HOW TO FIX FINANCE

The incentives facing financial executives ensure that we will face periodic financial collapses. This is not a desirable equilibrium. Perhaps more than any industry a stable financial sector is critical to a healthy economy.

When an investment banker takes a risk, he stands to gain far more if things go well than he stands to lose if things go wrong. Until we change this we will not have a stable financial sector.

There are two possible approaches: we can increase the personal risk faced by an executives in the financial industry are encouraged to take irresponsible risks individual decision maker or we can reduce the personal benefit the decision maker stands to gain from taking a risk.

Limited Liability ensures that shareholders only are liable for their initial investment in the firm. This protection makes sense in industries, such as medical research, where society wants to encourage risk taking. However, this may encourage an irresponsible attitude to risk in the financial sector. If shareholders could be held liable for all of a firm’s debt, managers would face pressure to avoid risky investments.

In particular this change makes sense for any firm that engages in propriety trading. It makes no sense to allow firms to make risky highly leveraged bets while hiding behind the protection of limited liability.

I would also favor forcing employees of bankrupt financial firms to forfeit any bonuses that they received during the several years preceding the firm’s bankruptcy. Thus base salaries would be protected, but the bonuses that they earned would not be safe from creditors.

These two changes would make the financial sector far more conscious of the downside risks that they are assuming.

The other side of the equation to stabilize the financial markets is to lower the profits that the industry gains from making risky bets. It would be possible to develop complicated industry specific ways to accomplish this, but what I am proposing is far simpler and more profound.

Increasing the top marginal tax rate would reduce the benefits that top Wall Street executives receive from their risky strategies. A larger share of the profits would go to the Federal Government. This seems fair because Washington is assuming much of the downside risk.

Over the past 45 years the top marginal tax rate has plummeted. Throughout the 50’s and early 60s the highest earners paid a marginal rate greater than 90%. In 1953 a millionaire would see just $80,000 in new spending money if his salary were increased by $1,000,000. This top rate declined several times over the next generation. By 1980 the top rate was down to 70%.

Then along came a retired actor from California. By 1988 the top rate was 28%, a 60% reduction over eight years. Today this figure is back up to 35%. The wealthiest Americans now have a far greater incentive to pursue higher incomes. In 1953 a rich banker faced little incentive to take unnecessary risks, as they would receive just 8% of the profits. Today that banker would take home 65% of the profit. That increased share of the profit encourages more risk taking.

Risk taking is not a bad thing. The greater profit incentive of the last 25 years has undeniably contributed much to the innovation and growth that has improved quality of life over the past 30 years. I am not proposing returning to the 90% rate of the 1950s, but I don’t think that a marginal tax rate of 50% would be unreasonable on income in excess of $1 million. A higher top marginal tax rate would likely lead to a slower pace of economic growth. I think this is a reasonable sacrifice to make for a more stable economy and a more equitable distribution.

Preventing propriety trading firms such as Goldman Sachs from hiding behind limited liability. Forcing individuals in the financial industries to forfeit their bonuses in the event of a bankruptcy. Increasing the top marginal tax rate. Implementing these three reforms would fundamentally change the incentives facing decision makers on Wall Street. Financiers would face a greater share of the downside risk from their decisions and earn a smaller portion of the profits.

This is not a perfect solution. These reforms would shrink the size of the financial sector and reduce the available funds to fund investment. Making the financial sector more risk averse would reduce the likelihood of systemic meltdowns like we are facing today. Some people might view this as an unreasonable tradeoff. But constructing an elaborate regulatory scheme to prevent this specific crisis from happening again will accomplish nothing. Incentives need to be changed. This will take some sacrifice, but it is the only way to move the financial sector to a more stable equilibrium.