It's not regulation, it's the incentive system

The press, the pundits, and both presidential campaigns have been recently talking incessantly about regulating the financial industry. Here's a representative quote from today's NY Times:

"The swaps market has been unregulated. It has been just a lot of people making bets with one another. Some of them made incredibly fortunate payoff wagers against the mortgage bonds, using credit-default swaps as their wagering vehicle."

http://www.nytimes.com/2008/09/28/business/28every.html?em

Although it is not stated, the implicit assumption in this article is that if the credit swaps WERE regulated, the market collapse could have been avoided. Which makes me wonder - wouldn't people just trade in a different unregulated security then? Swapped collared credit swap swaps :-)? The moment the game is defined, people will always find a way around the rules...

I think that the real reason for the financial disaster (it is actually more of a monetary crisis, but that's a topic for a different post) is that there is a broad incentive for managers in the US to underprice or outright ignore the risk associated with their decision.

It is in the structure of the compensation system: the upside of an action that produces very positive short-term effect but is detrimental long-term is higher than that of an action that results in steady, predictable, but not exceptional output. Corporate manager, a rational being when it comes to money, starts exhibiting the behavior that is better correlated with a speculator rather than a long-term investor.

(More here: http://1-800-magic.blogspot.com/2007/12/risk-vs-reward.html)

How this can be solved? Not with regulation of financial assets, that's for sure. The problem isn't even financial - it is endemic to every US enterprise, Wall Street or otherwise, and is rooted to a simple fact that a huge cash infusion in the form of a bonus is better than a steady stream of "just decent" salary.

One way to address it would be to make executive salary based on very long-term performance of the enterprise, for example, to eliminate stock-based compensation entirely, and make cash compensation dependent on 5-year average growth of stock price.

Government of course cannot do this - it would be up to the boards of individual corporations. Boards unfortunately are not known for the sort of the leadership this would require: it might have something to do with the fact that they are recruited by the very same CEOs whose compensation they are supposed to regulate.

What government CAN do is eliminate the attractiveness of huge cash infusions - for example, by raising the taxes for people making more than 10M/year to 90%. Then 1M/year for 10 years becomes much more attractive than 10M in the first year and 0 afterwards. This could actually realign the incentives of executive class to be more inline with those of the shareholders.

To free the economy from its dependency on bubbles, we need to move the country to a pre-Reagan tax structure.