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Anyone who was complaining about bonuses being paid out at companies that received government aid better think twice. Yesterday the Washington Post reported: “Citigroup to boost salaries, cut bonuses”.

Citigroup is raising salaries companywide in an effort to retain employees and offset new restrictions on bonuses after the troubled bank accepted $45 billion of federal bailout money.

The changes are not expected to affect overall compensation levels though some employees may be paid more and others less, and Citigroup expects to issue new stock options to help retain employees, according to people familiar with the plans.

"Retaining and attracting the best talent is very important to the success of Citi and all its stakeholders," the bank said in a statement. "Any salary adjustments are not intended to increase total annual compensation, rather to adjust the balance between fixed and variable compensation."

Oh and by the way, Citigroup (NYSE:C) is not alone in changing its pay structure as other government assisted financial institutions have made similar decisions.

This once again clearly shows that government interference within the marketplace never accomplishes its intended results. In every instance, governments are always unable to properly anticipate the consequences of their actions when trying to legislate “problems” away. Case in point, here, due to public outrage with regard to corporate pay scales, Congress and the Obama Administration decided to play the popularity game.

By playing the popularity game (instead of the “right thing to do game”) they attempted to appease the America public by imposing restrictions on bonuses. Through this decision, the government has inadvertently taken “Pay for profit” (i.e. work incentive) away and instead replaced it with “pay to remain competitive in hiring.” A great movie “Office Space” touches on this idea almost perfectly, if you’ll recall:

My only real motivation is not to be hassled, that and the fear of losing my job. But you know what, Bob, that will only make someone work just hard enough not to get fired.

By removing performance based job targets the government has displaced the competitiveness which is required within the financial industry for success. Ironically, now more than ever, this kind of competitive nature is what will be required at the assisted financial entities if they are to compete with non-assisted companies.

However, due to political intervention, as taxpayers, we are now paying people to strive towards not getting fired instead of towards hitting profit targets. Smart.

What Should We Have Done Then?

The right choice since the very beginning was to let all struggling companies go it alone and fail if necessary. Before I continue, ask yourself if we would have ever had to figure out the pay situation from above if we would have adhered to free market economic policy? Wouldn’t the market have worked this out if we would have allowed these banks to collapse and/or decide pay for themselves? Only through a truly free market can businesses compete, determine appropriate wages for services, and not drag tax payers down.

Contrary to popular belief it was not excessive bonuses and profit targets that brought the economy down. It was the government’s attempt at micro managing the economy through the Federal Reserve and other various legislative mandates that destroyed us. I would even argue that free market principals and accurate economic laws, if properly upheld, would have kept us out of the Great Recession altogether.

However, this article is not the place to get into a lengthy discussion on this point. Needless to say, the pay situation is just the tip of the ice berg going forward as intervention is now readily creeping into almost all private affairs.

The Hidden Costs of Bailing Companies Out

These are just a few of the very basic reasons why our government has been making poor choices throughout the Great Recession. Further, they are presented to illustrate how bad our situation may get as a result of our bailout decisions.

1) Bailouts Discourage Appropriate Risk Management

If companies were forced by the market to adhere to strict risk guidelines they would not make risky investment decisions without full consideration of those risks. In addition, through failure, individuals would further consider the repercussions of dealing with business entities due to the risk of losing monetary value. Ultimately, over time, this relationship would drive societal and economic morality to new heights. The very nature of a free market would actually force unscrupulous practices to the surface through failures and consumer lead decisions.

Of course, once risky business practices were revealed, companies could no longer pursue them and ultimately would have to change or cease to exist.

Thus, since our society is designed to run on free market principal, bailing distorts a fundamental rule in economics. The rule is: That all transactions, at the time they occur, are made by a mutual voluntary exchange which benefits both parties.

In this law, both parties must transact for mutual benefit, which is determined by the perceived value in their transaction. By bailing companies out, the government effectively warps perceived value in any transaction that is touched by a particular bailout. This then increases the likelihood that market participants will make unsound economic choices through distorted information.

As an example let’s say you wanted to purchase a pack of gum for $1.00. Since you are purchasing the gum, your perceived value of that gum would be more than $1.00. This value is driven by the gum’s usefulness to you at the time that you decide to buy it. At the same moment you want the gum, the store selling it to you has valued the gum as well. Its valuation however is different from yours.

Intuitively, the store has determined that the value of the gum is less than the $1.00 you hand them. The reason for this is that they value your dollar more highly than their gum because it enables them to make a profit. This only makes sense because our society has decided that our method of exchange will be the dollar. Profits in our society allow the store, and all others, to store extra capital in order to make future exchanges with other parties for mutual benefit.

In this scenario, because the perceived value of the gum to you and the dollar to the store are mutually beneficial, both parties are happy, and an exchange is able to occur.

