Stiglitz: It's Wall Street Bonuses, Stupid

(MoneyWatch)  Nobel Prize-winning economist Joseph Stiglitz told lawmakers this morning what he thinks is wrong with the banking industry. Testifying at a House Financial Services Committee hearing on Wall Street compensation, he boiled down his critique to four main points:

• Banks have consistently failed to fulfill their basic societal mission
• Banks have repeatedly been bailed out from bearing the consequences of their flawed lending
• The financial sector has imposed large costs on the rest of society
• Incentives within the financial system are distorted at both the individual and institutional level -- at both levels, private rewards and social returns are misaligned

Except for financial industry lobbyists, few would argue with Stiglitz's first three contentions, especially if discussion focuses on big banks. But the issue of pay remains a searingly hot button. In part, that's because some financial firms continue to shell out huge "bonuses" despite subpar results, making a mockery of the idea of "pay-for-performance."

But it's also because Americans have always been ambivalent toward Wall Street. Not only regarding how much money major bankers make, but also how they make it. For 200 years those misgivings have festered and periodically flared.

Yet as a nation we also venerate, if not the Street, then something of its values, its potent, unapologetic fixation on getting rich. For all the facile contrasts between Main Street and Wall Street, each is a product of the other.

"Every man is a speculator, from a wood-sawyer to a President, as far as his means will go, and credit also," wrote 19th century traveler and author Jeremiah Church.

As Stiglitz noted, people today are angry at the financial industry for what it's done (or failed to do). But they're also angry because of what it is. And what it is, or has become, reflects our own political and economic choices.

Excuse the café philosophizing, but it's important to draw connections between what's happening in this industry we're understandably preoccupied with and what's happening in the political economy at large, which touches everyone. It's one thing to make choices knowing they affect big companies, whose welfare often seems remote from own own. It's another to recognize that those choices -- how big should banks be, what kind of taxes they should pay, what bankers should earn -- affect us deeply.

In other words, the debate over financial reform is effectively a referendum on whether the banking industry -- and the country -- must change. And, if so, how.

Speaking of, how does any of this relate to the fight over Wall Street bonuses (sorry for the detour)? Simply this: The key to preventing Stiglitz's first three points is to resolve the fourth. One way to stop financial firms from getting too big to fail is, as President Obama proposed Thursday, to make them smaller. But that's not enough.

You also have to change the incentives to get bigger, which are the same incentives that lead to financial adventurism.

If bankers are financially rewarded for using leverage to maximize profits, leverage will spiral out of control. If executives are permitted to boost a company's stock price by shuffling risk off the balance sheet, then risk will inevitably bite us in the ass. Where bank personnel are bribed to write crummy loans, foreclosures will follow. When making money becomes a perpetual race for alpha, investment returns will lose all touch with fundamentals.

Unless we get such incentives right, as Stiglitz explains, our other fixes won't matter.