Deepish Thought

The front page of today’s Wall Street Journal features yet another article on the bonuses being paid to bankers at institutions recently bailed out, or essentially owned, by taxpayers.

For those of us who aren’t collecting these bonuses this is either infuriating, mystifying or simply mind numbing.  It may be helpful to step back for a moment and look at why banking can be such a lucrative profession.  Consider the following example:

Bob over at Silverman Slacks is setting up a deal to sell a package of derivatives to a group of hedge funds.  An average investment banker should be able to get $1B for these securities.  However, because of his superior acumen, drive, reputation, persuasiveness and network of contacts, Bob can do 0.001% better than the average I banker.

In most industries a 0.001% advantage is insignificant.  However, because of the scale of the transaction involved, in this case that 0.001% advantage translates into $1m in additional profit for Silverman.  Or at least it would, if not not for the inconvenient fact that Bob understands the significance of his 0.001% edge.

In order to prevent Bob from taking his 0.001% advantage over the road to Morbid Stansted, Silverman has to cut Bob in on the additional profits his superior abilities generate.  Assuming that Bob can reliably generate $1m in additional revenue on $1B deals then Silverman, assuming management is rational and the market for “talent” is competitive, should be willing to pay Bob $999,999 per deal.  If they don’t, Morbid Stansted will.  With this kind of a compensation package Bob doesn’t have to pull off many $1B deals to reel in a multi-million dollar bonus.

Wall Street types, who almost never suffer from a surplus of modesty, like to claim that they earn extraordinary bonuses with extraordinary performance.  This is complete rubbish.  The scale of transactions on Wall Street amplifies the effect of even incrementally above average performance.  Meanwhile the personality driven nature of the business ensures that the rewards from incrementally above average results flow disproportionately to the “talent” that provided the incremental advantage.

Note that this incremental advantage doesn’t have to come in the form of higher profits for the banks.  Incrementally lower losses are just as valuable.  This is why banks are compelled to pay huge bonuses even when their results don’t seem to merit it.

Brad DeLong has come up with an interesting fiscal policy proposal (emphasis mine):

The fact is that the appropriate fiscal policy for the U.S, right now is to pass: (a) a bigger stimulus over the next two years, (b) a standby tax increase to return the federal budget to primary surplus by 2012, and (c) devout and lengthy prayers that confidence in the dollar doesn’t collapse and send interest rates on U.S. Treasuries above the economy’s growth rate–in which case the situation changes from its current value of “dire” to “catastrophic.”

I suspect we should be a little suspicious of any policy prescription that includes “devout and lengthy prayers” as a key component.  Particularly when the other components seem designed to create the problem that the devout and lengthy prayer is intended to prevent.

If I understand Brad’s view correctly, the government appears to have two options:

1. Continue on the current path and endure an extended, painful recession.
2. Spend like a drunk sailor on shore leave, in which case things will either get better or confidence in the dollar will collapse, interest rates will shoot up and the economy will fall apart (those of us with limited faith in the power of prayer to influence economic trends would call this gambling).

I don’t know about you, but I need a drink.

Brad DeLong, in his “Fair, Balanced, Reality-Based, and More than Two-Handed” blog recently posted a couple of charts to buttress his contention that, “employment losses are about to be bigger than in any previous recession since the Great Depression itself”.

The more alarming chart is taken from Nancy Pelosi’s office wall:

A naive observer might conclude that the current recession is the worst since WWII.  Unfortunately this chart doesn’t adjust for the dramatic overall expansion of the labor force over the last fifty odd years.  William J. Polley has produced a more informative (less ludicrously tendencious) percentage based comparison.  Note that the current recession actually falls somewhere in the middle of the pack for post WWII recessions.

The second chart is an annotated copy of the Time Magazine original.

There is nothing actually wrong with the chart.  However, the annotations are interesting.  Mr DeLong has added the names of the Presidents who happened to be in office during the charted recessions.  It isn’t clear what Mr DeLong’s purpose in doing this was exactly.  Perhaps Mr DeLong is trying to suggest responsibility.  If so, he appears to have made the classic mistake of confusing correlation with causation.

The other questionable addition is the gratuitous highlighting of the current recession.  Painting something bright red and labelling it with a honking a great sign is not exactly the strategy of someone seeking to make a sober analysis.  Perhaps the real purpose of this overdone annotation is to conceal the fact that, when charted in relative terms, the trajectory of employment in the current recession looks a lot like that of the 1981 recession.  While certainly very unpleasant, the 1981 recession did not in fact result in the end of civilization, which is not the kind of thing you want to dwell on if you are trying to sell people on your, “the world is going to end if Congress doesn’t spend” view of the world.

In a revolutionary move your faithful correspondent is going to actually offer some evidence of his competence as a pundit. While the value of his opinions on politics, culture, economics and business are still in doubt, his brilliance in the arena of American Football can no longer be denied. In the Peter King Challenge your favorite blogger proved better than Sports Illustrated correspondent Peter King at predicting the results of NFL games.

Your inestimable reporter is so pleased with this unprecedented triumph that he has begun to refer to himself in the third person. The inevitable fall to earth is anticipated shortly.