The Goldman Sachs Bonuses: II

Here are two questions about the bonuses that I did not discuss in my blog yesterday:

1. Could the bonuses be compensating for the risks of a career in finance?

2. Shouldn't Goldman want to limit the bonuses paid its employees?

1. Consider actors' careers. A handful of actors have huge incomes. Most actors have such meager incomes that they abandon acting as a career. The lucky handful are like lottery winners. The only way you can motivate people to buy a lottery ticket is to have a big jackpot for the winner of the lottery. Similarly, the only way you can motivate people to attempt a career in acting is to provide a jackpot for the tiny handful of aspirants who succeed.

Could finance be the same? It is, after all, a risky business. The question is what happens to employees of Goldman Sachs or other financial firms if they engineer or approve a very risky deal, and the deal is a flop. Are they exiled from the industry? Do they end up as waiters? If so, the huge incomes of successful financiers would be justified as compensation for the risk of failure. My impression is that the failed traders, deal makers, etc., do not end up as waiters, or in other relatively impecunious jobs (I say "relatively" because waiters in elite restaurants are well paid by ordinary standards). Their training and experience equip them for a variety of good jobs in the financial industry. They can look forward to a soft landing, and therefore it is unlikely that the high incomes of the most successful financiers are compensation for the risk of failure.

It is true that anyone who is risk averse will seek compensation for taking risks, but the people who gravitate to risky occupations are unlikely to be risk averse. Put differently, as long as there is an ample supply of risk preferrers, an employer will not have to pay a premium based on risk aversion. And, as I have just suggested, the career risks in being a trader or deal maker for a major financial firms like Goldman Sachs are probably very small.

2. A "monopsony" is the converse of a monopoly. A monopolist reduces output in order to push price above the competitive level. A monopsonist reduces his purchase of an input in order to drive the price of the input below the competitive level. If a firm faces an upward-sloping supply curve--meaning that the more it buys, the higher the prices it must pay--then if it buys less, thus moving down the supply curve, it will pay lower prices for its inputs. Suppose the input in question is labor. If the relevant labor market is competitive, monopsony won't be feasible; workers offered a lower than market wage will quit and work elsewhere. But suppose all the firms in an industry conspire to reduce their hiring; then wages will fall because the affected workers will not have good alternatives.

So why don't financial firms welcome pay caps, or, in Goldman's case, since it isn't subject to the caps, voluntarily compress the compensation they pay? There are three answers. The first is that if the firm does so, its best employees will quit and work elsewhere. This is not as compelling an answer as it seems, since demand for financiers has fallen and, more important, because Goldman Sachs is regarded as the world's premier financial company and (therefore) immensely profitable, so it is unlikely to hemorrhage employees merely by cutting bonuses; and if it loses some, it should be able to replace them.

The second answer, which is related, is that without industry-wide pay caps, a reduction in wages is not an equilibrium; Goldman Sachs might be able to get away with limiting its employees' compensation in the short run, but in the long run it would lose superior employees to competitors. It might therefore flaunt its huge bonuses in the hope that this would power the movement for industry-wide pay caps.

But third (and a compelling reason for doubting that Goldman wants industry-wide pay caps), we know that the top managers of large corporations are not perfect agents of the shareholders--the nominal owners of the corporation. A pay cap might be in the interest of shareholders, but it would not be in the interest of the top managers, since it is they who would be subject to the cap, either alone or together with traders and other subordinate employees.

(Photo: Getty Images/Mario Tama)