 We have with us today Professor James Crotty, Emeritus Professor of the University of Massachusetts at Amherst, and one of the world's experts on financial economics and Keynes and Minsky and the current financial crisis. Thanks for being here today. That's my pleasure, I think. I wanted to talk to you about this paper you wrote on Rainmaker Financial Firms. And the precise title is How Bonus Driven Rainmaker Financial Firms Enrich Top Employees Destroy Shareholder Value and Create Systemic Financial Instability. So first off, I just wanted to ask you, what is a Rainmaker? This paper, which has a very long title, is specifically about the compensation structures, how they pay important people in critical Wall Street financial firms. So Rainmakers refer in this paper to anyone who has a lot of decision-making authority, a lot of influence on what the banks are doing, who raises a lot of funds for the banks. So it refers to traders, people who buy and sell, buy and sell partly for clients, but also very heavily for the banks themselves. So they're the gamblers. But also, mergers and acquisition teams, the leaders of those, initial public offerings, top salesmen for the banks and senior executives of the banks. Those are the people whose decisions essentially determine what the position of the banks is, how much money they make, how much risk they take, how vulnerable they are. And those are my Rainmakers. Now, the overall point of your paper, which we're going to come back to in more detail, is that somehow these Rainmakers were partly responsible for the financial crisis we've just experienced. Can you briefly say how that would be? Sure. There were a lot of elements that came together to generate the financial crisis. So financial crisis is nothing new. In fact, we've had financial crises off and on ever since we've had financial markets. So there's a pattern in history of financial booms and busts and some modest, some fairly big, some enormous over hundreds of years of the history of market economies. And so what causes them? Well, numerous things cause them. I mean, sometimes there's important to critical new innovations in the real sector where the internet might be invented or telecommunications might be really hot or some new technology or process will come along that will get people excited, it'll have profitable opportunities, people will want to invest lots of money in this. So there'll be feeder industries that come off of this and all of a sudden everyone will begin to think that the economy as a result of these new technologies and innovations is much more profitable than it used to be. And they'll be willing to pay more to buy the stocks and bonds and other securities associated with this. So something will trigger a sense that the financial markets are prosperous and that financial security prices are going to rise, in which case people thinking that they are going to rise will want to buy them, which will make them rise. People who begin to believe that it's a sure thing that they're going to rise will want to borrow lots of money to do this and we'll get this bubble started. So there's all kinds of reasons why the bubbles start. What I'm talking about is something that normally isn't discussed in this standard theory of what makes for booms and busts in financial markets. It happens to be the case that in modern financial markets, particularly in the last 20 years or so, that the people who are making the decisions about the buying and selling and creating of securities in Wall Street and other financial operations are increasingly paid by bonuses. So they get maybe 10% or 15% of their compensation in the form of a standard payment every year and the rest depends on how much money the firm makes. So any time that the rain makers can make decisions, the traders or the executives in Wall Street can face with decisions about what they should do in financial markets, their concern is to get their revenues and profits up so they can get their bonuses up. These are enormous bonuses, millions, tens of millions, hundreds of millions in some case. Now why does this cause the crisis or the bubbles to be worse and the crisis to be bigger? Well, basically if they can borrow money, can take excessive risks, can do things that look like they're shaky in the intermediate to long run, but this can allow them to do lots of business and sell lots of products and buy lots of products and take lots of risks. They take a lot of money, at least while the bubble is going on. They'll get enormous bonuses when the bubble is going on. So there's this enormous incentive among rain makers to take maximum risk, borrow maximum money to generate maximum revenues in the short run because when all this bubble creating activity leads to a collapse in financial markets, you don't have to give the bonuses back. So you keep the bonuses even if you crash your firm. So secondly, we know in modern periods if most people crash their financial firms, the Federal Reserve will step in and will rescue your firm and you'll be right back in business in six to ten months. So this incentive to take actions which increase risks, increase borrowing, increase leverage, because that's the way to make the most money is a significant contributor to financial instability. Now, economic theory would suggest that this operates in the best interest on the long term of the shareholders of the firm and the public. So that the rain makers... Well, actually, I'd interrupt you and say there isn't a theory about this in standard economic theory. There's no theory of the problems of perverse bonus structures. In standard financial market theory, nobody can take excessive risk. Nobody can be confused. You can't sell security to someone that isn't worth what they pay for it. So there are no stories about how you get financial bubbles. But isn't this operation of the rain makers, isn't it tolerated because it's in the best interest of the shareholders of the firm? If you look at the data over time, both the shareholders of the banks, the owners of the banks, don't they benefit from this? No. They tend not to benefit from this. It's a kind of... I suppose it's a delicate question. If you look at the financial markets by themselves and what these firms do, they take excessive risk. They borrow lots of money that they can't pay back when things go bad. And so they create these crashes. If financial markets were left to themselves and not constantly rescued by the public, what we would see is perhaps another late 1920s, 1930s collapse of the financial system where everybody got destroyed. Stock prices went down by about 80% between 29 and 1933. So it's absolutely against the interest of the public. So if the firms aren't rescued, then the stockholders get destroyed. If the firms are rescued, they're rescued with taxpayer money. And we just build up a bigger bubble. The data suggests, for example, that if you were a shareholder in S&P 500, you bought the average stock in 1999. And you sold it in 2009 when the crash came before the rescue came. You would have lost well over half the value of your holding. So it's a great... In the long run, in the intermediate run, the system is a great value destroyer. And the only reason we don't see it in the data is these firms get rescued constantly and get bigger and more dominant. And each crash then becomes more and more scary. So