Why Bonuses Matter

[See below for a post on a fradulent email that has been circulating claiming falsely to be written by me.]

Like the change of seasons, world-historical events often seem to spring from nowhere. The overhwhelming vote in the House of Representatives last week to tax this year’s AIG bonuses at a rate of 90% will in my opinion turn out to be such an event, even if the Senate and the White House block this move. The vote obviously reflected a broad upsurge of popular (not just “populist”) sentiment, and it has sent established interests into a tizzy. Wall Street is threatening mass defections from the financial industry, economic writers like Joseph Nocera of the New York Times are complaining that we are focusing on the wrong issues, and Senate Republicans are trying to decide whether to filibuster if the measure reaches the floor. (I do not think that even they will have the guts to do so.) But in my opinion these commentators could not be more wrong. The bonuses raise issues that are central, not peripheral, to the origins of the economic crisis, and the resistance the tax proposals are encountering reflects Wall Street’s failure to realize that the era in which its denizens have made their fortunes and careers is over. Meanwhile, the passage, by a vote of more than three to one, of a bill proposing 90% tax rates suggests that the current economic crisis will indeed lead to a return to the truly redistributive tax policies under which the country thrived from the mid-1930s until the early 1980s. It’s about time.
Both bonuses and 90% marginal tax rates, I am proud to say, are issues that I have been talking about in various contexts for some years. My involvement with bonuses dates to 2003, when my late friend and Harvard classmate Bill Strauss told me that some of the managers of the Harvard Endowment were about to receive an annual bonus of as much as $35 million a year. That led us to start a protest campaign which was still continuing, and which, as I have noted here, has been tragically vindicated by the collapse of the value of the Harvard Endowment, which is now going to have to reduce its contribution to the annual budget by 8% in each of the next two years. Mounting that protest was a very educational experience.
To begin with, 95% of the members of the financial community with whom I discussed the subject—ranging from investment bankers I shared chair lifts with to classmates at our 40th reunion—told us that we were naïve and mistaken, and that the managers were so brilliant that they deserved everything they got. Michael Lewis, one of the nation’s more respected financial writers, made the same claim in print, and regretted that Harvard President Larry Summers, who, he said, knew “how the game was played,” was going to make some concessions to our position. On the other hand, I got a very moving letter from an older financial manager who supported us completely and provided some important new information. He noted that the bonuses were awarded not based on absolute performance, but on performance relative to benchmark indices—and he said that the indices that the managers had to outperform were notoriously easy to beat. That presumably is the same system that AIG and other leading financial institutions have been using, and explains why bonuses continue to flow even in the midst of the worst economic crisis in 80 years. They may not have done well, but the S & P indices have done worse. In its defense, Harvard also noted that the managers' contracts included clawback provisions that would force them to return money if gains did not hold up--but those provisions, too, it turns out, are only triggered by poorer performance than indices, not simply by a decline in asset values.
It occurred to me at the time, however, and it has become obvious now, that this system had a much deeper flaw. It was rewarding managers annually with increases of millions of dollars—sometimes tens of millions of dollars—simply for paper increases in the value of assets. And it had become criminally easy (literally), with the Federal Reserve and foreign creditors like the Chinese flooding our markets with cheap credit, to structure deals that would continually bid up the paper values of various assets, but which would not provide any guarantee of increased future income. Subprime mortgages were simply one more asset whose values could be bid up, and they allowed financial irresponsibility to reach new and catastrophic heights. (To be fair, the Harvard Endowment has not, so far as I know, invested heavily in mortgage-backed securities, but it did reportedly take advantage of some speculative bubbles in commodities such as timber and petroleum which have now led to huge losses.)
These practices, combined with reductions in income and capital gains taxes (including Charles Schumer’s beloved loophole that taxed the income of hedge fund managers as capital gains), created opportunities to make private fortunes that simply did not exist half a century ago—because in those days, the top marginal tax rate was indeed 91%. And now the consequences of cutting that rate by almost 2/3 are becoming clear, even though the full damage will take at least a decade, I suspect, to repair.