(Note: A dollar is just paper and could be anything. Throughout time money can be anything that society chooses for value exchange…think on this deeply. If you do you’ll begin to understand why the Federal Reserve should be abolished; but that’s another discussion all together)

Now in the case of a bailout let’s say that the flu was accidentally included in the gum that you want. The store clerk, knowing that gum should cost him around .90 cents, is drawn to the flu gum because it is being sold for .10 cents. He understands that flu infected gum is risky for his business, however considers the profit increases he could make selling flu gum. While carefully weighing his decision he remembers that just last year a competitor of his did the same thing and profited wildly. He then remembers that his competitor eventually was forced to take all of the gum back and pay doctor’s bills for those who got sick from its gum. The payments would have put them out of business; however the town sent them money with no strings attached to pay damages out to its customers.

The shop keeper continues processing this decision and also recognizes that his store is one of the only places in town for people to get gum. Knowing that his town loves gum, he determines that it is unlikely they can afford to see him go out of business. Based on this information the shop keeper decides to sell the flu gum, knowing it’s risky, to make more profit based on the assumption the town won’t let him go bankrupt. His profit margins widen tremendously but only so long as his customers don’t know he’s selling flu gum.

The store clerk makes this choice knowing full well that sooner or later people will get sick and try to shut him down. However, because of his assumption the town will bail him out; he makes a poor business decision and remains open. He makes huge profits for a while, and the townspeople give him money to pay for the bills of the towns people who got sick. People who were sick only because they were not told that they were buying flu gum. In addition, the money that was given to the store does not take away from the fact that everyone got sick and the situation was not fixed.

As you can see a bailout skews the value exchange as it gives incentive to one party to not adhere to the economic laws of mutual exchange.

2) Bailing Increases Moral Hazard

Not only is moral hazard increased, but the morality of the entire marketplace is degraded through bailouts. Personal ethics are eroded and sound business practices often go out the window when incentive is given to do the wrong thing. After a state bails an entity out, there is no longer a reason for like sized competitors to run their businesses with appropriate risk controls and as efficiently as possible. As illustrated in the gum example they will maximize profits almost every time, regardless of the repercussions, knowing the state will save them.

Take for example the case of AIG. Knowing that the company was in trouble and probably would not survive without assistance, what incentive did executives have to present their situation in a best case scenario? Simply put they had no incentive what-so-ever to try and avoid a bailout. Think about it, if they presented their books and things looked “too good” they’d have to go it alone and knew they’d likely fail. Failing, means they would likely lose their jobs, their salaries, and would be at the helm of a failure.

However, if they presented things as poorly as possible, showed tremendous counterparty risk, and painted a “too big to fail picture” they had every reason to believe the government would help them out. They also must have known (as you should by now as well) that in a bailout (generally) the state experiences all of the downside risks while the business, and its affiliates whom are saved, experience the upside returns.

3) Bailout Costs Are Largely Unknown

Since there is no reason for a company on the verge of collapse to paint its books in a positive light, the actual bailout costs will be unknown. Beyond this sorting out these estimates and trying to determine the actual financial position of an otherwise failed company is next to impossible. Using AIG again the first bailout came on September 16, 2008 in the amount of $85 billion. Subsequently more bailout funds were needed driving tax payer obligations towards $180 billion. The same “multi-dip” situation holds true across nearly all of the US based bailouts.

In addition to unknown costs, legislative attempts to control bailed entities are also often unforeseen and detrimental. Executive pay is a great example of this, as is the fiasco with TARP repayment. I touched heavily on this idea when I wrote about exit strategies in “Barack’s Obama; The New Iraq” on June 4th.

In Summation: This Is Not What We Want

As you can see from above, there are a ton of reasons not to bailout a failing entity regardless of its role in the economy. There are even more reasons not to allow excessive government intervention into a free economy. My sampling is certainly nowhere near comprehensive, yet it plainly suggests that the government, by doing more, is actually accomplishing less.

Bailouts only undermine the taxpaying populace of a state that uses bailout policies; they cannot and will not assist it over the long run. Allowing companies that should fail to stand undermines the economic laws of capitalism and therefore cannot possibly work to accomplish good.

Companies must be allowed to fail so that those who make appropriate decisions are allowed to succeed. Without this component of free market succession, innovation, the driver of an economy, will be stymied and necessary changes within the market place prolonged to the detriment of a society.

I wouldn’t hold your breath for GM (GMGMQ.PK), Chrysler, Citigroup (C), Bank of America (NYSE:BAC), Wells Fargo (NYSE:WFC), AIG (NYSE:AIG), or any other bailed out company. Eventually, they all will suffer the consequences of breaking economic law, and will most likely slip from their current forms into non-existence.

Source: Salary Boosts Instead of Bonuses? That's Not What We Meant