02 February 2010

Incentives, Bankers, and Bailouts

One of the most important truths about human nature that one must always keep in mind is: people respond to incentives. If one forgets that, one is bound to be frustrated by all the otherwise inexplicable things people do.

For example, bankers paying themselves large bonuses. People are on their moral high horses about how bad it is that executives from banks that received bailout money are now going to pay themselves big bonuses. It is "shameful," "the height of irresponsibility" says President Obama. The standard story is that these bankers engaged in irresponsibily high-risk investments and then lost their shirts. The federal government then had to come in and bail them out, at taxpayer expense, to stabilize the economy; and now, since the banks have recovered, they're once again being totally irresponsible in paying themselves huge bonuses, even while the rest of America has not yet recovered.

President Obama has made this one of his new causes, suggesting caps on executive compensation, various new taxes or fees, etc. I think all this misses the boat.

In a free country, people should be allowed to take any risk with their money that they want. Who is to say that the risk someone takes is unreasonable? Some people are more risk-averse than others; entrepreneurs, gamblers, and skydivers take greater risks than most others. But there is no objective criterion determining when a risk becomes too risky. It all depends on one's schedule of values, one's available resources, one's obligations to other projects or other people, etc. Even knowing those variables in a given case does not tell one whether another person ought to take a particular risk, because there are no external grounds on which to base that "ought."

So bankers should be able to take any risk with their money that they want. Ah, but there's the rub: it's not their own money, the critics charge, that they're risking--it's ours. But whose fault is that? Put yourself in the bankers' shoes for a moment, and ask yourself how you would behave. If you knew that any losses you incur from your investments would be paid for by someone else, but any profits you incur would go only to you, what would you do? Would you be cautious and conservative in your investments, or would you be aggressive and take high-risk/high-reward shots?

Imagine you were going to spend a week in Las Vegas, and I told you that, although you have to gamble with your own money, I will pay for any losses you suffer, any at all--and yet you get to keep whatever winnings you get. Would that alter your behavior? Would you limit yourself to the low-risk games, or would you play with reckless abandon? Exactly. Now suppose that you did this once, lost a lot of money, and I duly paid for all your losses; but then I said to you that you shouldn't have done that and don't do it again, but if you do, I'll pay for your losses again, though I won't be happy about it. Well, you go to Vegas again; what's your behavior this time?

The federal government bailed out bankers for their risky investments the first time around, and it would do so again--and the bankers know it. To be shocked, shocked that bankers would continue their riskiness, or pay themselves huge bonuses when the big risks pay off, strikes me as either naive or disingenuous. Of course that's what they're going to do.

The only way to make sure that taxpayers are not left holding the bag for bankers' risky investments (or anyone else's bad decisions) is by making sure taxpayers are not required to bail them out when they lose. There is no other way. Say to them, "You're free to do what you want with your money, but if you lose it all, don't come crying to us. It's your responsibility. Now invest wisely." That instantly links decision-makers with the consequences of their decisions, introducing a natural discipline that no rearguard brow-beating or finger-wagging could ever accomplish.

So I say, cut them loose. Give them the freedom to decide how to spend or invest their resources, but also the responsibility of having to live with the results--good or bad. Such a policy would have not only the benefit of not obligating taxpayers to pay for others' foolish decisions, but it also treats everyone concerned with a dignity befitting truly moral agents who are both free and accountable.

1 comment:

Julie Robison said...

That was a really great post, Dr. Otteson! Thank you! I especially liked the discussion of risk and its relation to one's values and resources.