means out of a bust.

Is this credible?

It seems like quite a simple thing to say. Let’s just spend more until we can afford not to. It sounds irresponsible at best. But do not let the wrong statistics sway your decision. The question isn’t whether we should wait for austerity; it is whether we are able to do so. The answer is yes. Our debt is high, but not historically high. In the 1940s, our debt was over 200%! Japan currently has a debt stock of 225% and Italy well over 100%.

The UK is not Greece. We can afford to run high deficits and still borrow long-term, just like the US. The pound is still the third most widely used reserve currency. The UK is still among the highly rated sovereigns.

You only need to look at government bonds to see this. Low interest rates reflect investor confidence. Even though our credit rating was reduced a notch, our 10 year government bond yields 2.2%. This is an increase but compared to Greece (11.07%), or Kenya (13.5%), not one that should scare the government. The US bonds stand at 1.94% and Euro Area at 1.48% at the time of writing and both have experienced downgrades.

UK and US debt is still widely accepted as safe. It will take a lot more debt and quite a few more downgrades for investors to start dumping the pound.

Given the UK’s ability to borrow long-term, the best way out of debt is to spend your way out.

Horse Meat, Tax Avoidance and Credit Ratings: Where’s the Regulation?

Economics is all about incentives. Like it or not, free market capitalism revolves around profit (and utility) maximisation.  Embedded in any conventional economics is the market selection hypothesis that any firm whose main goal is not to maximise profits will disappear in the long run (a natural selection of business if you like).

In reality, first best conditions are rarely satisfied leading to market failure, which quickly turns into government failure if the state fails to intervene. I am big believer of a mixed Keynesian government role where the state intervenes in the free market in the presence of such failures. Without the economic jargon, this simply means: if an economy is concerned with key indicators such as fairness, equity and consumer interests then free markets must be propped up by significant and effective regulation.

Yet scandal after scandal emerges from banking to supermarkets. Governments can use such scandals as ammunition in attaining public approval. It is easy for David Cameron to demand Starbucks pay some tax ex-post and demand better regulation of the financial services industry after a financial crisis. Until more of the blame falls on the state in these situations, very little will be done to resurrect a poor regulatory system in many sectors.

I intend on looking at three examples of government failure, all with slightly different twists.

1)   Horse Meat: Incompetence

12 countries have now started DNA testing on high street meat products after horse DNA has been found in numerous frozen beef meals.  With 100% horsemeat found in Aldi and Findus products and 60% horsemeat found in the Tesco Everyday Value Spaghetti, there has quite rightly been public outrage. It is not that horsemeat is dangerous to eat but the fact that the consumer should have the choice over what he or she decides to consume. Supermarkets have a legal responsibility to correctly label the ingredients of their goods.

Most retailers claim that they did not know about the horsemeat. Fine. In fact, probably true. But by no means is this a sufficient excuse given their legal responsibility. So, of course, the consumer is perfectly within his rights to show some indignation towards the supermarkets. However, can we please reserve some of the blame for the regulators? After all, supermarkets are profit maximisers, hence their ongoing existence. They compete fiercely over prices and large scale testing of their products can be very expensive. Supermarkets enter into a prisoner’s dilemma whereby all firms testing would be the most efficient outcome (at the expense of higher prices). However, due to lack of regulation, not testing is a dominant strategy and the only Nash equilibrium. In other words, supermarkets blindly trust their suppliers’ goods in order to stay competitive.

It is only due to poor regulation by the Food Standards Agency (FSA) that supermarkets are even allowed to make this choice. Yes, the FSA are responsible for this epidemic just as much, if not more so, than the retailers. Externalities such as horsemeat are a nasty consequence of unregulated free market economics.

In this case, the government failure is simple. Incompetence. The FSA is responsible for food safety and hygiene. However, if the government wants a thoroughly regulated food industry, then the scale of regulation here needs to be enlarged many times over. Perhaps naivety that meat suppliers would keep a moral code instead of profit maximizing is the source of this incompetence. But any first year economics student can tell you that morality has no place in profit maximisation.

