Charles Wheelan, Ph.D. The Naked Economist

Representatives of the G-20 nations have agreed on the need to limit the pay and bonuses of financial executives so that they will have less incentive to do crazy, risky things that make life miserable for the rest of us. It's a reasonable goal. Too bad their approach won't work.

The first thing to recognize is that there is indeed a problem with compensation in the financial sector. However, that problem is not that people get paid too much. Workers and executives who do great things should get paid a lot (to our American way of thinking). This encourages innovation, risk, heroism, hard work, extra white teeth and other good things. All fine.

The problem in the financial industry is that we sometimes end up paying people a ton of money to do awful things. That's what rubs most of us the wrong way. The unique nature of finance is what makes this possible -- and difficult to fix. We can't always tell "good" from "awful" in high finance until a trader or executive owns his own island in the Caribbean, and then it's too late.

These people get paid to make complex bets with shareholders' capital. Here's the fundamental problem:  Some really bad bets can pay off handsomely for a while before the odds catch up and the shareholders' capital is withered away.

Suppose I go to work for a Wall Street firm. In year one, I take $100 million and bet on a 20-1 horse in the Kentucky Derby. At post time, it transpires that the horse is lame and the jockey is sick, so the odds shoot to 100-1. I bet another $100 million of someone's pension fund. Of course, my investment strategy would never be this transparent. I'd tell my CEO and our investors that I have pioneered "riding speed finish futures" or something equally opaque and arcane.

Then my lame horse with the sick jockey wins, because that happens every once in a while. Billions in profits pour in and I am a complete genius. But I'm not really. I'm just a guy who took a really stupid risk with someone else's money. Come bonus time, I get my $192 million bonus. (Do Wall Street guys get those big cardboard checks, or is that just athletes who win tournaments?) In any case, I buy a helicopter and a Caribbean island, I divorce my wife and I get calf implants. People start to think that I'm smart, even when I say the same banal things. Presidential candidates seek out my advice (and contributions).

The Kentucky Derby rolls around the next year, and the firm gives me even more capital to invest in "riding speed finish futures." I find a three-legged horse with a jockey who has developed a serious weight problem. It's not clear how a three-legged horse gets into the Kentucky Derby, but let's just go with it for illustrative purposes. The odds are 212-1. I put down $2 billion of the firm's capital.

The gates open. My horse's jockey has ballooned to 190 pounds, which is more than the three-legged horse can take. My horse falls over in the first stretch and eventually finishes last by 23 minutes. The $2 billion is lost.

Our investors have lost their money. The firm fires me. If we've borrowed money to make this bet, the firm may be wiped out. Congress holds hearings. The public realizes that a "riding speed finish futures" is just a bet on a horse race. In a rare moment of agreement, both Fox News and The New York Times say that this investment strategy was idiotic. The CEO of my firm is grilled as to why he thought betting $2 billion on a three-legged horse with an overweight jockey was a good idea. He answers, probably honestly, that he had no idea what I was doing with the money and that the "riding speed finish futures" had worked well for the firm in the past.

Here's the thing: Despite all that, I don't have to give back last year's $192 million bonus. (After all, I haven't committed fraud -- just reckless incompetence.) I'm hanging out on my Caribbean island teaching my new wife how to fly the helicopter. I have no regrets, because my incentives were never well-aligned with what's good for the long-term health of my firm and its investors.

Therein lies the fundamental challenge of compensation reform on Wall Street. We should reward innovation and success, but it needs to be real innovation and real success, not luck or reckless bets. This is actually really tough because first, innovators are, by definition, working on stuff that the rest of us don't understand, and second, even really stupid strategies can look brilliant for a while.

I don't like the G-20 cap on compensation idea because it treats the charlatans the same as the true innovators. While some joker is selling "riding speed finish futures," the guy down the hall might be making brilliant private equity investments or inventing new products with enormous value, such as indexed mutual funds or the bond futures contract. He should get paid a lot.

I'm also certain that wily firms will find ways around any compensation limits, and the unintended consequences of that could be worse than the system we've got now. Remember, our current employer-based health care system was an accident. The system was born when firms legally evaded Franklin Roosevelt's wage and price controls by giving workers health benefits instead of higher wages.

Don't get me wrong -- there is a problem here. The one-year anniversary of the Lehman Brothers collapse is a good reminder of that. The Wall Street compensation system is broken. Too many people get paid too much to do too many things of questionable value. But this problem is going to have to be solved by the firms themselves. The G-20 is not going to fix it.