nep-pke New Economics Papers
on Post Keynesian Economics
Issue of 2010‒05‒08
four papers chosen by
Karl Petrick
University of the West Indies

  1. The Bonus-Driven “Rainmaker” Financial Firm: How These Firms Enrich Top Employees, Destroy Shareholder Value and Create Systemic Financial Instability (revised) By James Crotty
  2. The Financial Instability Hypothesis:a Stochastic Microfoundation Framework By Carl Chiarella; Corrado Di Guilmi
  3. An Autopsy of the U.S. Financial System By Ross Levine
  4. International Trade, Factor Mobility and the Persistence of Cultural-Institutional Diversity By Marianna Belloc; Samuel Bowles

  1. By: James Crotty
    Abstract: <p><i>Revised April 2010</i></p><p>We recently experienced a global financial crisis so severe that only massive rescue operations by governments around the world prevented a total financial market meltdown and perhaps another global Great Depression. One precondition for the crisis was the perverse, bonus-driven compensation structure employed in important financial institutions such as investment banks. This structure provided the rational incentive for key decision makers in these firms (who I call “rainmakers”) to take the excessive risk and employ excessive leverage in the bubble that helped create the bubble and make the crisis so severe. This paper presents and evaluates extensive data on compensation practices in investment banks and other important financial institutions. These data show that rainmaker compensation has been rising rapidly, is very large, and has asymmetric properties that induce reckless risk-taking. Since boom-period bonuses do not have to be returned if rainmaker decisions eventually lead to losses for their firms, since large bonuses continue to be paid even when firms in fact suffer large losses, and since governments can be counted on to bail out the largest financial firms in a crisis, it is rational for rainmakers to use unsustainable leverage to invest in recklessly risky assets in the bubble. A review of the modest literature on financial firm compensation practices in general and those of investment banks in particular demonstrates that the giant bonuses of the recent past are not appropriate returns to human capital – they are unjustified rents. The paper discusses possible answers to the challenging questions: what is the source of rainmaker rents and how are they sustained over time? Answers to these questions can help guide debates over the appropriate regulation of financial markets. They are also necessary inputs to the development of an adequate theory of the “rainmaker” financial firm that can help us understand how these firms were able to maximize the compensation of their key employees through policies that destroyed shareholder value and created systemic financial fragility. To my knowledge, no such theory currently exists.</p>
    Keywords: bonuses; investment banks; leverage; financial crisis; perverse incentives
    JEL: G24 G10
    Date: 2010
  2. By: Carl Chiarella (School of Finance and Economics, University of Technology, Sydney); Corrado Di Guilmi (School of Finance and Economics, University of Technology, Sydney)
    Abstract: This paper examines the dynamics of ï¬nancial distress and in particular th emechanism of transmission of shocks from the ï¬nancial sector to the real economy. The analysis is performed by representing the linkages between microeconomic ï¬nancial variables and the aggregate performance of the economy by means of a microfounded model with ï¬rms that have heterogeneous capital structures. The model is solved both numerically and analytically, by means of a stochastic approximation that is able to replicate quite well the numerical solution. These methodologies, by overcoming the restrictions imposed by the traditional microfounded approach, enable us to provide some insights into the stabilization policies which may be effective in a ï¬nancially fragile system.
    Keywords: financial fragility; complex dynamics; stochastic aggregation
    JEL: E12 E22 E44
    Date: 2010–03–01
  3. By: Ross Levine
    Abstract: In this postmortem, I find that the design, implementation, and maintenance of financial policies during the period from 1996 through 2006 were primary causes of the financial system’s demise. The evidence is inconsistent with the view that the collapse of the financial system was caused only by the popping of the housing bubble and the herding behavior of financiers rushing to create and market increasingly complex and questionable financial products. Rather, the evidence indicates that regulatory agencies were aware of the growing fragility of the financial system associated with their policies during the decade before the crisis and yet chose not to modify those policies.
    JEL: E60 G20 G28 H1
    Date: 2010–04
  4. By: Marianna Belloc; Samuel Bowles
    Date: 2010–04–27

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