2) Tax Avoidance: Hypocrisy

Starbucks have now bowed to public pressure and agreed to pay £20m in tax to the UK over the next two years after paying no tax on UK sales of £398m previously. The media has blasted Starbuck, Google and Amazon for immoral tax avoidance leading to consumer boycotts. Complicated accounting allows big firms such as Starbucks to book revenue in tax havens, such as Ireland or the Cayman Islands.

The difference with the horsemeat example is that tax avoidance is legal. Therefore conventional economic theory tells us that firms will not only avoid tax but that it is completely rational to do so. I am by no means saying that tax avoidance is morally acceptable. What I am saying is that I am not surprised at all that it happens on a large scale. Are Starbucks any worse morally that any other firm? Maybe, but let’s be a bit more cynical. Firms make choices based on profits and a firm who has chosen not to avoid tax is not necessarily more ethical but has concluded that the potential reputational damage of avoidance is too high.

So why is the government a hypocrite? Because the lack of enforcement is by no means unintentional. This week’s Economist publication explains the US has a tax haven for offshore banking in Miami and the City of London specialises in non-resident tax avoidance.  The point is that governments continually participate in a race to the bottom, chasing the global stock of FDI that stood at $21.1 trillion at the end of 2011. Governments encourage foreign investment by weakening tax barriers and lax anti-avoidance rules are a very opaque method of doing just this. So is it fair that big companies pay no domestic tax? No. But do they add more to the economy domestically than tax revenue? Yes, by a long long way. Google, Amazon and Starbucks combined hire 25,000 UK employees and the state knows this.

The point here is that it is a win-win situation for the state. They set weak international tax laws, encouraging multinationals to locate in their economy and use public outrage at tax avoidance to win votes. As long as the public blame is wholly directed at the corporations, the government can simultaneously generate FDI and impress consumers with promised clamp-downs on tax avoiders in the future. The hypocrisy is rational; the costs of harsher tax laws far outweigh the gains in potential corporate tax revenue (if there is any left at all). It would be much less condescending and deceitful for the state to admit its role in all of this but then again politicians are just as rational as the corporations themselves.

3) Credit Ratings: Knowledge 

This is textbook asymmetric information so I will keep it brief. More specifically, moral hazard. A private market for credit ratings creates adverse incentives that lead to inneffiency. I have never understood how such a vital market can be kept private. For me, credit rating agencies were as much to blame for the financial crisis as the banks that pioneered complicated mortgage backed securities in the first place.

The problem with Moody’s and Standard and Poor is that, as profit maximisers, they wish to maintain market share and keep their clients happy. Thousands of junk securities were rated triple A during the financial crisis. Yes, it may be true that the credit rating agencies did not truly understand the effects or design of securitisation, but they had absolutely no incentive to improve their understanding.  Downgrading their clients’ inventions would seriously threaten their business and hence ignorance was bliss. These views are cynical but not outside the realms of possibility given that the department of justice are currently prosecuting Standard and Poor for fraud.

Why is this a government failure? Whilst the rating agencies had no incentive to understand how securitisation worked, it was definitely in the state’s interest to learn and track the developments in the financial world. By not regulating or understanding securitisation, a market failure of moral hazard very quickly became a government failure.

Why such a vital part of the market that so heavily affects the consumer is privatised I will never understand. However, if it is going to be privatised, then at the very least it should be heavily regulated. The problem here is that nobody, not even the government or banks themselves really understood the cataclysmic effects of securitisation. Perhaps if the state regulated banks’ products more closely, this could have been avoided to a certain extent.

Conclusion

Perhaps I am too harsh towards the state. After all, some regulation, such as competition regulation, usually works a treat. My point is that in some key sectors, regulation is simply not good enough and this needs to be recognised by the public.

Horsemeat, tax avoidance and credit ratings are all unintended consequences of unregulated capitalism and, in my opinion, only the tip of the iceberg. Resurrecting market failures is a government role in a mixed economy, which is why free market economics must be supported by heavy investment in regulating bodies. We must start to recognise the state’s role in these scandals.

Knowledge and incompetence are mistakes that can be learnt from. In the case of tax avoidance, the state must eventually decide between what is fair (everybody paying their fair share of tax) and what is rational (maintaining foreign investment).