There’s an old article by Milton Friedman that argues that as people get wealthier they don’t care much about modest increases in wealth and only about really big ones. What’s another $1 million if you have $1 billion? You are most interested in things that will get you another billion. I think it provides some insights for what went on in Wall St.

Someone who has amassed tens of millions of dollars doesn’t really care about making a modest bonus—they care about making a massive bonus. So they would rather take huge risks that might lead to enormous gains than modest ones that lead to modest gains. The problem of course is that unlike their company or the people they are investing for when they win, they win big, and when they lose, the most they lose is the possible bonus they might have gotten by taking a modest risk. So, that leads me to think that the compensation structure on Wall St. leads traders to take too big risks and that the same logic may apply to the heads of the companies—witness the fact that the guys who took the big risks made massive amounts of money when their firms were riding high and didn’t lose much (in fact walked away with large severance payments) when the whole thing went south.

One of the things Congress will need to focus on in reforming Wall St. in the wake of the financial collapse is balancing the important ability of companies to design compensation schemes and the principal-agent problem of corporate executives engaging in gambling that can bring the collective house down.