The Real Reason Occupy Wall Street Should Be Upset With the Financial Industry

While many advocates of the free market have been quick to dismiss the complaints of the Occupy Wall Street protesters, at least one aspect of their critique deserves support. A sizable portion of the income received by senior corporate management—especially in the financial industry—stems from government-conferred privileges rather than from value creating activity.. While libertarians and free market conservatives frequently criticize outright corporate subsidies, they often fail to appreciate the extent to which the institutional structure of our economy is the product of state intervention, and to recognize how these structural interventions have conferred wealth upon a relatively small number of well connected individuals.

Modern corporate structure owes its origins to charters first granted by the British royalty and later by American state legislatures. The corporate form that evolved from these interventions is handicapped by a large universe of uninvolved corporate shareholders. Most Americans own corporate equity through mutual funds, ETFs and other investment pools. These investors may not even know which corporations they own, let alone how the companies are managed. Even investors who purchase individual common stocks usually have too small a proportion of their wealth tied up in a particular company to have a meaningful incentive to understand how their holdings are managed. Finally, with the recent inception of high frequency trading, institutional investors may own large blocks of shares in a given corporation for seconds—or even milliseconds—once again lacking the time, much less the incentive, to involve themselves in corporate management.

The pervasiveness of disinterested ownership enables senior management and boards of directors to extract economic rents from their corporations. Boards and management often form incestuous relationships that enable CEOs and other top officers to receive compensation packages far above their value added, along with severance arrangements that would never be tolerated by a sole owner or limited partners. In return, board members often receive out sized compensation for their limited involvement, not to mention the prestige associated with board membership.

This is not to say that high frequency trading, the corporate structure, big bonuses, or passive stock ownership are inherently bad. But they would not have arisen in their current form without the helping hand of government.

The state’s creation of a liquid market in share ownership is but one of many government interventions that have artificially enlarged and engorged the financial sector. Other privileges include banking licenses which allow financial firms to lend money they don’t have, the right to borrow funds from the Federal Reserve at rock bottom interest rates, and the expectation of a bail-out in the event of trouble.

While defenders of TARP often argue that the government actually made money on the financial industry portion the program (a dubious claim at best), TARP and other 2008-vintage interventions still constituted an enormous transfer of wealth to the financial sector. In the absence of government intervention, many large banks and brokerage firms would have faced liquidation. By backstopping these firms, the government enabled their managements to stay in the game and thereby reap enormous profits and high salaries in 2009 and 2010.

The not-so-implicit government guarantee backing large financial institutions allow senior management and highly compensated traders to place one way bets. If they put on risky trades that succeed, they walk away with terrific annual bonuses and appreciated stock. If their trades go south, the worst outcome is that they lose their jobs. A more likely result is that they receive a diminished or possibly zero bonus and have to make do on their $200k+ base salary.

Again, the Occupy Wall Street crowd should not get angry that financial industry executives have the potential to make large sums of money. What is considered “large” is arbitrary, and it would be inappropriate to claim a universal standard for any executive compensation package. Where the anger should be focused on is in the second half of the reality, that there is no liability, that the upside bonus does not have corollary risk. This skews incentives and profoundly distorts market activity. In a fully laissez faire system, it is highly unlikely that trading profits would be able to support multi-million dollar bonuses, since they would be arbitraged out at as markets became more liquid.

Libertarians should not feel an obligation to defend the current pattern of business ownership, let alone the makeup of the financial sector, when debating with progressives. Instead, we may find substantial common ground in our critique of the current system if not the solutions to the problems it suffers. For example, a millionaire’s tax fails to distinguish between individuals who have become wealthy through value creation and those who have extracted economic rents from their positions at the ramparts of the institutional structure. If the government could somehow capture wealth from those in the latter category without affecting the former, it would have more money to spend (or, preferably, to pay down the deficit) without further hindering economic growth. Unfortunately, the policy ideas from supporters of Occupy Wall Street make no such distinction.