Why is Osborne obsessed with bonuses?

It is hard to work out what the bankers did to George Osborne. Perhaps he was refused an overdraft at a formative age. Whatever it was, he is taking his revenge, saying that the large British banks should only be allowed to pay trivial cash bonuses. The plan has its political attractions — focus groups tell him no punishment is too harsh for the City of London — but also three significant economic drawbacks. It is vindictive, ineffective and it fails to address the true reason for the crash.

Let us first examine this on a practical level. Cash bonuses would be outlawed, but banks would still be able to pay their staff as many millions as they want in shares (how the Treasury would feel seeing its stake in the Royal Bank of Scotland diluted, and bankers paying low capital gains tax rather than high income tax, remains unexplained). The rule would only apply to UK commercial banks, not to pure investment banks, or subsidiaries of foreign banks (such as Goldman Sachs), or hedge funds. At the root of this is the belief that there is a moral equivalence between RBS’s performance, which needed a huge taxpayer bail-out, and that of HSBC, which took not a penny from the government. Talk of moral hazard: regardless of how well you do, you will still be hammered by the government.

But like much of Tory economics, this is primarily intended to seek votes rather than to help the economy. It plays to a blame-the-bonus narrative, which is as clear as it is flawed. It goes something like this: greedy traders, incentivised by absurd short-term bonuses, took near-criminal risks with their firms, buying complex derivatives that turned out to be worthless. After being bailed out by taxpayers, they are at it again — taking renewed risks and helping themselves to the payouts.

Some of this critique is spot on. Many bankers behaved appallingly, pocketing huge payoffs for losing billions. Not all of those who cashed in by promoting dodgy products have lost their jobs. Bail-outs are always unjust. But pinning all the responsibility for the crisis on City firms and their bonus culture is dangerously simplistic. And it allows those who are truly to blame for the crisis — especially central bankers, regulators and politicians — to escape unpunished.

The real starting point for our problems was the tidal wave of cheap and easy money unleashed on the global economy, starting in the late 1990s and intensifying in the early noughties. City bankers had a walk-on part in this saga, rather than the starring role, which is shared between central bankers and politicians. For all their arrogance, bankers are merely the (highly paid) conduit for central bank policies. And such policies are the main motor of economic ups and downs.

The Tory obsession with bonuses confuses cause and effect. There were big bonuses because there were big profits; there were big profits because money had become so cheap and plentiful. This was the result of three simultaneous forces. First, low interest rates set by central banks in America, the UK, China and Japan. Next was the Federal Reserve promising to bail out the markets with more cheap money at the first sign of trouble. Finally, a wall of money flooding into Western markets from China and the Arab world, bidding up asset prices and pushing interest rates even lower.

One can add to this list of forces blowing up the bubble. Washington’s desire to promote home ownership at all costs led to the subprime disaster. Then there was the astonishing hubris whereby economists convinced themselves that their fancy mathematical models had allowed them to eliminate risk — and end the cycle. This profound intellectual error helps to explain why banks were encouraged to borrow so much and take so many risks. It explains why Gordon Brown was happy with what now stands exposed at his inept regulation.

And bonuses? Not a single rigorous academic piece of research supports the view that bonuses caused or were a significant contributor to the financial crisis. They may have had their place, but that would not even be in the top ten causes of the crash. Even Lord (Adair) Turner, chairman of the Financial Services Authority, who recently claimed that much of what the City does is socially useless, agrees that ‘it is possible to overstate the importance of bonus structures’ and points instead to ‘huge failures in capital adequacy and liquidity regulation’. His analysis is not much heeded. Politically, bashing bankers is far more fun.

The best academic paper on the subject — and one which has gone completely unreported in Britain — suggests that bonuses paid to bank chief executives had precisely zero impact on the crisis. The study was by René Stulz of the Swiss Federal Institute of Technology and Ohio State University, and Rüdiger Fahlenbrach of Ohio and the National Bureau of Economic Research. They analysed 98 US banks with assets of $12 trillion and examined several accusations. That bank bosses were too focused on the short run; that stock options incentivised them to take too many risks; that they tried to pump up their share price by accumulating excessive debt.

Their results came as a shock: the study found bonuses and stock options not guilty on all counts. Bankers misjudged reality and made colossal errors; but they genuinely believed that what they were doing was in the best long-term interests of their shareholders and banks. They would have failed with or without bonuses; they were mistaken, not evil or deliberately reckless. If the bank bosses knew they had done wrong, they would have sold their shares. Instead, on average, they personally lost $30 million.

So instead of wasting so much time obsessing about bonuses, which didn’t cause this crisis, we should look instead at simple reforms to our financial system and economic policy. Banks should be allowed to fail — we need new wind-down procedures that wipe out equity-holders, bondholders and management in the event of insolvency. Living wills are part of the answer; no bank should be ‘too big to fail’, however large it may be. Financial institutions must start to fear failure again. They should also hold more capital to protect themselves in the event of another recession. Meanwhile, the West must save more — and the East spend more.

Perhaps most importantly of all, central banks need to stop focusing exclusively on targeting consumer price inflation, a purblind strategy where booming asset prices (houses, wine, art) are not seen as the problem of cheap money that they invariably are. This was the warning sign everyone missed during this (and most previous) bubbles. The more the Tories focus on bonuses, the less likely they are to notice another such crisis in the making. Politicians love to decry what they see as business as usual in the City; but what would really kill the British economy is business as usual in politics. And so far, there are ominous signs that the Tories may well provide precisely that.

Allister Heath is the editor of City A.M.