Why Bankers' Bonuses Should Be *More*, Not Less

You may have noticed there has been a lot of indignation over the notion of bankers' bonuses - particularly since the financial crisis. Mention the two words "Bankers' bonuses" and most people you meet are likely to react as though you've told them they are being forced to spend a cold, rainy weekend in Bognor with Diane Abbott, Mehdi Hasan, Vanessa Feltz and Robert Kilroy-Silk. But aren't they onto something? Surely it makes perfect sense that bankers who make losses for the bank should not be given bonuses - it's the most obvious thing in the world, right? It might be the most obvious thing in the world, except for the fact that it is wrong.

For a lot of complex reasons that I won't bore you with in this Blog post (but on which I do elaborate in more detail here for those that are interested), if a bank can get away with apportioning some of the salaries in the form of bonuses, it is better than paying inflated salaries. So bonuses often aren't the financial bogey that people think they are - but let's get to the heart of it, though, with some questions:

Isn't it true that sometimes bonuses are a bogey?

Yes, but consider who's to blame.

Reckless bankers?

Sometimes, but the problem is underpinned by government interference. Consider that bankers were not regulated 100 years ago, yet banks were still full of profit-seekers. What changed is that a culture of recklessness came about primarily due to guarantees bestowed by the government.

But how do government guarantees encourage recklessness - bankers will only make deals they think are profitable, won't they?

The problem is, if depositors no longer benefit to the same extent by bankers' felicity, their incentive to look for prudence is diminished. When the government guarantees the losses of depositors, the depositors no longer have to monitor carefully whether the bank is a prudent lender. But as well, in such a culture, depositors are primed to favour riskier bankers, because higher risks increase the chances of higher rates of interest for their depositors in successes, whereas they only increase the chances of a government (i.e. taxpayers) bail out in failures.

Ah, so the government are the ones laying down a cushion for recklessness?

Primarily, yes.

What's the solution - stop the nationalisation and the bail outs?

It would have been better to never have started them. It's difficult to withdraw now as the State acts (among other things) to protect the capital of ordinary citizens whose money is tied up in failing banks.

However, as regular readers of my Blog probably hoped would be the case - I do have a solution. Scrap bankers' salaries and get them to work on a bonus-only culture relative to their success. This is not alien to many bankers anyway; a great many have variable pay in shares, or in a bank bonus, contingent on the share price. These are reliable indicators because share prices are a good measure of a bank's performance - but the system probably needs tweaking to give greater incentive against failure.

Which bankers are most likely to be attracted to such a pay structure? Fairly evidently it is bankers with the greatest ability to make lots of money for their bank. It is for that reason that the system of bankers selling their talents for pay-based rewards would work best. It's best for talented bankers with financial nous and business acumen, it's good for shareholders, and it's good for the economy too.

To see why it would work, consider a car boot sale as an analogy. With car boot sales sellers pay a few pounds for a pitch because they expect to make more than the pitch fee in items sold. A car boot sale with a £5 pitch fee is pretty standard in the UK. If all prospective car boot sale sellers in the UK were suddenly hit with a mandatory £15 sellers' fee you'd find people with lower quality items would be less inclined to bother buying a pitch. Those with lots of quality goods might still be tempted, though, because they would have confidence that their net sales would exceed the £15 pitch cost. Charging a pitch fee, be it £5, £10, £15 or whatever is a great way to organise a car boot sale, because the fee, and the effort to drive down and set up, attracts only sellers who think they have enough quality items to sell and return a profit.

Imagine what would happen if, instead of charging for a pitch, car boot organisers started to pay people to set up stalls. There'd be recklessness, as sellers would turn up in their droves, pitching lower quality items safe in the knowledge that they'll make a bit of money anyway.

Now apply that to bankers pitching for their own successes. Just as you don't need to pay car boot sellers with lots of quality goods to sell, you don't need to pay bankers with lots of business acumen and financial nous inflated salaries to perform well. To get them to make good decisions, you only need to give them share-based or bonus-based incentives to do what they do best, because their own wealth is tied up in their success.

The banking system would be much better if bankers' bonuses were more, not less, and their salaries capped at zero - because increased bankers' bonuses would mean increased revenue for the bank as a result of prudent investments, or increased revenue for the bank as a result of overseeing a profitable merger for which they receive a percentage of the bank's often very large fee.

* Photo courtesy of bbc.co.uk

Be Encouraged: Why Writing Blogs Is A Bit Like Publishing Books

There are perhaps 3 main rewards for writers:

1) The personal enrichment that comes from forming your ideas and writing about them. 

2) Being able to share your writing and attaining positive* public feedback (in the form of praise, prestige, admiration, notability and reputation).

3) Making a living (or in some cases a fortune) from doing something you love.

