The news is awash with stories about how Wall Street bonuses are reaching all-time highs this year, despite the near-total collapse of the economy last year and the continuing woes in just about every sector except for finance that we are still seeing. It didn’t take long for Wall Street to bounce back from its nadir, and now, buoyed by taxpayer bailouts, they are resuming the party for their employees. Understandably, this has caused outrage among just about everybody who doesn’t work in finance, along with calls to regulate Wall Street pay. But pay regulation misses the point completely, as these huge bonuses are just the symptom of the real problem. To correct the egregious bonuses, you have to solve the underlying problem.
What’s the problem? To answer that, it helps to first get an idea of why the financial system exists. In the simplest of terms, banks and the entire financial system exist to help move capital where it can do the most good. That "capital" can be anything from my checking account to my retirement savings to the multi-million dollar revenues of gigantic companies, and, in turn, it can be used on anything from mortgages to student loans to bonds to venture capital, just to name a few.
If I have extra money lying around, I could seek out investment opportunities, maybe give somebody an educational loan, or a mortgage, or invest in a business startup. This would cut out the middleman, but it would also require a lot of work on my part: I’d have have to check these applicants out, evaluate their finances, determine what a fair interest rate or percentage of equity would be, stay on top of collections, initiate legal proceedings if they fall behind, and so forth. It’s possible to do this (and the internet has made it a lot easier, with sites such as www.kiva.org allowing for the matchup of lender to lendee), but for the majority of people, it’s not worth the hassle.
That’s where banks and other financial institutions come in. They serve as middlemen in this process. I give them money, and they loan it back out. A local bank or credit union is going to take my money and probably turn it into home mortgages or business loans. If I have more money to invest, I could do things like buy corporate bonds, stock, or invest in hedge funds that do the same. They handle the details, and often provide research, information, and advice. For these services, and for acting as middlemen, they get a cut.
In the process, the goal for everybody involved is to put that money to good use. My savings account money goes to a family’s mortgage so they can buy a house, live in a good neighborhood, and go to good schools (sounds very "Bedford Falls", doesn’t it?). Or it goes to somebody who is starting a new business and adding to the economy. These are small examples, but the process scales up to companies floating bonds to build a hundred-million dollar factory that will employ hundreds of workers. In all these examples, I get a return on my investment, the people receiving the money put it to good use to better themselves and the economy, and everybody benefits.
Of course, there is risk involved. Perhaps the mortgage is going to somebody who can’t pay their bills, or the small business goes under. Failures are inevitable, but even in failure there is knowledge to be gained. Failure tells us that a particular allocation of capital isn’t a good idea, and so tells the market to redistribute it to other, more beneficial areas.
Where did it go wrong? In in ideal situation, banks are supposed to only be the conduit, the pipe that moves money into productive activities. However, banks realized that they could get more money by not merely directing the flow of capital to other industries, but to themselves. The flow of money became not a straight line, but a maelstrom swirling from bank to bank. Money was not invested in new factories and new technology, but in new financial instruments like CDOs and creating algorithms to programmatically trade better than the competition. Finance, instead of being a means to an end, became an end in itself. That is the true source of these insane bonuses: with that firehose of money directed not at other industries, but at itself, there is simply too much money sloshing around. It is inevitable that much of the money will go to employees in the financial industry.
For this to change, and for those bonuses to become a thing of the past, banking must "become boring" as Paul Krugman argues. Instead of directing money towards financial "innovations", which are of dubious benefit to anybody not immediately involved in the financial sector, money should be directed towards those endeavors that provide profit and social benefit. There’s a whole host of things that we could to to push finance in this direction: regulation of some of the more dangerous derivatives, a tiny (such as 0.25%) transaction tax on all stock trades that would discourage the programmatic day-trading that is endemic, or perhaps a new, super short-term capital gains rate (say for assets held less than 30 days) that would discourage short-term speculation and encourage long-term investment, which is what the finance industry is supposed to foster.
Obviously, there will be plenty of people who will fight any attempt to roll back the huge gains in the size of the financial industry, which has more than doubled in relative size in the past 30 years or so. Resistance doesn’t just come from the people making those bonuses either: opponents of reform argue that regulations will do everything from eliminate credit card reward programs to make it harder to get a mortgage. To a certain degree, this is correct. However, I would gladly give up my credit card cash back program if it meant a return to a saner, less dangerous, and far more boring financial system.