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Wednesday, January 23, 2008

"Capitalism's Enemies Within"

Robert Samuelson says there's something wrong with the markets that determine pay on Wall Street that causes pay to be too high and encourages excessive risk-taking:

Capitalism's Enemies Within, by Robert J. Samuelson, Commentary, Washington Post: Amid the mayhem on world financial markets, it is becoming clear that capitalism's most dangerous enemies are capitalists. No one can have watched the "subprime mortgage" debacle without noticing the absurd contrast between the magnitude of the failure and the lavish rewards heaped on those who presided over it. At Merrill Lynch and Citigroup, large losses on subprime securities cost chief executives their jobs -- and they left with multimillion-dollar pay packages. Stanley O'Neal, the ex-head of Merrill, received an estimated $161 million.

Everyday Americans will conclude (rightly) that this brand of capitalism is rigged in favor of the privileged few. ... If you leave your company a shambles -- with losses to be absorbed by lower-level employees, some of whom will be fired, and shareholders -- do you deserve a gold-plated send-off? Still, the more serious problem transcends the high pay itself and goes to the wider consequences for the economy.

Wall Street's pay practices perversely encourage extreme risk-taking that can destabilize the economy. Subprime mortgage losses may simply be chapter one. ... If banks and investment houses sustain more losses, the nation's credit system will be further wounded and so will the economy. ...

By "Wall Street," I mean all the commercial banks, investment banks, mutual funds, hedge funds and the like..., but particularly investment banks. Pay is eye-popping. In 2007, Lloyd Blankfein, chief executive of Goldman Sachs, received compensation estimated at $68 million. ... Just why investment bankers and traders out-earn, say, doctors or computer engineers is a question I've never heard convincingly answered. Are they smarter? Unlikely. Do they contribute more to the economy? Questionable. True, Wall Street often performs a vital function. ...

But Wall Street also frequently misallocates capital and credit. The "tech bubble" of the late 1990s was one episode. Now we have subprime mortgages. Why? Well, the herd mentality of financial crazes has a long history. But compensation practices skewed so heavily toward bonuses based on annual profits make matters worse. ...

To be fair, the real estate bubble had many causes, including low interest rates, the political popularity of homeownership and the (mistaken) belief that housing prices could never fall. This may explain why, so far, the backlash against Wall Street has been muted.

But if the subprime failure turns out to be a preamble to a larger financial breakdown, flowing from the creation of new securities that offered short-term trading possibilities but whose long-run risks were underestimated, then the mood could turn uglier. Indeed, many Americans may conclude that capitalism has run amok.

When I hear about inequality widening, the ultimatum game experiments where people are willing to do things that do not appear to be in their economic interest in order to punish unfairness sometimes come to mind. There is some tipping point - I don't know where it is - but there does come a point where the perception of unfairness causes people to demand change, and they may be willing to do things that appear to be economically irrational in order to bring that change about. Often, it is the threat of taking action, not the action itself, that promotes changes that reduce inequality. On a smaller scale, we see this when workers go out on strike and appear willing to pay a far higher cost than any gain they might eventually reap in order to ensure that pay is fair according to their perceptions of what fair means. And often the threat of a strike is enough to change the outcome of negotiations over who gets what share of the profits, the strike itself is not necessary.

Was the Great Depression such an event, a time where people came to believe that the system did not treat the typical household fairly, and thus demanded change? Some of the policies that came out of the Great Depression to alleviate inequality may have been an attempt to stave off more drastic change - it was either give in to the demand for a reduction in inequality within the capitalist system itself or, some feared anyway, face the possibility the capitalist system itself would be fundamentally altered or even replaced.

If we have a hard landing, a true hard landing where significant numbers of people are thrown out of work for a substantial period of time while those who were rewarded in recent years do not face similar hardship, will that trigger change? I think it might, though it's not exactly comfortable to think that something like universal health care has a better chance of being enacted if we have a severe recession that causes people to demand change, any change that benefits the working class, than if times remain relatively good. But hopefully I'm wrong about that and we'll get the needed change in healthcare and other areas without having to suffer through a long, deep, recession first.

    Posted by on Wednesday, January 23, 2008 at 02:43 AM in Economics, Income Distribution | Permalink  TrackBack (1)  Comments (87)


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