you say that the rain makers make a lot of money on the way up and they don't have to give it back on the way down. And part of the reason is because these banks get rescued by the taxpayers. But are there things internal to the operations of the firms? Something about the structure of the rain baker compensation systems that give them such a big share of the bonus going up and don't make them give it back on the way down relative to other stakeholders in the firms? So there's two questions. Why don't the rain makers... Why do the rain makers give such a big share of the upswing and don't have to give so much back on the downswing, even relative to other stakeholders of the financial firms? What is it about the way the rain maker operation works? Well basically, the bigger firms operate in relatively non-competitive markets. They dominate the market. So they're kind of like in oligopolies, they have monopolistic power. But fundamentally, the issue is that the firms are run by the rain makers. They're run for the rain makers. And so they don't want to share the booty with shareholders on the way up, although stock prices do go up on the way up. Their goal for the firm is not to maximize shareholder value. Their goal for the firm is to maximize rain maker bonuses. And there's no one who can prevent them from doing this. So in this paper I mentioned from a somewhat longer paper that we might expect regulators to stop them since it's so destructive, but we don't have effective regulation. We did not have it before the recent crash and we still don't have it. You might expect the chief executive to want to... He's supposed to take care of the interest of the shareholders, but in fact, he's the chief rain maker. But he doesn't make any money. The people who make his money, the reason he gets 10 million or 20 million or 100 million or whatever, is that he's got these traders and IPO guys and salesmen and whatever who are making all the money. So if he wants to make his 100 million, he's got to keep the rain makers who are actually generating the funds happy. So he has no intention of stopping them. There's a famous quote from Chuck Prince, who was the CEO of Citigroup saying that, you know, I'll lose all my people if I start acting appropriately and don't take these risks and they don't get these bonuses. It's like a game of musical chairs as long as the music is playing. Even though I know the end is coming, we have to keep dancing. I have to keep paying these bonuses. Shareholders can't do anything about it. First of all, they don't have the power. The boards of directors and CEOs are insulated from shareholder pressures. And moreover, shareholders don't want to stop it in the bubble because they're making money in the bubble. The prices are going up. There's always a story about why this bubble, why the internet stock market telecommunications based stock bubble in the late 1990s or the mortgage backed security bubble in the mid 2000s. There's always a story that spreads about why this is permanent, why this is long run, why this isn't going to end. And people believe the story, act on it, shareholders buy the stock, hold the stock, buy more stock, and it goes up and up and up and up. So in the midst of the bubble, which they begin to think is permanent, they don't want to tell these guys to stop doing what they're doing. Competition is not sufficiently strong to cut down the returns that they get so that there's no one in the standard story of things that are supposed to stop this from happening. The CEO is supposed to stop it, the board of directors is supposed to stop it, Sheryl is supposed to stop it, regulators is supposed to stop it, competitors is supposed to stop it, none of those things are true. So are there things that we can do? Are there changes in laws or rules or taxes or regulation that could be put in place to prevent this kind of perverse incentive towards risk and crisis from occurring? Sure. What are some of the proposals? There's been lots and lots of proposals about this, about changing the compensation system. For example, it has been proposed by many people, including you, that instead of having people get their bonuses and be able to cash their bonuses out during the bubble, that if there are bonus payments, they should be put aside someplace. The term is usually they're put in escrow, but they're held. And if the bonus parts were held for five, seven, ten years, then the incentive to take the risk right now wouldn't be so good if when the markets crashed, the firm took the money back. And there are other kinds of suggestions. Another approach is the regulatory approach, which says that you shouldn't be allowed, the firm shouldn't be allowed to take the risk that it takes because of these incentives. So it shouldn't be able to leverage itself very much. It should have to have low leverage. It should have to keep lots of capital. It should have, if it takes risky activities, there should be honest assessments of risks rather than the fake assessments of risks that we have now. And then the firm has to hold more and more capital, can't borrow more money. It's constrained from taking part in these activities, in which case the return to the bubbles wouldn't be so much. So there's many, many ways of eliminating this. The problem is there's no political will to eliminate this because, on the one hand, economists keep arguing that relatively unregulated financial markets are good. We should let the markets set compensation. On the one hand, so we have that. And on the second, Wall Street firms are one of the largest contributors to the politicians and political campaigns. They have immense lobbying power. They give everyone money to the people who are going to decide on the regulations of politicians. They give them money to run their campaigns. They surreptitiously or in a hidden way, they offer marvelous job opportunities to congressmen and to their chief staff so they don't want to irritate Wall Street. So nobody will do it. It's easy to do. No one will do it. Well, the banks themselves say that if you impose some of these taxes or some of these regulations you described, then the rain makers won't be able to make as much money and they'll go somewhere else. They'll go to London or they'll go work for hedge funds or they'll go to Germany. And U.S. banking system will become less competitive and that will be bad for the economy. What do you say to them? Well, I'd say that we should get a big blimp and run it over Washington and let smoke come out the back that says, go, okay, go. Stop destroying us. Stop distorting our economy. Stop giving all the wrong signals to people coming out of schools that they shouldn't be scientists and technicians and doctors and engineers but they should basically gamble as on Wall Street. What the Wall Street guys are doing to us is destroying our economy. I'm sure you've noticed that economic performance in general has been really bad. The economy isn't working for ordinary people anymore. It's a complicated story but part of the reason is that our financial markets are too big, they're too bloated, they're too risky, they do the wrong things, they suck up all the profits, they suck up all the talent, they crashed. The society they caused in the crashes of the economy caused the budget deficits that we're also concerned with. Go. Thank you very much. You're welcome.