In case you missed it, Citigroup will owe Andrew Hall, top trader and head of its Phibro energy trading unit, an estimated $100 million paycheck in 2009. Actually I’m sure you didn’t miss it because this stunning sum has made Citi and Mr. Hall the poster children for Wall Street’s “excesses.” On the one side you have the government that bailed Citigroup out to the tune of $45 billion so far, not an insubstantial sum, plus harsh criticism from politicians and commentators about “excessive” pay and systemic risk. Then there is Citi which has a binding contract with Mr. Hall to pay him performance bonuses which in 2009 may add up to $100 million. There is also Ken Feinberg, the Obama Administration’s new Pay Czar, who has the duty to determine who gets paid what in banks and regulated financial institutions.

The politicians believe that “excessive compensation” led bankers to take “systemic risks,” risks that endangered the entire financial system and brought on the recession. A number of new rules enable Mr. Feinberg to be the banks’ paymaster. These new rules are nothing but a form of government wage controls. Fortunately for Mr. Hall these rules may not apply to him; his contract pre-dates the new rules.

The Fed has been tasked with the job of writing up new rules concerning the pay of bank executives and employees.

Fed officials would give banks wide leeway in how they structure their rewards. They would not prohibit million-dollar pay packages or address issues of fairness. Rather, the rules are intended to restrict pay plans that encourage reckless behavior by rewarding only short-term gains. …

The draft rules, which are expected to be introduced in the next several weeks, would apply not just to the pay and bonuses of top executives but also of traders, loan officers and others. The biggest and most complex institutions, roughly 20 companies, would have to present their compensation plans to bank regulators, who could then demand changes.

Fed officials do not plan to impose specific rules on how those banks structure their pay plans. Instead, they are expected to spell out ways in which banks can reduce incentives for excessive risk-taking.

For example, examiners will be looking to see whether banks defer bonus compensation for several years, allowing enough time for risks and potential losses to surface. …

Some industry analysts said the Fed’s plan would complement what banks have already started doing in their own self-interest.

“The simple proposition should be that you don’t want people being paid for taking too much risk, and you want to make sure that their compensation is tied to long-term performance,” said Timothy F. Geithner, the Treasury secretary, in an interview by telephone.

This is one of the key issues of the G20 meeting this week in Pittsburgh. These major economies are trying to coordinate their efforts at regulating financial institution compensation so they don’t engage in regulatory forum shopping.

By the way, Paul Krugman thinks this is a really good idea:

Equally important, in this case populism is good economics. Indeed, you can make the case that reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road.

Let me say that compensation or bonuses had absolutely nothing to do with the crash or systemic risk to the economy. These rules are a scapegoat, a proxy for attacks by people who perceive that capitalism is a destructive economic system and should be allowed only with strict government supervision. These people have no clue what caused the economic crisis, the boom, or the crash.

I have written extensively about the causes of the crisis. But here are the highlights:

1. The main systemic risk to the economy is interference from the Fed and the government.

2. This crisis, like all economic crises, was caused by the Fed’s easy money policy, starting in 2001.

3. Money flowed into housing and its derivates that emerged during the boom because of government policies that favored housing.

4. The risk models that investment bankers and investors used were flawed and the systemic pervasiveness of these models hid the obvious from them: bubbles never last.

The fact is that greed always exists, on Wall Street, and everywhere else, in that it’s basic to our nature. It takes something more than greed to create a bubble and that something is the creation of fiat money, something that only the Fed can do. Because people made stupid bets doesn’t mean that they caused the bubble. The Fed and government policies set the stage and created the rules and provided the excess credit for this crisis and traders and capitalists do what they always do: make money. Or at least try to make money.

Limiting pay or structuring bonuses longer term results won’t change anything if people still use the same risk models. Investment bankers and investors don’t yet understand the flaws of their basic concepts of evaluating risk. Modern Portfolio Theory, CAPM, and Black-Scholes are all based on the same faulty science. You would think that after a while the advocates of these models would wonder why their models don’t work and why their strategies keep blowing up in their faces. But they really don’t question the basic science.

Back to Mr. Hall. Vikram Pandit, Citi’s CEO, said the other day that Mr. Hall’s $100 million pay package was too much. Apparently others at Citi disagree:

Senior company executives have justified Mr. Hall’s contract by noting that his trading resulted in earnings for the bank that were many multiples of his pay. A Citigroup executive who was granted anonymity because he was not authorized to speak for the company, said that Mr. Hall’s pay was based on a percentage of the pretax profit at the Phibro trading unit he leads and that the payouts were adjusted for risk so that the more leverage taken by the firm, the lower the potential bonus. Mr. Hall’s contract also contains provisions to recoup some of the money if the unit loses money.

But, how much did Mr. Hall earn for Citi? According to the NY Times, “Mr. Hall … the standout performer at [Phibro] has netted Citigroup about $2 billion over the last five years. If Citigroup will not pay him the huge sums he has long made, someone else probably will.” Phibro reportedly made Citigroup $667 million in revenue from commodities trading last year, while the company overall had a record $27.7 billion net loss.

If I were Mr. Pandit, I would be kissing Mr. Hall’s behind to thank him for the wonderful job he is doing in helping keep the Citigroup ship afloat. If I were Mr. Feinberg, or Mr. Geithner, or Congressman Frank, or Senator Dodds, I would beg Mr. Hall to stay and take the money and go forth and do what he has been doing successfully for years. If he leaves and takes his traders, he will also take a big chunk of Citi’s earnings with him, which only lessens the chance that Citi will be able to pay the $45 billion back to the taxpayers.

This illustrates the problem with having a “Pay Czar”, or any kind of czar for that matter, make decisions based on politics rather than market conditions. They have no clue what they are doing, they don’t understand what the consequences of their actions will be, and it will usually cause the opposite of what was intended.

Their is no “fair” compensation in the marketplace. Pay is determined by freely contracting individuals, and if an employee doesn’t work to the firm’s advantage, it will be because the market says so. Ultimately it is the consumer who determines what pay should be. In this case, with a trader like Mr. Hall, his consumers are his investors and if he loses their money on a consistent basis, not only will his pay not have been worth it, he will lose his job.

Pay czars have been around for a long time, mostly in socialist countries, where bureaucrats determine who gets paid what. China and the USSR found that it didn’t work very well. Wage controls along with price controls have been tried in this country and they have always achieved the opposite of what was intended. All this pay cap will do is deter competent people from working in wage controlled businesses. In this case, Mr. Hall should run for the doors and set up his own hedge fund.

Let’s see what Citi can do without him.

Jeff Harding maintains The Daily Capitalist, from which this article has been permissibly reproduced.