Over fifty years have passed since Ayn Rand penned her classic criticism of government interference in economic matters,  Atlas Shrugged.  For those unfamiliar with this seminal work, it illustrates how government’s proliferation of myriad programs and regulations sabotages the creativity and production of the very economic well-being it desires to improve.

Friday, Congress ratified, and the President is about to sign, the $787 billion economic stimulus bill.  Concealed in the bowels of this 1,000+ pages of legislation is a restriction on executive compensation — thank you, Senator Christopher Dodd of Connecticut.  Proudly announcing his vanquishing of Wall Street gluttony, Dodd crowed:

“The decisions of certain Wall Street executives to enrich themselves at the expense of taxpayers have seriously undermined public confidence in efforts to stabilize the economy.  These tough new rules will help ensure that taxpayer dollars no longer effectively subsidize lavish Wall Street bonuses.”

While at first blush, curtailing pay packages for employees at firms receiving government (taxpayer) funds might make sense, a closer examination reveals more problems than solutions.

James F. Reda, an independent compensation consultant, responded to the new legislation (via The New York Times):

“These rules will not work.  Any smart executive will (a) pay back TARP money ASAP or (b) get another job.”

This highlights just two of the major difficulties with government dictating how companies compensate their employees.  Talented workers will abandon a company shackled by government handcuffs for greener pastures at hedge funds or foreign banks.  This exodus would occur at the very time when their abilities are most needed to help ensure that TARP money is protected and paid back to the government.

Perhaps more importantly, do we really want to incent banks to return TARP money before it is fiscally optimal for them to do so?  Prematurely returning TARP funds carries with it the dual disadvantages of weakening banks’ capital structures and reducing the amount of money available for lending.  The latter cancels out the very purpose of replenishing bank capital — ameliorating the dearth of credit in the system, thereby turning off the lending spigot.

Many of the banks that received TARP funds did not want the funds to begin with.  Back in October when nine bank CEO’s were summoned to Washington, then-Treasury Secretary Paulson stuck a $125 billion gun at their collective heads, ordering them to take the funds.  Furthermore, the money was not given to the banks.  Uncle Sam received preferred stock, paying a 5% dividend (for 3 years, then stepping up to 9% for as long as the firms retained the funds).  Given that the government’s 3-year cost of capital at the time was less than 3%, taxpayers stand to earn more than 2% annually on their money.

If bonuses are limited, companies will be forced to pay higher salaries in order to lure the top professionals to their firms.  This will simultaneously raise banks’ fixed costs, increase their risk, and diminish the incentive for employees to work harder to maximize shareholder value as well as their own remuneration.  Commission-based employees such as loan officers will have little reason to maximize credit availability once their commission compensation approaches the government imposed ceiling.

Dagny Taggart knows how they feel.