Fifty years ago, when Americans thought of the wealthy, they were more likely to think of the leaders of our enormous corporations than those of the tightly regulated financial and securities industry. The stock market, moreover, depended upon industrial performance, not the other way around. But with 91% marginal tax rates, it made no sense for the President of Ford Motor Company, for example, to award himself a bonus of $5 million for one year (the equivalent of perhaps $40 million today), because the government would immediately have taken almost all of it. That gave companies, obviously, a huge incentive to use profits to expand, to hire more worker (and create more management positions, and to pursue further growth—all steps that benefited the whole economy. The steady reduction of the top tax rate from 1964 through the 1980s, and then again after 2001, destroyed that incentive. And I cannot believe that it is a coincidence that during that very same period, companies began to focus on employing less, rather than more, workers—especially American workers. Every wage- or salary-earner they could eliminate freed more cash to hand out to the top executives at the end of the year, and that had become the goal of the enterprise. Meanwhile, the center of gravity of the economy shifted dramatically from industrial production and transportation to the financial sector, which became increasingly transnational. Producing widgets became sooooooooo 19th-century; inflating values made one a master of the universe.
The popular revolt that led to the passage of the House bill partly reflects justified resentment that any American actually believes he needs $10 million (or even $4 million) a year to do his job well or live in the style to which he has become accustomed. But the bill also means that we are starting to return to a tax structure based in effect on the 19th-century theories of Henry George, who thought all property sales ought to be taxed at a very high rate. George argued that a speculator who bought property for $10,000 and sold it for $50,000 did not deserve to keep the $40,000 increase because he had not created it: the increasing wealth of the society around him had, and the increase should be returned to society. Even in good times, our wealthiest fellow citizens are essentially enjoying the benefits of good luck, not simply the rewards of being superior. High marginal tax rates reflect that. Eventually the same resentment will target professional athletes and entertainers as well, and within twenty years, I predict, the highest marginal tax rates will have at least doubled to 70% for everyone.
As I write the Obama Administration is floundering, I regret to say, because its economic leadership is composed of mainstream economists who want to get things back to “normal” as quickly as possible. Readers can find a most eloquent discussion of this point here. The author of the piece is Jamie Galbraith, a maverick economist at th LBJ School of Public Affairs in Austin whose views, like many of mine, have suddenly been vindicated by events precisely because he, like me, never threw the intellectual and public-policy heritage of the first half of the twentieth century out the window to remain in sync with current trends. He also points out that the Administration’s relatively optimistic economic forecasts are use models based upon the experience of the last 60 years, which implicitly assume that the recession of 1981-3 represented the worst thing that could happen. I suppose that we should not be surprised by all this, or necessarily discouraged. Although FDR’s achievements were indeed substantial (another point Galbraith illustrates effectively), many of his initial experiments, including the NRA, did not work particularly well, and some of his most enduring achievements didn’t occur until the third and fourth years of his first Administration. The danger, of course, is that Obama could lose political momentum. Should the center of the political spectrum lose confidence in him the results could be catastrophic.
Our recurring 80-year crises cause tremendous pain, but they have been the occasion of the greatest changes in American life as well: the establishment of republican national government in the eighteenth century, the abolition of slavery in the 19th, and the government’s assumption of real responsibility for economic health and some redistributive justice in the twentieth. The twenty-first century, it seems, will be the occasion for two more such crises (although no one old enough to read this post is likely to live to see the second one.) The question is whether we can once again clear away enough of the accumulated dead wood from our national forest to let newer growth eventually thrive, as we did in 1861-8 and again in 1929-45, or whether our luck will run out and the entire forest will burn to the ground, as it did in France in 1789-99 or Russia in the great crisis that began in 1914. I think we can once again avoid catastrophe, but only at the expense of a great deal of conventional wisdom, both at home and abroad.