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Government Reduces Risk - But Also Reduces Reward

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New pay limits could extend to hedge funds, private equity.

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In its ongoing attempt to rewrite the rules of what's quickly becoming our quasi-capitalist nation, the Obama Administration is weighing options that would expand compensation restrictions to all corners of the financial-services industry.

According to the New York Times, well-publicized efforts to rein in executive pay at firms that accepted TARP money could extend to companies that have thus far stayed off the government dole. In other words, the spottily regulated world of hedge funds and private equity could be subject to some of the same restrictions faced by their government-subsidized competitors.

However unpleasant, firms like Citigroup (C) and Bank of America (BAC) (both in hock to the US taxpayer for hundreds of billions of dollars) have lost their right to be the masters of their own executive compensation destiny. On the other hand, pay at hedge funds that haven't touched a penny of government money should be determined by the firms themselves.

Since he took office, President Obama has been a loud advocate for pay that's closely tied to performance. The prevailing view in Washington is that Wall Street traders were able to take on massive risk -- either their firm's or their clients' -- without feeling much pain if the bets went sideways. This led to excessive risk-taking, and the kind of near-criminal alchemy that ultimately blew up the financial lab.

And while this is true to an extent, the result of this typical government overreaction will be a system reduction of risk - and by extension, of reward. Financiers, entrepreneurs and businesspeople of all types engage in risky behavior every day - which is what keeps the economy humming.

Systematically reduce the incentive to take risks, and economic output will slow. It's simple math.

Already, even as Washington bumbles its way towards legislation on executive pay, what's left of the free market is sorting things out on its own.

Raising capital is well-nigh impossible for upstart hedge funds, as even management teams with strong credentials are struggling to get off the ground. Existing funds, most of which remain below their so-called "high-water mark" (the level at which juicy performance incentive fees kick in), won't see big bonus payouts until well into 2010.

This is the market at work, punishing bad actors -- even ones that were just marginally bad -- and creating an environment where only the most astute, talented, and driven can succeed.

By contrast, as policymakers look to make up for years of ignoring their fiduciary responsibility to safeguard the public interest, we're witnessing the development of an economic system that benefits only the most well-connected.

Needless to say, this is an unwelcome progression.
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