Economics: Of Bonuses and Human Nature

I love bonuses. As someone who tried working as hard and (hopefully) as intelligently as possible, I looked forward to my bonus at the end of the year. I used bonuses to either bolster my savings or to take a vacation. But I always realized that bonuses were a way of rewarding good performance, not a birthright.

Which is why I find the latest controversy about bonuses at American International Group (A.I.G) so interesting. The financial giant, stricken by huge losses, is planning to use US $ 165 million dollars of the U.S. government’s bail-out money to pay bonuses to traders in its financial products division. These bonuses, when awarded, will go to the very same people who got A.I.G. into this mess in the first place.

So what are the basic facts about the A.I.G. bonus controversy? The facts are as listed below:

1. A.I.G (specifically their financial products division) made billions of dollars of losses with bad bets on derivative financial instruments, including trading in mortgage backed securities.

2. A.I.G then went to the U.S. government with hat in hand, pleading for a bail-out. Six months ago the organization’s Chief Executive said that if A.I.G. collapsed, there was a real danger of the entire U.S. financial services industry collapsing. This was true.

3. Based on Point # 2 above, the Bush and then the Obama administration agreed to bail out A.I.G. The U.S. government then pumped in US $ 150 billion to keep A.I.G. alive. This gave the U.S. government 70% ownership of this once-mighty blue chip financial conglomerate, a beacon of American free enterprise.

4. A.I.G. came back recently and said they needed another US $ 30 billion, which the U.S. government, in principle agreed to provide. This additional infusion of money by the U.S. government meant that the U.S. government would own about 80% of A.I.G shares, effectively nationalizing the organization (though nobody wants to use that dreaded word)

5. Last week, A.I.G. said that they planned to use US $ 165 million of the bail-out money (about 1% of the total bail-out funds) to provide bonuses to employees in their financial products division.

When asked about the wisdom of providing such large sums of U.S. taxpayer money to the people who caused such huge losses at A.I.G. in the first place, an A.I.G. spokesman responded by saying that these bonuses had been “contractually agreed to” in 2008, before this disaster unfolded. The spokesman also said that if A.I.G. did not provide these bonuses to these selected employees, it would be detrimental to A.I.G “attracting and retaining the best and brightest talent”.

“Contractually agreed to”? Huh?? I always thought that bonuses are optional, in the sense that they are awarded to employees based on individual and organizational performance. Therefore, in good years when the organization turns in a healthy profit, deserving employees get a healthy bonus. In bad years, you do not get bonuses. When the organization in question makes a loss, it is supposed to either terminate the services of those employees who caused the losses, or at the very least, not give them bonuses. That is how capitalism and the private sector are supposed to work.

“Attracting and retaining the best and brightest”. Huh?? Are these A.I.G. derivatives traders the best and the brightest in the financial services industry? Remember, these are the same guys who put A.I.G. in this hole in the first place. If these guys were so bright, how come they caused this mess in the first place? They should consider themselves very, very lucky to still have jobs. If not receiving bonuses for their disastrous performance makes them leave their jobs, A.I.G. should consider itself lucky. America is in real trouble if these traders constitute the “best and brightest”. I am sure there are thousands of people within A.I.G. who do deserve a bonus. But not these guys!!

Does President Obama have the right to use the “bully pulpit” of the Oval Office to denounce A.I.G’s decision to give these bonuses to derivative traders? You bet! Remember, A.I.G. is now 80% government owned. The U.S. government is the majority shareholder in A.I.G. As head of the U.S. government, the President has every right to do everything in his power to prevent this bonus being paid. A.I.G. is now (to use an Indian term for a loss-making government-owned organization) a sick “Public Sector Unit”.

However, the President has been left red-faced; because it appears that no such pre-conditions were put in place before the governmental bail-out money was handed over to A.I.G.

Obama, and his administration, are definitely going to be slammed for not putting in stringent conditions in their bail-out package before actually handing over the money to A.I.G. in the first place. Two U.S. administrations rushed the bail-out package through, without providing for adequate checks and balances. The fact of the matter is – the U.S. government does not have any legal recourse when it comes to A.I.G. and the bonus issue. The President can rail, rant and thunder, but he cannot stop A.I.G from handing out these bonuses. He can sway public opinion against A.I.G. (which is what he is doing), he can pressurize A.I.G. to reconsider its decision, but he cannot actually stop A.I.G. from using taxpayer money for bonuses to those who caused this financial crisis.

Coming back to bonuses, I did not think that India’s Sixth Pay Commission payout to India’s (largely non-performing) Civil Service last year was a good idea. This bonus was given to our bureaucrats to help get their votes in the approaching General Election. It had nothing to do with their performance. They did not deserve the money, because collectively, they failed in their job – which was administering India. Like the traders at A.I.G’s financial products division, India’s bureaucrats and politicians believe that bonuses are a birthright, and not a reward for good performance.

To summarize, bonuses are optional, and not a birthright – and this should apply to both the private as well as public sectors of the economy. I am amazed that private sector companies can “contractually agree” to provide bonuses, even before the performance of employees can be assessed. I am also amazed at the cynical way in which politicians use bonuses and pay commissions to woo bureaucrats and buy their votes at election time. Unfortunately, that is how human nature and bonuses actually work.