It is perfectly understandable that the public should be furious at the continued payment of bonuses to high-earning investment bankers and financial traders while the taxpayer is being called upon to rescue their banks. Well, finally, action is being taken. Several European countries have imposed caps on bank executive pay. In the United States, on Thursday, the House of Representatives approved a bill that would impose 90 per cent tax on bonuses to employees whose gross income exceeded $250,000 at bailed-out firms.

Astonishingly, investment bankers now seem to be braving the waters of public fury by striking back at limits imposed on their earnings according to an article in the Financial Times.

It amazes me that these people actually think they are entitled to claim a bonus while their companies are in the process of being bailed out by the taxpayer in an attempt at avoiding financial oblivion. I was obviously naïve in believing that a bonus (in the sense of remuneration) was an additional reward paid to employees if certain goals were achieved or if they performed well according to some measure or benchmark.

Investment bankers and financial traders were paid vast sums simply because of their use of leverage to amplify the result of any financial transaction they made – both positive and negative. Any percentage, however small, of the gains earned by a trade, inevitably amounts to a huge sum when the value of individual trades can reach into the equivalent of hundreds of millions of euros. When a trade goes wrong, however, the bank incurs huge losses thanks to leverage. On what basis can the traders possibly claim to have earned a “bonus” for losing money?

The taxes on bonuses are not fundamentally about seeking revenge on individual traders. The importance of making concessions to public opinion at this critical time should not be under-estimated. This is especially true in countries where the crisis is so severe that no funds are available for fiscal stimulus. The government needs the support of the people to push through tough measures and to raise funds to fight the crisis. A relatively minor penalty on high-earning employees of bailed-out financial insititutions is a small price to pay to garner support.

Yet again, the tactic of using fear to manipulate the decision-makers is used. As reported by the Financial Times, a memo sent by Vikram Pandit, Citigroup’s chief executive tries to imply that a tax on bonuses will cause “talented” people to leave the company and imperil efforts to stabilise the financial system:

“The work we have all done to try to stabilise the financial system and to get this economy moving again would be significantly set back if we lose our talented people because Congress imposes a special tax on financial services employees…”

Well, let them leave! The traders will be fleeing reckless institutions without effective risk control procedures. They will then be at the mercy of the jobs market like anyone else which will hopefully purge some of the incompetence from the system. Don’t forget that the tax on bonuses only applies to banks that have been bailed out by the government. Other, more stable banks that are strong enough to continue without needing government funds would, in my opinion, probably provide a much more controlled environment and would benefit from the “talents” of these traders while minimising risk by controlling their activities.

“Bankers at Deutsche Bank said it could benefit from the proposed legislation by poaching its US rivals’ most talented employees.”

As for the argument that the likes of AIG and Citigroup need these people to restructure their companies – I thoroughly disagree. Speculative traders are not required to unwind risky trades – accountants would do the job perfectly well, even if it means bringing in a government-appointed third party to manage the process. So, call their bluff – cap their salaries and tax their bonuses. Even if they flee, fewer traders would be a small price to pay to win public support for the rescue of the financial system.

Vikram Pandit’s predecessor, Charles O. “Chuck” Prince, III, famously said to the Financial Times in July 2007:

“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing…”

A systemically important bank such as Citigroup with an incompetent board that stupidly employed Chuck Prince as CEO, is prime candidate, along with AIG, to be dismembered and have any non-viable units wound-down. AIG and Citigroup, and any other financial organisation that kept “dancing”, are dysfunctional entities that can only increase the threat of systemic risk thanks to their reckless management. Let Schumpeter’s creative destruction kill off the beasts that cannot survive. Their government-assisted survival only serves to weaken and punish other banks that were well-run and increases the tendency towards moral hazard in the long run. An orderly winding-down also avoids the massive disruption of a Lehman-esque bankruptcy. Their extinction would help to create a stronger financial system.