Bonus bubble

Bent Wall Street sign


It will take more than turning to Keynes for a way out of this mess, writes Mark Blyth

A few years ago, bankers’ bonuses were not a political issue. When the credit bubble was inflating and the neoliberal rising tide seemed to be lifting all boats, those who took the risks, according to both the left and the right, deserved the rewards.

Jump forward a little and we see the Australian Prime Minister, Kevin Rudd, decrying undeserved bonuses “generated by greed of epic proportions”. Populist reaction and social democracy become easy bedfellows on the downside of a bubble.

But to focus only on the level of compensation is a mistake. Yes, the numbers involved are outrageous, but you could take all the bonuses awarded during the past decade and throw them at the $US4 trillion hole the banking system has blown in financial space-time and it wouldn’t make much of an impact. The real issue is how bonuses generate systemic risk.

As Nassim Taleb, author of The Black Swan: The Impact Of The Highly Improbable, has argued, allowing banks to self-regulate and become “too big to fail” generates what bankers call a free option. That is, on the upside of the bubble they take the profits and hide the risks. On the downside, they expose the risk, socialise it via bailouts, and continue to privatise the profits through state guarantees. The engine driving this deeper scandal is the bonuses system.

Bonuses are based upon beating targets, usually the average of some index, or a historical average of competitors’ performances.

The problem with bonuses is that if everyone tries to beat the average, the average is built up over time. Such moving averages generate systemic risk because they encourage banks to take ever more risky positions in order to beat the ever-increasing average and keep their place as above-average performers.

But as a consequence, more and more risk is taken onto the books, then passed around the system via derivatives in the name of risk management, which brings us to where we are today. In this version of the story, greed is a secondary issue. The billions given out in bonuses are a detail. What matters are the trillions in systemic risk generated by the bonus culture itself.

In his Monthly essay, Kevin Rudd implicitly implicates bonuses in his call for social justice, tying the greed of the financial “haves” to the suffering of the bailout-paying “have-nots” and he is right to do so, but doing so has a cost. It misses the bigger problem of how bonuses generated much of the risk that exploded.

The ideas that got us there are the root cause of such behaviour to be sure, but to stop at bad ideas and bandwagon with populist outrage risks missing this key point. It also risks something even more important: the need to ground claims for social justice, and therefore for social democracy, in something more than a claim for fairness.

Social democracy can’t claim the right to govern simply because neoliberalism is unfair. Life is unfair. To defeat neoliberal ideas, Rudd’s appeal to fairness must do something more. It must generate a convincing economic argument, not a moral one based on the size of bankers’ bonuses.

Rudd must make the case for a practical and self-interested embrace of social democracy. Twenty-five years of “I’m all right Jack–you buy your own Tim-Tams” doesn’t disappear overnight. Neoliberal ideas didn’t win the day by banging on about being fair. They won by having a compelling story about why policies based on its ideas would be economically superior. Rudd’s claim for social democracy is somewhat rudderless in this regard.

Like many centre left politicians today, Rudd has rediscovered John Maynard Keynes. The only problem is that the version of Keynes that has been rediscovered across the world is the one Joan Robinson once called “Bastard Keynesianism”. It is what happened to Keynes’ ideas when a bunch of post-war American economists chucked out all the bits that couldn’t be mathematised, and reduced his core ideas on uncertainty, social conventions, the subjective nature of investment etc, to the propositions that wages are downwardly rigid and that fiscal deficits per se can cure an economic depression through a simple, estimable, and predictable multiplier.

Rudd’s comments on “growth gaps” and the need for fiscal policies, quoting Tony Blair’s oddly vampirish understanding of economics as a situation where governments must “do whatever it takes to get the blood pumping around the financial system”, reflect an almost hydraulic Keynesianism in which if one pumps in enough liquidity, the economy, like a flat tyre being inflated, comes back to life.

Such a conception of Keynesianism is deficient in many respects, but the one of importance here is its political deficiency. By treating economics as hydraulic engineering, it misses the politics implicit in economic ideas. Keynesian economics heralded not only the discovery of the macro-economy, it also provided social democracy with a particular political economy.

