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Friday, September 18, 2009

Hamilton on Regulating Banking Sector Compensation

by Calculated Risk on 9/18/2009 02:09:00 PM

Professor Hamilton, at Econbrowser, excerpts from the WSJ on curbing bankers' pay, and adds some important comments: Regulating compensation in the banking sector

One of the key questions for understanding the causes of our current problems is the following. Suppose that in 2005, the individuals who were putting together securities derived from subprime and alt-A mortgage loans could have known, with perfect foresight, events that were going to unfold in 2008. Would they have still done the same things they did in 2005? My concern is that, for many individuals, the answer might be "yes", insofar as they were richly rewarded personally in 2005 for making exactly the decisions they did. It was other parties (namely you and me) who later down the road were forced to absorb the downside of their gambles. Capitalism functions well when individuals are rewarded for making socially productive decisions. It is a disaster when individuals are rewarded for making socially destructive decisions. For this reason, I am quite supportive of the broad idea of the above proposal.
For some people I don't think there is any question the answer would have been "yes". For many others, they would have ignored the "perfect foresight", and rationalized away the risks. The result is the same, but the second group can feel better about themselves while living large.

Hamilton also adds some comments on regulatory capture - another important issue.