Congress passed financial reform in response to the recent crisis even though they have not yet fully understood what caused it. There are still commissions working to study the crisis.
There will never be complete agreement on the causes and political preference tilts the analytical balance of how much this was caused by ordinary capitalism gone awry and how much was the result of government incompetence and market meddling.
Beneath the perverted incentives that many financial critics decry led to excessive risk taking is an addiction to short term thinking that unfortunately plagues the entire American economy, not just the financial sector.
To be sure the financial and banking sector prefers the fees generated by originating loans and products to the slow returns made by actually holding those assets. Banks were much more careful to make prudent mortgage loans when the loans remained on their books. When your local mortgage banker became a fee based loan originator they were separated from the risk of their product.
During the leveraged buyout days of the 1980’s raiders bought companies and dismembered them to maximize their asset value. While this often did succeed in increasing shareholder value in the short term it often increased shareholder risk with excessive new debt.
Management and boards created incentive systems that focused on short term compensation rather than long term shareholder value. Focusing on a single year’s performance for bonuses that were often excessive led to hiding risks often from themselves. It is the private sector equivalent of the politicians who plies the voters with generous benefits and programs with the bill coming due when he is out of office.
Sometimes the bonus amounts themselves were the problem. When an executive can make a lifetime of income in a single year’s bonus, perhaps you should consider that his long term interests and the long term interest of the company are not in sync. A lot of ball players can hit a home run occasionally, but only a distinct few can hit it out of the park with any regularity.
We tend to assume that large executive compensation is indicative of talent and it should be to a point. But will you really get 10 times the performance from a $100 million bonus that you would get from a $10 million dollar bonus. On the extreme scale there are some greatly diminishing returns on executive comp.
In fact excessive bonuses for short term performance will likely increase risk and may actually diminish long term performance. We also may tend to believe these executives are talented because they are highly paid. We have a history of underestimating uncertainty and randomness is assessing performance.
Executive bonuses should be based on performance measures that span five years instead of a single year, and substantial segments of it should be deferred in a way that it is at risk if the company falters later. I cringe at the government requiring such changes, but they could tax such packages with a preference to encourage them.
A preferred tactic would be to legislate board room reform that breaks up the unholy alliances and facilities more responsible accountability to the shareholders.
We cannot dismiss the instability of our taxes and laws that creates uncertainty and short term thinking. Tax cuts may stimulate capital investment but that effect will be muted if the investor fears that the rates will go up later. Who would want to hold an expensive piece of equipment if the profits on it are likely to be increased years later?
Business people see extreme debts and expect taxes to go up to pay it down. They do not know how much or when and are thus reluctant to expose themselves to tying up their capital with such uncertain returns. Capital allocation will tilt toward the short term and the certain. Capital investment is still weak in this recovery.
The government is also reluctant to commit to long term improvements like our highway system program under Eisenhower in favor of quick fix solutions and ‘stimulus’ such as the ridiculously short sighted ‘cash for clunkers’.
Excessive debt forces a short term perspective. The short term disease may just be a part of the American mindset that values action, mobility, and impatience. It may be naïve to expect our political leaders who think ahead for the next election to truly focus on any long term perspective.
With the unwinding of the excess debt we should focus on systems that encourage a longer term perspective. This would be preferable to encouraging short term thinking with one set of policies and then creating complex regulatory agencies to control the natural results of those policies. The inflexible and slow nature of government bureaucracies will never be able to keep pace with the innovation in the private sector.
Long term thinking requires simple clear rules that stand the test of time. It also requires a sense of stability that means controlling debt.
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