Fantastic incentives to reduce bribery

I just read this clip about Kaushik Basu, the new World Bank chief economist:

A paper he released last year caused a bit of a stir: While advising the Indian government, Mr. Basu argued that countries could reduce the incidence of “harassment bribes” – e.g., “I’ll approve this home renovation project for you for a small fee…” – by making it legal to give a bribe, though not to receive one.


“This will cause a sharp decline in the incidence of bribery,” Mr. Basu said. “After the act of bribery is committed, the interests of the bribe giver and the bribe taker will be at divergence. The bribe giver will be willing to cooperate in getting the bribe taker caught. Knowing that this will happen, the bribe taker will be deterred from taking a bribe.” (Mr. Basu notably argued against giving an amnesty for past incidents of bribery.)

As a brilliant woman I know likes to say, “intentions are good, incentives are better.”

Wall Street actions are a result of incentives

How can the financial crisis be a result of anything other than the incentives created by incomplete regulation and incorrect company structure?

People will always respond to the strongest incentives they see and are able to take on. The strongest incentives are so far-reaching across financial firms and the government:

  • Complete lack of either oversight or transparency of the derivatives market creates the incentive to build supposedly market-neutral bets that are orders of magnitudes larger than what capital reserve requirements dictate
  • Compensation packages that pay bonuses now on trades that can blow up later creates incentives for employees to take risks now; if the house falls down, they will be laid off, but will also be much wealthier.
  • The tacit understanding that the largest banks and hedge funds will be rescued no matter how stupid the actions that got them there to begin with creates the incentive to take on increasingly risky positions. If you aren’t playing with house money, you will be playing with taxpayer money.
  • The SEC’s inability to regulate Wall Street, because Congress told them not to, because they were told that regulation hampers innovation by a Wall Street lobbyist, creates the incentive to continue doing what you are doing, as no one from the government will bother you.

I am sure I am missing probably 3-4 other causes for these incentives, but to me these are the biggest.

The financial regulation bill reaching Congress today is a step in the right directly, but will likely introduce or leave behind holes. This will create additional incentives that financial firms will rush to fill. I don’t know what those holes are, as I haven’t read any part of the bill, but I know they will be picked apart by the blogs I do read (mentioned below).

Any argument that talks about morals (e.g. “Wall Street is too greedy”) is doomed to fail. Spend five minutes with a trader from one of these firms, and economic morals is generally completely lost on them. They wouldn’t be successful traders if this wasn’t the case, as their jobs are to take advantage of these kinds of inefficiency.

This post was inspired by this summary from Russ Roberts on Marginal Revolution, as well as from two years of reading Naked Capitalism and Marginal Revolution

“1. It isn’t “too big to fail” that’s the problem, it’s the rescue of creditors going back to 1984, encouraged imprudent lending and allowed large financial institutions to become highly leveraged.

2. Shareholder losses do not reduce the problem even when shareholders are the executives making the decisions

3. These incentives allowed execs to justify and fund enormous bonuses until they blew up their firms. Whether they planned on that or not doesn’t matter. The incentives remain as long as creditors get bailed out.

4. Changes in regulations encouraged risk-taking by artificially encouraging the attractiveness of AAA-rated securities.

5. Changes in US housing policy helped inflate the housing bubble, particularly the expansion of Fannie and Freddie into low downpayment loans.

6. The increased demand for housing resulting from Fanne and Freddie’s expansion pushed up the price of housing and helped make subprime attractive to banks. But the ultimate driver of destruction was leverage. Either lenders were irrationally exuberant or were lulled into that exuberance by the persistent rescues of the previous three decades.”

(Side note: I use the term Wall Street quite loosely here. In reality, many firms that contributed are not physically on Wall Street, and many that are on Wall Street did not contribute in meaningful ways.)

Antidote du jour

One of my favorite blogs of the day is Naked Capitalism. The blog offers an almost increasingly despairing look at the economy and the politics behind making it better, and makes you want to crawl into a hole and hide for a couple of decades after you read it.

It is topped off by posts of “Links“, which contain a barrage of interesting and usually pessimistic links from across the news and blogosphere. At the end of each of these “Links” posts, however, contains a picture that author Yves Smith entitles “Antidote du jour”, usually contributed by a reader. Instead of describing the picture, I’ll post a few below.

Given the starkly negative (/realistic?) tone of the blog, “Antidote du jour” always makes me smile.

Banks were profitable in January and February… because of AIG


AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

How to make AIG executives give up their bonuses

The government claims they are contractually obligated to pay 400 AIG executives and employees their $165M in bonuses.

How do we get these people to do the right thing and forgo these completely undeserved bonuses?

The administration can play hardball. Make a public statement that states, yes, you can take your bonus as the law dictates. However, if you do, we will make your names, addresses, and the amount of your bonus public. Not hardball enough? Then, make this policy apply in perpetuity (e.g. if you move, we will keep your address up to date). Too hardball? Limit it to those taking home >$500K from this bonus pool.

This will certainly make them think twice about accepting this money.

Of course, none of this would have been a problem if we hadn’t bailed them out in the first place – they would enter bankruptcy and these contracts could be void.

Why bailing out Detroit is bad

Seeking Alpha has an excellent article on why bailing out Detroit is a terrible idea. From the article:

When it comes to bailouts, the real discussions are not centered in Washington but rather in Beijing, Tokyo, and Riyadh. With no money of our own, our ability to bailout our own citizens is completely dependent on the world’s willingness to foot the bill. While I am sure that Bush and Paulson are doing their best to convince the world that open ended financing of the United States is in the global interest, my guess is that, unlike Congress, our foreign creditors will see through the self-serving nature of our plea.

Explaining the credit crunch

The New York Times has a fantastic piece explaining how the little subprime mess has ballooned into trouble at some of the nation’s premier banking institutions. Great for those who know a little about the current situation, but probably not detailed enough for those bankers who live in it every day.

Favorite quote:

“The mortgages were then sliced into pieces and bundled into investments, often known as collateralized debt obligations, or C.D.O.’s (a term that appeared in this newspaper only three times before 2005, but almost every week since last summer).”