Not every writer has number 3, but every writer can have numbers 1 and 2 (in the case of 2, assuming they're any good). 

For those for whom number 3 is a bonus and not to be expected, and for those not being paid by newspapers or magazines, 1 and 2 can still be obtained either through writing books and attempting to get them published or through writing Blogs.

If we assume the pleasure of 1 is steady irrespective of 2 (that certainly is the case for me), then a writer has an interesting consideration regarding number 2.  Blog writers like me are not being paid for Blog posts, but we can share information to a wide-ish audience, and obtain positive public feedback.

Playing around gracefully with hypotheticals, as I often like to do, I wonder what sort of value I (or anyone like me) would place on number 2 in all sorts of scenarios. Suppose there were 50,000 impressed readers reading my Blog for free each week vs. 50 super-duper impressed readers who would pay £2 per week to read my Blog (I doubt it - but humour me). What's better for the writer - all that adulation and no money, or 0.1% of the adulation and £100 per week? What about 100,000 non-paying impressed readers per week vs.100 super-duper impressed readers who would pay £2 per week to read my Blog (earning £200 per week for me) - which of those is preferable to most writers, or is it fairly evenly split? Perhaps the mass adulation would be worth losing £100 per week for but not £200. I don't know. There are lots of other factors too, and I haven't given them a lengthy consideration.

In real life terms, though, how might my Philosophical Muser Blog fit into the above consideration? Let's start by asking the following question. Suppose you're a budding writer - would you be happy if you wrote a book, had it published, and it sold 4562 copies?** There are, of course, a lot of variables attached to that question (even aside from financial ones). When it comes to expectations, if you're Lawrence Krauss or Francis Collins then 4562 copies sold would be a flop. If you're JK Rowling then 4562 copies sold would be a disaster. If you're an unknown sending off a book you're not that pleased with or bothered about then 4562 copies sold would be quite a success. If you're an unknown who has written what you think is your magnum opus then the disappointment of only 4562 copies sold may outweigh the pleasure at getting a publishing deal.

The number 4562 is not insignificant in my deliberations. My Blog reader count is 188,488. If we say that each hit has an average time of 2 minutes, which accounts for those who spend less time per hit and those who spend more, then that amounts to a total of 9124 hours for my aggregate readership. If we say that an average regular size book takes 2 hours to read, then 9124 hours of Blog reading is equivalent to the reading time of 4562 books. Thus, if I take into account only the information shared and the readership interest, then my writing this Philosophical Muser Blog has been roughly equivalent to writing a book that has sold 4562 copies.

As it happens, I am writing books as well, but haven't yet reached the stage of attempted publication. Until then I can dabble in my Blog writing. I wanted to write this to encourage fellow Blog writers, and others writing pro bono and au gratis - if as yet you're happy with the rewards of 1) the personal enrichment that comes from forming your ideas and writing about them, and 2) being able to share your writing and attaining positive public feedback - then what you're doing has some of the rewards of writing a book and having it published, so be encouraged to keep up the good work.  

* That's not to say negative feedback isn't valuable - but if we are being truthful, no writer really likes it.

** You may say selling 4562 copies has the added benefit of enhancing your future chances of being published, but consider it may have the opposite effect. Having a first relatively unsuccessful book published might be a springboard to future success, but equally its relative failure might put off any future publishers.



Women Drivers & The Counter-Productive European Court of Justice

My car insurance is due soon. I hadn't kept up with all the arcane ways that EU legislation affects UK business, but being curious about whether women still get cheaper car insurance than men on grounds of being statistically safer drivers who have fewer accidents, I looked online and found this:

The European Court of Justice (ECJ) has ruled that the long-established practice of setting insurance prices according to gender is illegal discrimination. The Court's decision forced members of the European Union to introduce a ban on gender-based pricing.

So, in basic terms, car insurers used to yield to market-based risk calculation (using a reliable tool called actuarial mathematics) and offer statistically safer drivers cheaper premiums (perfectly sensibly, in my view). Then the EU decided that it's much better to ignore all this data and assent to a spurious anti-unfair-discrimination policy, while failing to see the irony that in penalising statistically safer people for purposes of parity they are unfairly discriminating against safer drivers. This is beyond absurd. The primary measure of unfair discrimination in actuarial analyses is not treating different people differently, it is treating different people the same. Women are statistically safer drivers than men, which means they are cheaper customers, which means to increase their premium to the same as men is to unfairly discriminate against women.

The reasons why women are safer drivers are well known. Women are, on average, less likely to have fast cars, they drive fewer miles, they drive slower, they take fewer risks, and they are less aggressive than men. Giving women a lower premium based on those facts amounts to a simple and rational statistical evaluation of risk. The same is true of other considerations too - age, post code, miles per year, type of car, and so forth - each of these are important factors in risk evaluation, and the ECJ should leave well alone. The free market is the best tool for eradicating unfair discrimination in business, because pretty much any time a company decided to discriminate against women, black people, gay people, tall people, fat people, or whomever, they would pay for it with a reduction in profits*.

