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Big banking bonuses

by on February 21, 2011

Henry Gruijters says the government needs to listen more to Hayek and less to Keynes to avoid extravagant bonuses. First Publshed on The Graduate Times.

 

If asked what a government should do, the answer we do not expect to hear is “nothing”. There is a feeling – certainly on the Left – that the state should control and manage the economy and that leaving economic decisions to the market is simply too risky. In this light, it is hardly surprising that Britain has been operating under a Keynesian policy of active government ever since the 1930s. However, choosing to limit the state, as the great Austrian rival Hayek would have liked, might just save the government on the issue of bank bonuses.

The Keynesian philosophy states that if the market is no longer willing to invest, the government should take up the slack by investing itself. This would have a “multiplier” effect through the economy. The investments themselves should theoretically reap returns as well. Evidence of a multiplier is weak, as often public expansion replaces private retraction. In addition, there is a good reason why private investors are not willing to invest,  because they feel the potential risks are too great and that the returns do not warrant the investment. Why should the government know any better, and be willing to wage war against the market with tax-payers’ money?

A perfect, healthy market can suffer from a lack of “effective demand” and the government may want to pick up the slack. Government intervention in this country has, however, not typically been temporary, but constantly present; even when there was no lack of effective demand in the build-up to the crisis.

Governments on both sides of the Atlantic have for decades encouraged home ownership.  The home-owning democracy is only possible with cheap mortgages. The NINJA mortgage (“No-Income-No-Job-or-Assets”) was itself partly responsible for fuelling the bubble. The issuance of loans to people with a low or no income was actively encouraged by the government as we have discussed.

This cheap credit and bank protection caused severe moral hazard. Those who knew the extent of the risk were not taking it, and due to financial alchemy the loans became part of triple-A bonds. This meant that there could be thousands of miles between the issuer of the mortgage and the owner of the loan. Further moral hazard occurred when it became clear that the government would bail out the banker if the investment went wrong. This meant that bankers were able to roll the dice and, if the bet paid off, they would get a massive return and an enormous bonus. On the other hand,  if the bet did not pay off, then the government would bail them out anyway. It was a zero-sum game.

The example above has striking similarities to the Austrian explanation of cyclical swings in business resulting from uncontrolled credit expansion at the hands of the government. If there was no government safety-net, bankers would be a lot more wary when taking risky investment decisions. Bondholders would still demand insurance on their deposits. To avoid bank-runs, banks would, therefore, need to insure each other’s credit. To make this insurance hold they would scrutinize each other’s investments, since everybody would bear the cost of only one bank’s imprudence.

The public can get angry with the bankers; one could state that it is “immoral” to acquire such enumerations under such severe social circumstances. However, the public should remember that it is their representatives in government that have made the bonuses possible by providing a safety-net and cheap money for all.

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