A great piece by John Cassidy in the New Yorker on one major reason why Wall Street crashed.

According to a common narrative, we have lived through a textbook instance of the madness of crowds. If this were all there was to it, we could rest more comfortably: greed can be controlled, with some difficulty, admittedly; overconfidence gets punctured; even stupid people can be educated. Unfortunately, the real causes of the crisis are much scarier and less amenable to reform: they have to do with the inner logic of an economy like ours. The root problem is what might be termed “rational irrationality”—behavior that, on the individual level, is perfectly reasonable but that, when aggregated in the marketplace, produces calamity.

Take new, potentially dangerous types of securities:

If Merrill Lynch sets up a hedge fund to invest in collateralized debt obligations, or some other shiny new kind of security, Morgan Stanley will feel obliged to launch a similar fund to keep its wealthy clients from defecting. A hedge fund that eschews an overinflated sector can lag behind its rivals, and lose its major clients. So you can go bust by avoiding a bubble. As [Citigroup's CEO] Charles Prince and others discovered, there’s no good way out of this dilemma. Attempts to act responsibly and achieve a coöperative solution cannot be sustained, because they leave you vulnerable to exploitation by others. If Citigroup had sat out the credit boom while its rivals made huge profits, Prince would probably have been out of a job earlier.

In fact, Prince essentially said so at the height of the bubble:

Prince conceded that a collapse in the credit markets could leave Citigroup and other banks exposed to the prospect of large losses. Despite the danger, he insisted that he had no intention of pulling back. “When the music stops, in terms of liquidity, things will be complicated,” Prince said. “But as long as the music is playing, you’ve got to get up and dance.”

This is hardly a new insight; Keynes pointed it out many decades ago.

Whatever the asset class may be—stocks, bonds, real estate, or commodities—the market will seize up if everybody tries to sell at the same time. Financiers were accordingly obliged to keep a close eye on the “mass psychology of the market,” which could change at any moment. Keynes wrote, “It is, so to speak, a game of Snap, of Old Maid, of Musical Chairs—a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops.”

But it’s one of those lessons that we have a hard time learning — largely because a) it’s a really lucrative game for many players on Wall Street and b) we keep bailing them out with no strings attached.

What do we do about it? For starters, says Cassidy, we need to rein in executive pay.

Even some top bankers have conceded that current Wall Street remuneration schemes lead to excessive risk-taking. Lloyd Blankfein, the chief executive of Goldman Sachs, has suggested that traders and senior executives should receive some of their compensation in deferred payments. A few firms, including Morgan Stanley and UBS, have already introduced “clawback” schemes that allow the firm to rescind some or all of traders’ bonuses if their investments turn sour. Without direct government involvement, however, the effort to reform Wall Street compensation won’t survive the next market upturn. It’s another version of the Prisoner’s Dilemma. Although Wall Street as a whole has an interest in controlling rampant short-termism and irresponsible risk-taking, individual firms have an incentive to hire away star traders from rivals that have introduced pay limits. The compensation reforms are bound to break down. In this case, as in many others, the only way to reach a socially desirable outcome is to enforce compliance, and the only body that can do that is the government.

What might this look like? For example, the Fed

should issue a set of uniform rules for Wall Street compensation. Firms might be obliged to hold some, or all, of their traders’ bonuses in escrow accounts for a period of some years, or to give executive bonuses in the form of restricted stock that doesn’t vest for five or ten years

What are the odds that any of this will happen? I’d sell short on this one.