Friday, September 25, 2009

Capitalism without Capitalists: You don’t need to outrun the bear

When a Nobel Laureate weighs in an issue, then you really ought to at least listen and think about whether their thoughts have some merit. Well, the Nobel Laureate in economics Paul Krygman has weighed in on the issues of compensation for the financial industry and I think you need to look at what he says.

What's wrong with financial-industry compensation? IN a nutshell, bank executives are lavishly rewarded if they deliver big short-term profits--but aren't correspondingly punished if they later suffer even bigger losses. This encourages excessive risk-taking: Some of the men most responsible for the current crisis walked away immensely rich from the bonuses they earned in the good years, even though the high-risk strategies that led to those bonuses eventually decimated their companies, taking down a large part of the financial system in the process.

The whole article is here:

This is nothing more complicated than understanding that when you play with Other People's Money (OPM is the inside term), that the rules are "heads I win, tails you lose".

It doesn't take a financial genius to understand this principle. Give me $1,000 to gamble for you in Vegas. I'll only ask for 10% of any winning. I am a bad poker layer and even worse at craps or blackjack, so I'm just going to put your money on the roulette wheel. In fact, I'm going be number 22 in honor of Casablanca. If I win, then we get $36,000-$3,600 for me and $32,400 for you. But if we lose then you're out a grand and I'm out nothing. Given the house odds, we will always lose if we play long enough. Maybe sooner, maybe later, but we will always lose.

I don't care because when we win I get my money. When we bet then it's only your money at stake. When we lose then it's your money.

During the financial crisis of the late 1980's and early 1990's I worked for a law firm representing the FSLIC and FDIC -- the entities that guaranteed your deposits in savings and loans and banks. I know more than a half dozen ways to create big short term profits (that would generate big bonuses), while making long-term losses almost inevitable. I know as many more ways to simply gamble on the economy that may or may not work, but when they do work would make profits that would justify big bonuses. All my incentives are to gamble with OPM -- if I win then we both win, if I lose then you just lose.

My level of financial expertise is really pretty rudimentary. I know a lot of people that are more sophisticated than I am -- and I don't even know many many people at the top end of this spectrum. Unless you trust each and everyone of us to deal with perfect fidelity with your money (and we have it, in mortgages, checking accounts, savings accounts, 401ks, money markets, the stock market and everywhere else), then you need to worry about regulation of compensation for people in the financial industry. My Dad taught me to trust everyone but always cut the cards.

People thought Bernie Madoff was a financial genius. The truth is that no one can out think the market, but making money doesn't require beating the market, only finding investors more gullible than yourself. It's like the old joke:

You'll Never Outrun that Bear

Two lawyers walking through the woods spotted a vicious-looking bear. The first lawyer immediately opened his briefcase, pulled out a pair of sneakers and started putting them on.

The second lawyer looked at him and said, "You're crazy! You'll never be able to outrun that bear!"

"I don't have to," the first lawyer replied. "I only have to outrun you."

If we don't put controls on compensation for people working at financial institutions, then they don't need to beat the market. All they need to do is find a way to make short term profits, at least some of the time that beat the market. Risk doesn't matter to them (or at least that percentage of people that are more interested in making money rather than doing right), after all it's OPM.

Capitalism only works when people have just as much to lose as to gain. That's not the case when you are playing with OPM.

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