Of course, we know the probable motive in the ECJ's equalisation of gender - it is to guard against people with identical data having different premiums based solely on gender. But that misses the whole quintessence of how competition works in the free market. Suppose we have Jack and Jill, who are the same age, with the same car, same post code, and driving the same miles per year - the ECJ would have it that they should be given equal premiums because to do otherwise would be to discriminate on the only variable factor - gender.

But that is not what happens - while the data picks up facts like age, car type, post code, and miles per year, it doesn't account for those significant differences - speed of driving, risk-taking, aggression and other factors of mentality behind the wheel that make women more likely to be safer and have fewer accidents, and better candidates for cheaper premiums. The ECJ is guarding against the general being applied to the particular - but this is part of what makes competitive business healthy. In a free market we can work under an assumption of cheaper insurance premiums for a safer driving record at the individual level anyway - so it's a law that only actually compounds what already happens.

But we can extend far beyond that too - competing firms can solicit new custom by offering deals to acquire that custom. This proves very effective in the insurance market: some providers specialise in good deals for modified cars (like my modified Subaru), some specialise in good deals for women, some specialise in good deals for the elderly, some for first time drivers, and so on. Insurance companies have asymmetry of information when it comes to those vital premium-changers - they have transparency with data like age, post code, miles per year, type of car - but they don't have anything like the same transparency with things like speed of driving, risk-taking, aggression and other factors of mentality behind the wheel - which is where the actuary matters.

A company that's free to offer deals for women is acting on probability related to those invisible factors - but that also means women are free to look for insurers sensitive to such data, as are Subaru drivers, as are the elderly, and so forth. That's how beautifully the market for insurance rewards this innovation. If women are consistently safer, then they are consistently on average cheaper customers, which rewards those companies that are prepared in response to lower the premium for women. But if the data is spurious and women are less consistently as safe as the premium indicates then those same companies will incur a loss and adjust their women-favoured premiums to accord with that. It's a hugely efficient system that the ECJ hasn't properly factored into its considerations.

* Here's a simple illustration to show why discrimination hurts profits. Imagine there are just three beer-drinking people (Jonny, Billy and Jenny) in a village of one thousand people. Jonny makes home brewed beer to sell to his two friends Billy and Jenny, both of whom love home brewed beer and will pay £3 a pint for it, each drinking around 30 pints per month. Jonny suddenly develops a sexist mentality and refuses to sell beer to Jenny on the grounds that she's a woman. As a result, Jenny spends her beer money on other things and Jonny only sells beer to Billy. Clearly being a sexist has hit Jonny in the pocket. How much has Jonny's dissemination cost him per month? Selling 30 pints per month to Billy and Jenny generates £180 per month for Jonny - so by discriminating against Jenny, Jonny has cost himself £90 per month. That's as simple as I can put it to show why unfair discrimination is bad for profits.

** Photo courtesy of womenscheapcarinsurance.co.uk

Sometimes 'Life' Should Mean 'Life'

The European Court of Human Rights declares that it is a violation of human rights for criminals to be incarcerated for life with no hope of release. Such a declaration is, in my view, based on two faulty assumptions:

1) That there are no heinous conditions under which an offender should be expected to forgo his or her freedom for life.

2) That there are no criminals dangerous enough to warrant permanent incarceration, and no crimes committed, for which an offender should be locked away for life to keep the public safe from future harm.

Both those assumptions strike me as being false enough to cast serious doubt over the position of The European Court of Human Rights on this one. I'm glad to hear that the Court of Appeal made the right decision today.

* Picture courtesy of walesonline

"Smoking" Gun Evidence of Inconsistency

Parliament is now going to change the law on stealing food. It thinks stealing food is bad, but it thinks stealing some food is worse than stealing other food. From now on if you steal fresh fruit, chocolate or bread you will have committed a crime; but if you steal cereal, tinned food or crisps you will have committed no crime. Sound absurd? It is, but it is no more absurd than the government's latest 'no smoking' policy.

Parliament thinks subjecting children to cigarette smoke is bad, so it has passed a law to make it illegal to smoke in a car when there is a child in the back. But it has made no law against smoking whilst pregnant or smoking 40 a day in the living room surrounded by children.

My intention here is not to comment on whether the 'no smoking in a car with children' law is a good or bad move - it is to say that Parliament's position on this is inconsistent by being incomplete. Either it is a bad thing to harm children with your cigarette smoke or it is not. The State says it is, and most people agree. Therefore if the State is committed to a view that harming children with your cigarette smoke is bad enough to be illegal in the car, it should be consistent in being committed to a view that harming children with your cigarette smoke whilst pregnant or smoking 40 a day in the home should also be illegal.

