Satyricon331 saidYou misapprehend an individual’s optimization when you conclude that an incentive effect depends on the original intention from some point in the past. I fail to see how “penalizing by not honoring contracts does nothing to prevent others from avoiding the problem in the future” when it simply signals that people, who could have had grasped the risks but didn’t, will face opportunistic penalization. That type of uncertainty provides an obvious disincentive from endangering the economy.
Your claim that they had no way of knowing what they were doing is, again, simply implausible. Even if they couldn’t have taken the time to think about it while they were in the midst of doing these trades (which is implausible enough to begin with, given how elaborate these transactions were, and therefore how much time these people invested in them), the mere availability of rumors about AIG’s systemic risks could have prompted them to reflect on the situation at some other point (and so, contrary to your claim, I simply don’t need to make assumptions on floor mechanics to identify abstract information structures). Moreover, they wouldn’t have needed to know what the others were doing specifically; they wouldn’t have even needed to know it generally, although they probably did. Even if they didn’t, people in such situations in the future may have opportunities to do so, and it’s perfectly reasonable to induce those people to take every opportunity to do so. And lastly, even if they never will have such an opportunity, ex ante there’s still the possibility they could. This idea you have that their contracts should be sacred and inviolable seems antiutilitarian.
Me thinks you're confusing timelines here. These contracts were made post AIG blowing up and after
the government bailout. If you were to argue that they should have no expectation to receive any bonuses because they helped cause the blow up - or at least were part of the company as it went down - I would agree. However, that's not what happened. We're not talking about contracts made prior to the bail out, we're talking about contracts after
! In a normal bankruptcy as I understand it, all contracts get renegotiated - and that's more or less what happened here.
If they had screwed up the unwinding, I'd agree - take away their bonuses but that's not what happened either.
The only lesson to be learned then is not to trust the government or any bailout firm. It'd take a big stretch to suggest that by taking away what was promised to them in order to help clean up the mess that they'd feel remorseful or learn from their role before hand seems bizarre at best.
You've made a series of assumptions of how a trading floor works and information structures on that floor that simply aren't true - which is the primary reason why what you suggest doesn't make sense for anyone who has worked on a trading floor, around one, or with traders. The people on the floor just don't have the ability to see the big picture and generally aren't given the tools to do so. They would have very much understood their own trades and their individual risks/part of the hedge (a hedge has two sides of course), but it is very possible and likely they didn't know the whole picture - either the entire hedge and definitely not what everyone else on the trading floor was doing.
Further, you've discounted the importance of retaining people to unwind transactions because of the potential for a significant blow up that could cost billions and even hundreds of billions. All to save $165 million that the government acknowledges it promised these people in the first place to keep them from leaving.