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The Baseline Scenario
Bankers and Athletes
Good Idea Coming
The Problem with Positive Thinking
Hoenig Talks Sense On Casino Banks
Still No To Bernanke
Bankers and Athletes
Posted: 07 Jan 2010 10:44 AM PST
Bill George, a director of Goldman Sachs, defending the bank’s compensation practices, said this: “The shareholder value is made up in people and you need the people there to do the job. If you don’t pay them for their performance, you’ll lose them. It’s much like professional athletes and movie stars.”
The idea that the level of inborn talent, hard work, dedication, and intelligence you need to be a banker is even remotely comparable to that of, say, NBA basketball players is ridiculous. But leaving aside the scale, there are some similarities. Most obviously, athletes on the free market–those eligible for free agency–are overpaid. John Vrooman in “The Baseball Players’ Labor Market Reconsidered” (JSTOR access required) goes over the basic reasons, but they should be familiar to any sports fan. There is the lemons problem made famous by George Akerlof: if a team gives up a player to the free agent market, it probably has a reason for doing so. There is the winner’s curse common to all auctions: estimates of the value of players follow some distribution around the actual value, and the person who is willing to bid the most is probably making a mistake on the high side.
Another common factor is the mistake general managers make in overpaying for luck. Take any group of .265 hitters, give them 450 at bats, and a handful will hit .300. On the free agent market, they will be paid like .300 hitters, especially if they are young and they do not have a long history of hitting .265 behind them. This is the exact same as one bank making a huge offer to a trader from another bank who just had a great year.
For another, the apparent productivity of a player in a team sport is largely due to his team and cannot simply be reproduced individually. John Vrooman in “The Baseball Players’ Labor Market Reconsidered” cites the sad case (for New York Mets fans, of which I am one) of Bobby Bonilla, who racked up spectacularly numbers hitting ahead of Barry Bonds for the Pirates, but flopped with the Mets. The same trader who makes big profits at Goldman based on its low cost of funding, sterling reputation, and tremendous client connections will not necessarily do nearly as well on his own.
Finally, while there is a strong relationship between pay and past performance, there is only a loose relationship between pay and future performance. Look at the teams that won the World Series between 2000 and 2009: Arizona Diamondbacks, Anaheim Angels, Florida Marlins, Boston Red Sox, Chicago White Sox, St. Louis Cardinals, Boston Red Sox, and Philadelphia Phillies. Only the Red Sox were among the sport’s traditional big-market teams. Yes, there is a correlation between payroll and number of wins (the Yankees do win the World Series more than other teams), but the random factors play a big role as well.
So yes, bankers are like athletes. Their individual contributions are overrated relative to their supporting environments; they are overpaid; they are paid based on where they randomly fall in the probability distribution in a given year; and paying a lot for bankers is no guarantee that your bank will be successful in the future. Team sports, like banking, are an industry where the employees capture a large proportion of the revenues. And one with negative externalities, like upsurges in domestic violence around major sporting events. Neither one should be a model for our economy.
By James Kwak

Good Idea Coming
Posted: 07 Jan 2010 08:51 AM PST
One striking aspect of the public debate about the future of derivatives – and how best to regulate them – is that almost all the available experts work for one of the major broker-dealers.
There are a couple of prominent and credible voices among people who used to work in the industry, including Frank Partnoy and Satyajit Das. And there are a number of top academics, but if they help run trading operations they are often unwilling to go on-the-record and if they don’t trade, they lack legitimacy on Capitol Hill and in the media.
The Obama administration is criticized from various angles – including by me and, even more pointedly, by Matt Taibbi – for employing so many people from the finance sector in prominent policy positions. But, the administration pushes back: Where else can we find people with sufficient expertise?
The defense sector faced a similar problem after World War II. The rising importance of technology in combat meant that the military needed specialized suppliers who would invest large amounts of private capital in developing tanks, airplanes, radar, and other types of equipment. But there was – and still is – a real danger that these companies would capture the Defense Department and push it to buy overly expensive and ineffective technologies (or worse).
