For free market enthusiasts, the Obama administration’s $500,000 remuneration limit for banks receiving public bailouts is less obnoxious than it seems at first. Most obviously, it provides a useful incentive against further recourse to taxpayer funds – even the near-deadbeat Citigroup is not to be subjected to it until it asks for yet more money. More interesting, it may result in a restructuring of the financial services business in a way that moves it closer to the economically ideal.

It has been obvious since at least the 1980s that Wall Street’s compensation structure was cuckoo. Whereas the $150,000 typical base salary for a Wall Street partner was a decent upper-middle-class wage in the early 1970s, the last time Wall Street had a run of bad years, by the late 1980s it had become an amount that a senior investment banker, locked into obligations such as an expensive Manhattan apartment or townhouse, could not conceivably live on even in a down year.

Naturally, bonuses were 10, 20 or even 100 times this amount, but this brought distorted incentives into the picture. Notoriously, Wall Street bankers were tempted to play games with year-end valuations in order to maximize their bonus payout. What has been less publicized, but has always been clear to those in the industry, is that employers played political games with bonuses in order to minimize payouts to the disfavored, thus maximizing the amounts available for the in-crowd.

(Disclosure: My own experience with bonus schemes, never anywhere near the top Wall Street scale, was pretty unpleasant. Of eight years I should have been eligible for bonus awards – my merchant bank first employer didn’t give them – I received only two, in spite of making at least some net profits for my employers every year. Tricks used included moving the disfavored to a different department in November, deciding unilaterally that no bonuses would be given at all that year (twice, with different employers, after my two most productive years), and firing the disfavored on Christmas Eve, relenting only after the New Year.)

It’s one thing when bonuses earned but not received represent 10-25% of one’s income; it’s quite another when they represent almost all of it. Thus I have considerable sympathy for at least some of the recipients of the $18 billion in 2008 Wall Street bonuses about which President Obama is so exercised. If the base salary is not remotely appropriate for a senior executive, and a senior (but not top-management with overall responsibility for disaster) banker has worked very hard and successfully on a couple of big deals in 2008, bringing the firm substantial revenues (which were then eaten up by trading losses) it seems unfair to deprive him of a bonus altogether, making him, even with a relatively modest Manhattan lifestyle, run at a substantial loss for the year.

The solution to the problem is thus obvious: pay higher base salaries – and by all means, much smaller bonuses. This will increase company loyalty, since the banker will receive a nicely juicy paycheck each month, rather than running up debt in the hope of a huge payoff. It will not significantly de-motivate him, since bonuses will remain large enough to be “interesting” – and if it means he works 70-hour weeks instead of 100-hour weeks, the quality of his work and his ethical standards will both substantially benefit, as will his mental health. It will also remove significant arbitrariness from his remuneration, an arbitrariness which unscrupulous bosses will use against him, and the threat of which causes unproductive and unpleasant office-politics, as well as accounting shenanigans.

Obama’s $500,000 limit, which will apply only to those banks which have drunk more than once from the TARP well but should ideally apply to all staff within those banks, is a significant move in this direction. Senior bankers will no longer work for $150,000 base if their remuneration is to be capped at $500,000; even in a down market they will demand a base at or close to the cap. Thus the most counterproductive feature of the Wall Street remuneration, the disproportion between base remuneration and bonus, will automatically diminish or disappear.

At a senior level, once business rebounds, $500,000 won’t be enough to keep good investment bankers or traders, if the restriction remains in place for more than a limited period. However, $500,000, if it is mostly base salary, is a perfectly adequate remuneration for retail bankers, corporate lending officers and even for retail brokers, as well as for top back-office types and IT specialists. One can – I speak from long experience – live quite well on it, although a pay-restricted top management might reasonably wish to move the institution’s headquarters out of Manhattan. Thus institutions that remain under the restriction for a lengthy period of time will find themselves surviving quite nicely, but metamorphosing into very much less risky entities.

If those entities are large, $500,000 will not attract aggressive, entrepreneurial top management in today’s market. However the public should not want aggressive entrepreneurial top management at the head of any institution that is deemed “too big to fail” or is otherwise liable to land the public purse with huge losses. Fannie Mae and Freddie Mac were perfectly solid albeit economically useless bureaucracies until somebody came up with the idea of paying their top management tens of millions of dollars. Had their top management remuneration been capped at $500,000 – more than for any purely public sector job – they would have continued guaranteeing only prime home mortgages, without acquiring a large portfolio on their balance sheet and without venturing into the subprime sector. It must surely be crystal clear that the US economy would in that event be in very much better shape today.

By capping salaries at $500,000, and ensuring that any loopholes found are closed, Obama would zombify the senior management of affected institutions. Instead of competing ferociously for new and ever riskier ways of rent-seeking, leveraging the huge pool of capital they controlled, the management cadre would over time collectively lose all initiative, competing un-aggressively, with capabilities only in the well-trodden, low-risk financial product groups which comprise 90% of the sector’s economically useful transactions. Zombie management would be much cheaper than entrepreneurial management, so the zombified banks would in those product areas out-compete banks whose management remained on the traditional pay structure. That would force those banks also towards government intervention. Banks that were “too big to fail” would thus be zombified rather than bankrupted, to the great economic benefit of the US economy. Financial services sector rent-seeking would largely disappear and its share of GDP would be reduced towards 1970s levels, about half those of 2007.

While the hugely capitalized “too big to fail” banks would become zombies, entrepreneurial skills and financial innovation would not disappear from the financial services sector. It would simply migrate to smaller institutions, such as the boutiques Greenhill and Evercore Partners. Those would not be able to tap the rent-seeking opportunities from deploying huge amounts of outside shareholders’ money, and would never have the balance sheets of the current behemoths. They would however provide the full range of advisory services, as well as developing new financial products and providing value-added financial solutions in areas left fallow by the zombies. To the extent they required underwriting for a large financing, they would be able to obtain it from the zombies and from large passive pools of investment capital such as insurance companies and pension funds, both of which would make modest additional incomes from underwriting securities in which they would normally invest.

The function most seriously affected by the new structure would be trading. In well-established areas such as bonds, foreign exchange, top tier equities and straightforward derivatives, this could be carried on by modestly paid staffs in the zombie banks, which would have no incentive to take great risks. High-rollers would work for hedge funds, whose capital is specifically dedicated to taking risks; there seems little need to have a separate group of high-risk trading-desk institutions for the hedge funds to fleece. To the extent (very limited, in my view) additional returns were available from exotic trading strategies, hedge funds would be well placed to achieve them. “Principal trading” which in the current Wall Street consists largely of profiting from the firm’s insider information and connections at the expense of its customers and the market, would no longer be a significant factor in the zombies’ operations, because their controls would be too tight and their staff would not be capable of undertaking it profitably.

As a populist gesture, Obama’s new restrictions are odious banker-bashing. As a general principle applied to business as a whole, as suggested by House Financial Services Committee chairman Barney Frank (D.-Mass) they would be hugely economically damaging, taking the United States a long way towards the failed experiments of socialism.

However as a corrective to the “too big to fail” doctrine they have considerable merits. Obama is a very clever man; he may have found a way, without draconian legislation, to re-mould Wall Street, producing a downsized and economically efficient structure.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)