Monday, September 21, 2009

Banker Pay NOT the Problem

Tyler Cowen (Marginal Revolution, September 21) is quite right to raise the question: everybody now says it caused the crisis. But is this new conventional wisdom, embraced by President Obama and the leaders of France and Germany, true?

John Kay’s argument, for instance, about the “New Peter Principle” (Financial Times, August 25) according to which top managers (and bankers) always reach their incompetence level and then waste shareholders’ wealth by mismanaging, thus leading the economy into crisis, is based on a faulty understanding of the classical agency problem well known to financial economists. The loss of control by shareholders was there on a permanent basis well before the crisis. It explained some waste but at a steady level. In order to cause the excesses of the recent years it should have been increasing steeply, all of a sudden, and there is no evidence of such an increase in the loss of shareholders'control.

Moreover, the fact that managers reach their level of incompetence does not mean that from that point on they will systematically make all the wrong decisions, ruining the firms they manage. It is a mechanism for allocating scarce talent among firms, not a macroeconomic decrease of the agregate amount of talent in the economy.It means on the contrary that the allocation of managers to positions is optimal, i.e. maximizing the total wealth they create for their firms.

The reason is that their incompetence is marginal. At the margin of the amount of business they supervise, their marginal productivity is decreasing up to the point where the value that they create is just equal to the payment they receive from the firm. Thus they should not be allowed to develop the volume of business under their control any more. But this is true of all contributions from factors of production in the neoclassical analysis. It does not lead to any “crisis”.

True, there is indeed a large responsibility of banks in the current crisis (excess diversification in risky activities, too big to fail problem) but excessive payments to greedy bankers is not central, and one can fear that it is used to draw attention away from the main difficulties and possible solutions.

Read the Cowen post here .

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