Thursday, May 5, 2011

Comparing private and government compensation

There is an assumption in many quarters of society that virtually any form of government is inherently bad. Private enterprise and the free markets can do things much better. Consider this essay entitled If Supermarkets were like Public Schools, as one of many examples. Donald Boudreaux lays out the scenario:
Suppose that groceries were supplied in the same way as K-12 education. Residents of each county would pay taxes on their properties. Nearly half of those tax revenues would then be spent by government officials to build and operate supermarkets. Each family would be assigned to a particular supermarket according to its home address. And each family would get its weekly allotment of groceries—"for free"—from its neighborhood public supermarket.

No family would be permitted to get groceries from a public supermarket outside of its district. Fortunately, though, thanks to a Supreme Court decision, families would be free to shop at private supermarkets that charge directly for the groceries they offer. Private-supermarket families, however, would receive no reductions in their property taxes.
He went on to assert that private enterprise, or the free market, could deliver those services much better [emphasis added]:
Being largely protected from consumer choice, almost all public supermarkets would be worse than private ones. In poor counties the quality of public supermarkets would be downright abysmal. Poor people—entitled in principle to excellent supermarkets—would in fact suffer unusually poor supermarket quality.

If the free market is the superior choice in virtually all instances, then incentivizing workers by their output, as well as a business friendly tax policy, is the correct solution. Nowhere else can this attitude be found than the gargantuan compensation packages found on Wall Street.
The Epicurean Dealmaker has a more nuanced interpretation of banker compensation. He explains that investment banks are networks that can be rented by clients. The investment bankers and traders are also valuable in and of themselves:
Clearly, a proprietary trader or an M&A banker is more powerful and effective if he or she works at a great platform with outstanding network resources, like Goldman Sachs. He or she can do more, bigger, and more profitable deals because of it. But Goldman Sachs itself is more powerful and more valuable to its clients because they have that person (and his or her network(s)) in place. To the question, "Who is more valuable, the banker or the platform?," the answer is always "Both." Take one away from the other, and both are diminished.
So discussions like this one, where an individual who arranged a massively profitable trade for his bank expects far more compensation than the bank wants or is likely to give him, are an annual staple of my industry. Clearly the trader could not have done such a trade without the capital and resources of his employer, so a huge bonus is not merited. But the bank has incentives to make him happy, too, lest he leave with the special knowledge or relationships he employed or developed in that trade to replicate it—and the accompanying profits—at a competitor. Investment banker compensation is always comprised of some portion of reward for business won and profits made plus an option on potential future business and profits from that same banker. This insight helps explain the fact, puzzling to most outside the industry, that investment bankers can get paid tons of money even when they or their firms lose it: they are being paid for future potential results.
So if you accept the principle that someone makes a zillion for the bank, he deserves a reasonable cut of the profit (with definition of the term "reasonable" subject to later discussion).

Greed is Good, but it isn't the only motivator
Contrast that to the paradigm of how government works. Civil service workers have little incentive to do a better job, largely because market based signals are largely absent.

Now think about the jubilation over the death of Osama bin Laden and the adoration of the anonymous SEAL team that executed the raid. Now think about these questions:
  • Why is there all this adoration over a bunch of people who work for the federal government?
  • There was a $25 million reward for OBL, why didn't that get results earlier?
  • Would we have seen better or faster results if these civil servants had been incentivized properly (perhaps to give a three or six sigma effort)? Should this SEAL team, along with the numerous intelligence analysts involved in the operation be incentivized with multi-million dollar Wall Street bonuses?
People do things not just because of greed. Greed is a powerful motivator, but it isn't everything.

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