Drop the Pitchfork!

The torch and pitchfork brigade rose in force to confiscate the earnings of the AIG employees responsible AIG bonuses are outrageous—but taxing them is just plain stupid. Will somebody please start making sense?

The torch and pitchfork brigade rose in force to confiscate the earnings of the AIG employees responsible for effectively bankrupting that company and threatening the stability of the Western financial system.

The result was the House of Representatives passing an unprecedented tax: The feds threatened to grab 90 percent on the earnings of any individual who with his spouse earns more than $250,000 on or after Jan. 1, 2009 if his earnings are derived from a firm that received more than $5 billion in aid from the federal government under TARP. The Senate is working on a similar, albeit less Draconian, version.

And that's just one more example of Washington lawmakers acting emotionally to address issues that need to be approached rationally. It may be that this effort to rule by hysteria will be derailed. But it has sent a chill through the business community.

Let there be no mistake: The AIG bonuses are a disgrace.

But there are other ways to prevent them from being paid.

Under basic contract law, contracts that are contrary to public policy or illegal are unenforceable. For example, a contract for prostitution or to buy illegal drugs is not enforceable.

It would be much better for the government to attack these bonuses on the basis that they are contrary to public policy than to engage in post hoc confiscation via taxation.

Mark my words: The bonus tax would have wide-ranging implications that cannot be accurately predicted right now. We can know, though, that the repercussions wouldn't be good.

For one thing, rather than employ the law of contracts itself to solve the problem, this approach creates substantial doubt about the sanctity of contracts in America. And that is not good for business—especially when creditors are frozen in fear that others won’t honor their obligations.

For another, this law is a churlish response to a problem that Congress created in the first place with a poorly structured bailout of AIG. All Americans—federal lawmakers included—need to take more responsibility for our actions, not less.

About the best thing that can be said about this legislative embarrassment is that it is marginally better than Senator Charles Grassley’s suggestion that the recipients of these bonuses consider committing suicide. His comment only serves to demonstrate how low we could see public discourse sink before this economic crisis is done.

Fire Them

The arguments proffered by AIG to defend the bonuses are pablum. It is complete nonsense to argue that the only individuals who can manage the complex positions that sunk the company are the incompetents who created them in the first place.

Forget “retention bonuses.” We need to think about firing these AIGers. They are the last people whom the company and the government should be depending upon to lead us out of the morass they created.

The reason these derivatives exploded in their creators’ faces is because they were based on erroneous assumptions about basic concepts such as correlation and risk. The people who constructed these positions misunderstood how financial markets operate; there is no reason to believe that they are any smarter today.

In fact, they likely remain intellectually and emotionally vested in salvaging their reputations and careers by trying to prove that their original theses were correct, and that the market sell-off was an aberration—rather than an all-too-predictable result of years of excesses about which some of us were warning.

There’s still a misconception that the involvement of mathematics in finance renders investing a precise science. Nothing could be further from the truth.

Investing and finance are as much art as science. The presence of mathematical formulas in certain investment strategies such as derivatives does nothing to change that—and actually increases risk by creating the illusion of scientific accuracy when no such thing exists.

What AIG and the government need are honest people with common sense to unwind the mess, not a bunch of eggheads who haven’t yet figured out that markets work in practice but do not work in theory.

This is Critical

The AIG bonus mess could be dismissed as a sideshow in a much larger financial crisis. But that would be a mistake.

Rather, this scandal highlights the key issues at the heart of the financial crisis and why many of the steps taken to solve it are less than optimal.

Reliance on the modes of thinking that led to the crisis—undue dependence on financial models, a belief in quantitative finance, are just two—must be thrown out the window.

People, let’s put down the pitchforks and get to the real business at hand. It’s time to reform the financial markets and properly align the incentives of those who work in them with the society that these markets are supposed to serve. Nothing less will do.

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