President Eisenhower famously warned in 1960, as he was leaving office, about the military-industrial complex. His concise remarks were brilliant – look at the text or YouTube versions. And C. Wright Mills’ influential The Power Elite, published in 1956, put weapons suppliers at the center of our national power structure. (link: ; but this may be copyright violation.)
Constraining the power of defense contractors is a hard problem – and you might say that we have not completely succeeded, depending on your view of Vietnam, Iraq, and Afghanistan.
But, at least in terms of weapons design and procurement, we have made some progress in developing a set of highly skilled independent engineers – as argued by Larry Candell in the latest issue of Harvard Business Review (now on-line, but there’s an awkward page break; here’s an alternative link – look for idea #3).
Larry is an interested party – from a leadership role at Lincoln Labs, he explains that this organization provides an independent design and evaluation capability that is not government bureaucracy and definitely not a profit-oriented defense contractor. (Disclosure: Lincoln is part of MIT, where I work.)
Irrespective of what you think about the defense business, Larry’s proposal vis-à-vis finance is intriguing. He thinks the government should set up its own arms-length labs (or sponsor nonprofit research organizations to do the same) that would concentrate on testing financial derivative products in test bed-type settings.
This would not, of course, be the same as trading in real markets. But with today’s computer resources and plenty of unemployed finance talent at hand, it should be possible to develop individual people and a broader organizational capacity able to test the effects of various kinds of derivatives on customers, as well as on overall financial system stability.
The proposed National Institute of Finance (NIF) would have similar broad goals – and the National Institutes of Health is an appealing model – but as NIF is currently proceeding with industry-backing (e.g., Morgan Stanley, Bank of America), we should be skeptical.
We definitely need independent derivatives experts who can be called to testify before Congress or work in an administration. They must have a deep understanding of financial markets, as well as hands-on experience with products that are dangerous to our economic health.
It would be great if people from hedge funds or other financial institutions were willing to step forward and play this role – many of our best experts don’t actually work for the big banks. But while these independent people criticize eloquently the major broker-dealers in private, very few of them are willing to step forward in public.
Initial responses (e.g., by Stefan Stern, writing in the Financial Times) suggest that Larry’s idea may get some traction.
By Simon Johnson
This piece appeared, in an edited form, earlier today on the NYT’s Economix; it is used here with permission. If you wish to reproduce the entire post, please contact the New York Times.

The Problem with Positive Thinking
Posted: 07 Jan 2010 08:30 AM PST
There’ s a quotation by Stan O’Neal that I’ve looked for occasionally and failed to find. John Cassidy found it for me (How Markets Fail, p. 274; original source is The New York Times). It was an internal memo from O’Neal describing the company’s second-quarter 2007 results (which were good, at least on paper). Here are some quotations from memo in the Times article:
“More than anything else, the quarter reflected the benefits of a simple but critical fact: we go about managing risk and market activity every day at this company. It’s what our clients pay us to do, and as you all know, we’re pretty good at it.”
“Over the last six months, we have worked successfully to position ourselves for a more difficult market for C.D.O.’s and been proactively executing market strategies to significantly reduce our risk exposure.”
Greg Zuckerman, in The Greatest Trade Ever, has this from O’Neal in 2005 (p. 173): “We’ve got the right people in place as well as good risk management and controls.” (No original source–the entire book has only forty-three end notes, at least in the pre-publication copy that Simon got.)
Since then, we’ve all had our fun at O’Neal’s expense (and he’s had his $161 million golden parachute, although presumably it ended up being worth considerably less) and moved on. Most likely he simply had no idea what was going on; the other possible explanations are worse.
But that first quotation has always bothered me, because it reflects a problem that goes far beyond Wall Street, and something I always found particularly distasteful about Corporate America: CEOs, and business people in general, saying things they want to be true, without bothering to find out if it actually is true.
Do all people behave this way? (“Heck of a job you’re doing, Brownie.”) Maybe, but not all people are CEOs that have investors and employees listening to their every word. Everyone who writes for a top newspaper or for a subset of the top magazines (The New Yorker, The Atlantic, etc.) has every word he or she writes fact-checked. The fact-checkers literally go word by word and cross them out when they are confident they are accurate. There’s no way a good fact-checker would have allowed O’Neal to say “successfully” without proving it. If he had had to prove it, he would have known it was a lie. As it was, he was able to get away with it, probably without even having to think about whether he was living in a fantasy or not. (And, of course, O’Neal almost certainly didn’t write the memo to begin with.)
