Tuesday, March 17, 2009

Contracts must be honored

One of the decisions that provoke emotions in the U.S. these days is the recent decision to pay significant bonuses for the financiers (especially derivative traders) in AIG, an American insurance corporation that is not doing terribly well recently.

What is being discussed are certain bonuses comparable to 165 megadollars that were guaranteed to some important guys during the last year or so. Well, there are many levels of this problem. First:

This money is negligible relatively to the overall aid

You know, I definitely do think that all those people in the big money business are being heavily overpaid, relatively to other jobs I can imagine.

On the other hand, unlike other occupations, they are dealing with huge amounts of money and they are being paid a rather small fraction of this money to do it well - or at least more successfully than otherwise.

Small relative improvements of their work can lead to substantial savings or increased profits. The market price of their work is such that if you increased the salary even more, they would be barely able to increase the company's profit by the same amount - but for further hikes, they would no longer do this job.

That's how and where the market sets the average salary for such people - or any other employees, for that matter.

165 megadollars is one thousandth of 165 gigadollars, the approximate cost of one package to help the company. Because it's such a small fraction, it's very clear that the taxpayers cannot possibly be offended by the money they have lost: they are irritated by the fact that someone doesn't suffer even though he should.

But should he? That brings me to the second point:

Hard times need hard-working financiers, too

In fact, it is very likely that the good work of the finance experts in the age of crisis is more crucial than their good work at the times of peace. In this sense, it is not terribly logical to expect that the salaries should naturally go down these days. The amount of stress in these jobs may have increased, too. Moreover, I don't really think that the AIG employees are the primary culprits of the crisis and they shouldn't be blamed for that.

During the crisis, bad decisions can cost hundreds of billions or trillions of dollars. If key employees are lost or they lose their interest to help the corporation or the system, such a decision may become very expensive for everyone. Because most people have no idea about the amount of work and expertise that is needed to do hard work - and the costs of such work - they shouldn't try to influence these matters too much.

However, you may offer another argument:

The salaries should be a fraction of the profit which went negative

Well, not really. Of course, a corporation may sign contracts that the salary of its experts is linked to the profit. But almost no experts are going to work for the company if the overall salary may go to zero or become negative. That's why a big part of the salaries is still constant, independent of the financial results of the company.

The company must plan accordingly. Some of the expenses are pretty much fixed. Even if a company is doing badly, it must pay high enough salaries to certain specialists, otherwise it will lose them - they may go elsewhere - and end with even worse results. If the profit margin drops dramatically, the salaries to the important employees may drag the company to red numbers. But that's how the life works: the salaries belong to the expenses, after all. The bonuses are being paid for the extra sensitive work that is needed, not for the results that were bound to be bad during this year.

Most importantly:

The contracts must be honored

The bonuses were decided in the past and they are based on certain contracts. These contracts simply cannot be abrogated. This is a very essential rule. Sudden annihilation of contracts and treaties would lead to anarchy, an even higher lack of confidence, and that's simply not what a civilized country can afford.

Some people say that the government has the right to say that "if you won't abolish the bonuses, AIG, we will let you go." When they say so, they assume that this sentence means that the AIG will decide to revoke the bonuses in some undetermined way, in order to survive. But the reality is that the sentence has two possible outcomes. One of them is that AIG will prefer bankruptcy. The sentence leaves the decision up to the AIG bosses.

Whatever the reasons are, that's not what Obama's administration wants.

They want to decide what actually happens and they want AIG to survive, in order to reduce the hysteria of the markets. That's why they cannot give the AIG bosses this choice. Because they want to save the AIG, it follows that they must treat it as a company that is alive. Such a company must fulfill its contracts with other parties which includes not only other big companies but also individuals and the employees. The AIG's ability to fulfill its obligation with respect to others is the very reason why AIG - or any other corporation - is being saved or kept alive.

There is no decent way to avoid this conclusion.

Summary

So I warn against all attempts to revoke the contracts - directly or indirectly (by "tricks" such as a "special tax") - because such irregular decisions pave the road to hell. If illegal things have occurred, they must be investigated and punished. But if some contracts were signed in accordance with the laws, they must be honored. All the losses that follow from such contracts are real - they're a small part of the overall losses - and they can't possibly be "undone", unless the goal is to create much higher losses, brutal havoc, anarchy, and an overall loss of confidence in the companies, the government, and the legal system itself.

It is up to the taxpayers - or their representatives, the politicians - to decide which solution is better for the society (and the taxpayers) as a whole: AIG may either be saved or sacrificed. It seems that the costs-and-benefits analysis has been made and the decision has already been calculated: AIG should be saved. It follows that the help also includes all the disadvantages that follow from such a decision.

That includes the unpopular high salaries for the managers that have already been guaranteed by the contracts. There's no legally decent, ethical way to selectively obey some contracts and not others. Not even the taxpayer has the right to abrogate the contracts that he finds inconvenient; others can't do it either. The government is just another subject that is bound by the law - unless we are talking about totalitarian systems. The situation in which the government doesn't obey its promises - or forces others not to obey their obligations - is an extremely dangerous one. Look at some corrupt countries where such a development could end.

And that's the memo.

1 comment:

  1. As someone who prefers the market to liquidate bad companies I think that AIG should have been allowed to fail. But let us note that most of AIG would have survived intact because most of the companies that were a part of it were actually profitable and the losses by the parent and the various divisions were not liable for the losses by the derivative outfit that caused the trouble or the parent holding company.

    It is also important to note that the Treasury did not save AIG as much as it saved the counterparties that held the bad contracts insured by AIG. The AIG 'bailout' is simply a scheme to get cash flowing to those companies, pension funds, hedge funds and states that made bad bets and lost. While printing money and sending it to these players may reduce the stresses for a while you are smart enough to figure out that eventually the central planners will fail and that the system will have to adjust to reality. It looks as if the prudent players need to abandon hope that the central planners will get something right for a change and take steps to protect themselves from their incompetence. If gold was not looking desirable to many investors it should be looking very good about now.

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