Category Archives: Bank Bonuses

Devastating Mistakes of Economics

In 1792, William Pitt told parliament that Adam Smith’s “extensive knowledge of detail … will …furnish the best solution to every question … of political economy.” Since then it’s been downhill all the way. For Smith, the industrial firm (his famous pin factory) was the key to economic progress, with the market only serving to enable the division of labour. But economists have always given primacy to the market, almost ignoring the industrial firm, because they don’t begin to understand it. In late nineteenth century, economists adopted differential calculus to model the economy, which meant describing the firm as a “production function” comprising two variables, price and quantity, and seeking to maximise profit. This was not just stupid, but hugely damaging. Maximising one thing requires the neglect of everything else, which has done great damage to Anglo-Saxon industry. Finally, in the 1980s, still completely unable to conceive of what a firm involves, they adopted the agency idea, claiming that the managers of a firm were the agents of its shareholders and should not therefore be maximising profit but maximising shareholder wealth. It is a lie. Managers have no contract with shareholders, but with the firm which is a legal entity in its own right. Shareholders do not own the firm – if they did they would not enjoy limited liability. They own shares which entitle them to dividends and capital growth, both at risk. Maximising shareholder wealth, as required by Friedman and followers, requires neglecting everything else. When specific decisions have to be taken, notably in the case of hostile takeovers, this is crucial. It has destroyed much of what remains of Anglo-Saxon industry, the latest British example being Cadbury. It has also justified the obscenity of top executive share option bonuses, which unless reversed will be the source of what is called euphemistically, social unrest.

The Institutional Truth About Free Markets

The theory which, over the past three decades, has become the ubiquitous orthodox free market wisdom, is widely assumed to be simply the current version of classical economics originally expounded by Adam Smith. Moreover, it might be reasonable to assume, it being the latest, it is the most insightful and effective, having been shaped by the errors and excesses of previous versions. The current free market model certainly includes Adam Smith in its provenance, but what makes it different from previous models is the fact it is also based on certain theoretical foundations which are demonstrably false and which previous versions did not share. It has become what J K Galbraith described as an institutional truth. That is, not a truth at all, but a downright lie, but one to which all associated must subscribe if their careers are to prosper.

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Earning the £Bn Bank Bonuses

Justification of bank bonus payments proceeds apace. Despite having in effect gone bust last year, and being only rescued as a publicly quoted company because the Labour Government was so paranoid about nationalisation, the directors of the Royal Bank of Scotland now wish to set aside £1.5Bn of tax payers’ money for next year’s bonus payments. Their argument is that unless the bonuses are paid, their most talented people will leave and they won’t be able to recruit in this highly competitive field. But it’s been said before that it was precisely these individuals who broke the bank. So why should the tax payer worry if they leave and aren’t replaced?

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Bad Theory: the foundation of excess and disaster

Successive governments from Thatcher on, have been committed to free market capitalism with minimised regulation. That was the bad theory that got us into this mess. But the prescriptions for what will get us out of it, permanently, have so far been piecemeal and fragmentary. The pragmatic response of the British government may restore confidence short term and get the wheels turning again, but it does not offer a coherent long term alternative to the erstwhile orthodox wisdom propounded by the late Nobel laureate Milton Friedman and colleagues.

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