Some would argue that smoking in the car with the child is more harmful to the child than smoking when pregnant. It seems obvious to me that the opposite is true. Car journeys are occasional and usually brief; whereas being pregnant is a constant nine month process. Who would you rather be: a child in the back seat whose parent sometimes opens the window when they drive, has one cigarette whilst holding it out the window, and blows any exhaled smoke outside, or a foetus inside a mother who smokes 10 cigarettes a day for eight and a half months? Whilst neither would be ideal, I'd choose the former.

Banning smoking in the house sounds like a step too far. Not banning smoking whilst being pregnant sounds like a failure to act. But in declaring that harming children with cigarette smoke is bad enough to warrant a law being passed to law to make it illegal to smoke in a car but not whilst pregnant or chain-smoking around kids in the home, Parliament has created a difficult position for itself, where it is either compelled to pour more fuel on the flames of legislation it considers necessary and extend the ban to pregnancy and home, or it has to adopt an inconsistent position whereby all flames are equal but some are more equal than others.

Why We Shouldn't Make A Habit Of Compensating UK Flood Victims

I heard on the news today that some of the flood victims in Somerset (and other places) are demanding compensation from the government for the damage to their properties. Giving it to them is a bad idea, and here's why. The price of their properties would have been cheaper to buy than equivalent properties not in precarious areas with increased flood possibilities. In buying a property at a reduced rate with a higher chance of flood damage, the buyers are, in effect, taking a risk with the reward of a cheaper property commensurate with that risk.

A government that gives compensation to riskier consumers ends up subsidising risk with your (the taxpayers) money. You might say that frequent dredging solves the problem, but it doesn't because dredging constitutes part of government expenditure, so it is still a case of subsidising risk - it's just a risk subsidy in the form of dredging instead of compensation. When risk is subsidised there is more of it, and when there is more of it there are further increases in it in the future - so instead of adopting more sensible property planning in the future, there will be a continuance of risky, and even riskier, ventures.

Imagine a time, say, one hundred years henceforward when - if the climate change portents are accurate - there is regular property-damaging flooding a few times a year. A situation in which governments kept compensating the victims would exhibit a system in which prior warnings were not heeded, and were, in fact, exacerbated by irresponsibility - an irresponsibility supported by taxpayer hand-outs (if you're interested, two corollary effects would be the raising of taxes for every taxpayer, including those who live in safer areas; and raising the value of property in these flood zones, which would have the effect of limiting people’s freedom to buy cheap, higher-risk property in preference to more expensive, safer property).

Having said all that, I try to be a fair-minded, compassionate man, and I will acknowledge that, so far, flood damage to the properties in question has been relatively infrequent. Thus, if government hand-outs of this kind are rare responses to relatively unforeseen disasters for families, it is a nice thing to help them out. I would just be very wary of any government that wantonly subsidises risks - because spending other people's money on things that bring about less of an incentive to be prudent won't be a good thing if flood-frequency starts to rise.

* Photo courtesy of The Times

Why It *Doesn't* Pay To DIY

At Drexel University, designer Kelly Cobb has tried to prove a point in favour of self-sufficient local trading by making what's called the "100 mile suit" – a suit made solely of materials raised, produced, processed and constructed within 100 miles of Philadelphia. She said:

“I think about cluster economies and how ideally a small community could clothe itself. If you bring the idea of local and sustainable clothing production down to the person-to-person level, the realization that a small community could clothe itself is possible with reasonable expectations and a little ingenuity.”

Kelly Cobb is confused. Her project doesn't prove that local clothing production can be accomplished under reasonable expectations, it proves the opposite – it proves a whopping point against self-sufficient local trade. While extolling the virtues of making the 100 mile suit, Kelly Cobb and her team have forgotten to count the cost of staying local and making it themselves – namely the time, effort, and the cost of denying the volunteers other uses of their skills.

In fact, in the article we get an idea of the extent of the cost with this statement from Cobb:

“Creating the suit was a massive task. Nearly two-dozen artists volunteered 506 hours. “It was a huge undertaking, assembled on half a shoestring,”

Half a shoestring? That must be the world's most expensive half-shoestring. Let’s be ultra-conservative with our estimate by rounding it off to 500 hours, and let us suppose that the average hourly rate of the artists was only £15 per hour. Let us also ignore the additional travel time, fuel costs and other negative externalities associated with those 500 hours – that still works out at a whopping £7500 cost for the suit. For a twentieth of that price she could have bought a decent suit in just a few mintutes in any good clothes store - a suit that was made much more efficiently thanks to global trade, division of labour and specialisation of skills.