To see what I mean, consider a facet of neoliberalism Rudd didn’t mention: the best supporting actor role played by so-called supply-side tax theory. Although regarded as intellectual miasma by most economists–the supply-side idea, to cut taxes and get more revenue and growth–also carries a particular politics. Like its intellectual forebear, Jean-Baptiste Say’s injunction that supply creates its own demand, it assumes that all the action in the economy is on the supply side. That is, the very action of bringing a product to market creates the demand sufficient to justify it. In this world, the heroes are the entrepreneurs who bring things to market. Workers and their consumption are an adjunct to the entrepreneurs’ risk and endeavour, and so the investor class should be rewarded, mainly by paying as little tax as possible.

Keynes’ economics challenged this view fundamentally and for a while, it won, and for good economic reasons. Often called demand-side economics, in Keynes world, consumption, not investment, is key, since in a downturn, it is irrational to invest. The point of state spending is not to pump blood into the beast or air into the tyre, but to alter the investment expectations of investors, which is best achieved through raising the level of consumption in the economy.

However, if one accepts this, the politics of Say’s world are reversed. Rather than the investor class being the heroes, it’s the joint consumption decisions of millions of ordinary people that lie at the heart of the machine. Their consumption choices drive investment demand, not the other way round. As such, who should be favoured, protected and served by the government become the ordinary worker, not the extraordinary banker.

Acknowledging this has two consequences for any refashioned social democracy. First, don’t go after neo-liberals on fairness issues, go after them on their home turf of economic efficiency. For a real Keynesian, inequality is economically inefficient, since those at the top don’t need to consume and those at the bottom cannot consume.

Tax cuts should target those most likely to spend, not those most likely to invest, since they already have most of the rewards–they are simply unwilling to part with them. Welfare states make sense not because they are well…fair, but because they provide a consumption floor in moments of crisis and create automatic stabilisers in the form of transfers that stop governments having to spend excessively in the short run to counter downturns. This is why the Europeans are right in not spending as much as Obama and Brown. Their so-called bloated and outdated welfare states mean that they don’t need to.

Given this, public-good provision becomes not just an economic bonus, it becomes a political strategy. As more and more people are freed from their reliance on markets and the risk they generate but cannot compensate for, the party that supplies such goods will be favoured politically. One of the world’s richest and most productive countries, Sweden, has tax rates that would make an American reach for a gun, and yet there is no tax revolt and the social democrats have been in power, with few exceptions, since 1923. Win the economic argument and you win the political one too. Argue for fairness and you’ll lose.

Second, embracing authentic Keynesian politics necessitates a break with the false dawn of the past decade and with the left parties that governed on the up side of the bubble. It’s not just neoliberalism that needs to be repudiated, it’s the new democrats and new labourites that really got us here. In 1997, at the time of the East Asian crisis, British chancellor Gordon Brown stood on the steps of No.11 Downing Street, babbling on about rational investors, transparency, efficient markets and all the rest, in a script written by his then adviser, Ed Balls. Brown a that point presided over the inflation of an asset bubble so large it basically turned the UK economy into a gigantic housing swap, during which time, inequality became far worse than it was under Thatcher.

Having sat atop this powder-keg of risk and privilege and having done nothing to prevent its detonation, Brown now tries to assure the British public that he is uniquely qualified to fix the system that just blew up, since he helped build it. The same is true for Larry Summers with Obama.

Neoliberalism may have been invented by neoliberals, but it was carried to full flower by those who would today call themselves social democrats. This legacy needs to be repudiated, too. Otherwise, those voters who will see their pensions disappear and their houses sink in value will not accept the heirs of those parties saying the party is over, when, in fact, they were the ones who ran up the bill the voters are now being asked to pay.

All governments need to rebalance the market and the state, but perhaps none more so that those parties that carry the Labor banner, since they have carried little except an admiration for bankers and neoliberal ideas for the past several years. Rudd’s essay is a good start, but it remains just that, a good start. If he learns the political economy of Keynesianism and wins the economic argument over the fairness argument, he might just turn that start into a new beginning.


Mark Blyth is professor of International Political Economy at Brown University and author of Great Transformations: Economic Ideas And Institutional Change In The Twentieth Century.