The result is that smart people know to ignore everything a company executive says in public that is not backed up by facts in the public domain, and everyone else gets bamboozled. And if you don’t put up the confident, cheerful face on CNBC, you’ll get slammed because all the other people on CNBC do. So we end up with this charade of everyone spouting the talking points fed to them by their PR people (I was in marketing at Internet boom company; I’ve written those talking points) without even knowing if they are true, which means they can never be held responsible (since any misrepresentation they make isn’t “willful”).
Is there a solution? I wish business executives would show a little more interest in reality, but that isn’t going to happen by itself. Maybe there should be a different legal standard for certain types of speech by corporate officers, so they can be held responsible on some level for making inaccurate statements, even if they don’t know they are inaccurate. That would inspire greater respect for the truth. But mainly this is just a pet peeve of mine that isn’t going to change.
By James Kwak

Hoenig Talks Sense On Casino Banks
Posted: 07 Jan 2010 02:47 AM PST
Thomas Hoenig, President of the Kansas City Fed, has been talking sense for a long time about the dangers posed by “too big to fail” banks. On Tuesday, he went a step further: “Beginning to break them, to dismember them, is a fair thing to consider.”
Hoenig joins the ranks of highly respected policymakers pushing for priority action on TBTF, including some combination of size reduction and/or Glass-Steagall type separation of casino banks and boring banks.
As Paul Volcker continues to hammer home his points, more policymakers will come on board. Mervyn King – one of the most respected central bankers in the world - moves global technocratic opinion. Smart people on Capitol Hill begin to understand that this is an issue that can win or lose elections.
Ben Bernanke still refuses to address ”too big to fail” directly and coherently. He needs to make a major speech focussing on bank size, confronting the critics of today’s big banks in detail (if he can) and specifying concretely how banks will be prevented from becoming even larger. Without such a clear statement, he will have lost all credibility even before his second term begins.
The independence of central banks is earned, not written in stone for all time. Mr. Bernanke seriously undermines the Federal Reserve System by remaining essentially silent on this crucial issue.
By Simon Johnson

Still No To Bernanke
Posted: 06 Jan 2010 05:39 PM PST
We first expressed our opposition to the reconfirmation of Ben Bernanke as chairman of the Fed on December 24th and again here on Sunday. Since then a wide range of smart economists have argued – at the American Economic Association meetings in Atlanta - that Bernanke should be allowed to stay on.
I’ve heard at least six distinct points. None of them are convincing.
Bernanke is a great academic. True, but not relevant to the question at hand.
Bernanke ran an inspired rescue operation for the US financial system from September 2008. Also true, but this is not now the issue we face. We’re looking for someone who can clean up and reform the system – not someone to bail it out further.
Bernanke was not really responsible for the failures of the Fed under Alan Greenspan. This is a stretch, as he was at the Fed 2002-05, then chair of the Council of Economic Advisers, June 2005-January 2006. Bernanke took over as Fed chair in February 2006, when tightening (or even enforcing) regulation could still have made a difference. He had plenty of time to leave a mark and, in a very real sense, he did.
Bernanke understands the folly of the Fed’s old bubble-building ways and is determined to reform them. This is wishful thinking. There was nothing in his remarks this weekend (or at any time recently) to support such an assessment.
Bernanke will be tough on banks when needed. Again, there is not a shred of evidence that would support such a view – the markets like him because they see him as a soft touch and that’s great, except that it encourages further reckless risktaking by banks considered Too Big To Fail and leads to another financial meltdown.
Dropping Bernanke would disrupt the process of economic recovery. This is perhaps the strangest assertion – we’re in a global rebound phase, fueled by near zero US short-term interest rates. Official forecasts will soon go through a set of upward revisions and calls for further worldwide stimulus will start to sound distinctly odd. Now is the perfect time to change the chair of the Fed.
By Simon Johnson