Calling the current assault on the banking profession a "witch hunt" misses a crucial point. If a witch is captured and burned at the stake (or whatever you do with witches), the society does not later suffer from the dearth of witches. It is, in fact, precisely because a witch has no redeeming qualities whatsoever that it is okay to take the rather irreversible step of eliminating them.

But although some of us would like to believe otherwise, we do need bankers. Your favorite industrial concern, you may notice, once sold stock to raise capital for the enterprise, and periodically needs to float bonds, establish a line of credit, factor receivables, hedge inputs and output, and so on. You can't do this on eBay.

I mention this because today there comes another story of an attempt to do harm to people who populate the banking industry; a Bloomberg story "Cap Bankers' Bonuses at Half Their Salary, EU Lawmakers Say" goes on to further advocate that salaries themselves should be limited to the (large) amount of €500,000, and any bonuses should be paid out over a long period of time. Total compensation would therefore be capped at around $1mm, no matter how much money was made for the bank.

This is a destructive policy that will have a long-term crushing effect on global capital markets.

The problem isn't that people in finance need to make a ton of money. Indeed, most people in finance do not make anything close to these limits. Nevertheless, it is important that these limits not be instituted. Why? Let's consider what causes inequality in compensation - as explained by one of the most famous political economists who lists five reasons that pay differentials exist:

Inequalities arising from the Nature of the Employments themselves (excerpts from An Inquiry into the Nature and Causes of the Wealth of Nations, Chapter X, Part I, by Adam Smith. Full text here.)

First, the wages of labour vary with the ease or hardship, the cleanliness or dirtiness, the honourableness or dishonourableness of the employment...

Secondly, the wages of labour vary with the easiness and cheapness, or the difficulty and expense of learning the business...

Thirdly, the wages of labour in different occupations vary with the constancy or inconstancy of employment...

Fourthly, the wages of labour vary accordingly to the small or great trust which must be reposed in the workmen.

Fifthly, the wages of labour in different. employments vary according to the probability or improbability of success in them. [ed. note: focus your attention here!]

The probability that any particular person shall ever be qualified for the employment to which he is educated is very different in different occupations. In the greater part of mechanic trades, success is almost certain; but very uncertain in the liberal professions...In a perfectly fair lottery, those who draw the prizes ought to gain all that is lost by those who draw the blanks. In a profession where twenty fail for one that succeeds, that one ought to gain all that should have been gained by the unsuccessful twenty. The counsellor-at-law who, perhaps, at near forty years of age, begins to make something by his profession, ought to receive the retribution, not only of his own so tedious and expensive education, but that of more than twenty others who are never likely to make anything by it. How extravagant soever the fees of counsellors-at-law may sometimes appear, their real retribution is never equal to this...

Those professions keep their level, however, with other occupations, and, notwithstanding these discouragements, all the most generous and liberal spirits are eager to crowd into them. Two different causes contribute to recommend them. First, the desire of the reputation which attends upon superior excellence in any of them; and, secondly, the natural confidence which every man has more or less, not only in his own abilities, but in his own good fortune...

The overweening conceit which the greater part of men have of their own abilities is an ancient evil remarked by the philosophers and moralists of all ages. Their absurd presumption in their own good fortune has been less taken notice of. It is, however, if possible, still more universal. There is no man living who, when in tolerable health and spirits, has not some share of it. The chance of gain is by every man more or less overvalued, and the chance of loss is by most men undervalued, and by scarce any man, who is in tolerable health and spirits, valued more than it is worth.

That the chance of gain is naturally overvalued, we may learn from the universal success of lotteries. The world neither ever saw, nor ever will see, a perfectly fair lottery; or one in which the whole gain compensated the whole loss; because the undertaker could make nothing by it. In the state lotteries the tickets are really not worth the price which is paid by the original subscribers, and yet commonly sell in the market for twenty, thirty, and sometimes forty per cent advance. The vain hope of gaining some of the great prizes is the sole cause of this demand. [emphasis added]

So why do bankers struggle through long years of education and higher education, endure long working hours and often arduous travel schedules in a highly stressful environment, and do so for entry-level pay that is not particularly elevated? In many cases, it is because they believe that they might someday make the big bucks. As Adam Smith understood, the chance of that golden ring is enough to get much more productivity, on average, than the pay alone would be, and to attract a great many entrants that would otherwise choose more pedestrian pursuits.

Some people will remark that "perhaps it wouldn't be a bad thing if some of these rocket scientists actually went into rocket science, rather than to Wall Street." But before you say that, remember that the rocket scientist is able to ply his trade for Boeing because, and only because, a market exists (thanks to Wall Street) for Boeing's debt and equity, and the planes they sell on long-term contracts to United Airlines can be financed by Wall Street, and their long-term contracts can be hedged through derivatives designed by Wall Street, and they have access to project financing from Wall Street. I wonder if Boeing would mind if their senior banker at Morgan Stanley was 30-year-old accountant who was willing to try and sell their bonds on a "best efforts" basis but couldn't help them with hedging and who could only loan them $5mm because that is all the risk the bank, without access to credit default swaps, could take on their name?

Capital markets are raucous and chaotic, and firms need to be subject to discipline if they do not maintain a healthy enough margin of safety against economic vicissitudes. But it should be a market discipline, and not legislative discipline, that they are subject to: they ought to be permitted to fail when they mess up. Legislators are of course angry that they helped create monsters (especially Fannie and Freddie here, and lots of Euro-related problems there) that they later decided to bail out, and are of course intent on making sure that someone (not them) is punished for forcing government to bail them out. But it is a supremely bad idea to destroy the future of the global capital markets just to deflect voter ire. And if a cap is placed on the earnings of bankers, that is exactly what they will be doing.