Executive Pay – Ethics and Economics

We have often dealt with the two big questions of executive compensation: A. Is it too large? B. If so can anything be done about it? This topic has achieved great prominence in the ongoing financial crisis for a number of reasons.

On the visceral level, there is a feeling of resentment and vindictiveness towards the leaders of financial institutions. In the United States, there is no instinctive revulsion to “excessive” salaries, as there is in many more traditional countries, from large countries like Japan to small ones like Israel. But it is a mistake to think that Americans don’t believe in “fair” salaries. They just are more willing to accept that a great manager may really be worth eight or even nine figures – just as they accept that Tiger Woods, on his own merit, is really worth over a hundred million dollars a year.

But when they see executives getting that kind of salary for throwing the economy over the brink, they can begin to get resentful. They may think that these huge salaries are obtained through unfair influence, rather than a fair bargain between the company and the executive. (Remember that executives themselves have a role in setting salaries – unlike Tiger, who doesn’t have any position of authority in the companies that pay him.) As a result, one of the popular demands for the bailout bill was limits on executive compensation.

On the scientific level, many economists began to feel even worse than the average Joe. Main Street morality took the line that these guys threw their institutions to the dogs despite their astronomic salaries. Ivory tower analysis raised the possibility that it happened not despite compensation plans, but because of them. Economists, unlike moralists, don’t like to blame people for responding to incentives, but they have no compunctions about blaming the incentives.

The two main concerns regarding incentive programs are;

(1) They encourage manipulation of the stock price or massaging the numbers, in order to enable cashing in on options packages or bonuses linked to profits;

(2) Compensation is seldom capped up, but is always capped down, since you can’t lose more than everything (under US law, they can not enslave you for your debts). So even without funny business, incentive packages can encourage excessive risk-taking.

In order to address these issues, the US bailout bill includes the following provisions for nationalized banks (the following is a citation from a US Treasury press release):

(1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution;
(2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate;
(3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and
(4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive.

We can easily see that the first condition addresses the “excessive risk” concern; the second addresses the “manipulation” concern, and the third addresses the “influence” concern.

The last clause should be familiar, as a proposed Knesset bill includes the same provision. Companies can pay executives as much as they want, but beyond a certain reasonable amount they can’t expect taxpayers to foot the bill. In my view, the rationale is as follows: Executives at the top level are competing for “play money”. The standard of living of these individuals is not really affected by an extra ten or hundred million dollars; many don’t even have particularly extravagant lifestyles. But these are people who are driven to be the best and to be compensated the best, and it is very important to them to be able to know that they are among the highest earners. If this is the case, then lowering the stakes makes the game just as fun and challenging but much less expensive. As John Maynard Keynes wrote, “There are valuable human activities which require the motive of money-making and the environment of private wealth-ownership for their full fruition. . . But it is not necessary for the stimulation of these activities and the satisfaction of these proclivities [for self-aggrandizement] that the game should be played for such high stakes as at present.” (Keynes was writing at a time when income inequality was at historically high levels, as it is today – I mean, as it was yesterday.)

By removing the tax deduction, the executive costs the company a lot, showing his great worth and importance. But much of the cost accrues to the taxpayer since the outlay is not tax deductible. It seems that the US Treasury has come to agree with Keynes, and as Richard Nixon astutely commented in 1971, “We are all Keynesians now.”

Two prominent bloggers have made cogent contributions to this discussion. Stanford’s Brad Delong suggested that bonuses could be make contingent on the company’s performance years ahead, thus creating a stake in the long-term success of the company. In fact, many options programs do vest only many years in the future, and companies encourage stock ownership by employees to create such a long-term stake. With due respect to Brad, this mechanism does not always work, and many executives who failed to exercise basic prudence paid for their lack of foresight with losses of hundreds of millions of dollars. And Tyler Cowen pointed out that despite its shortcomings, performance-based compensation will be needed to motivate managers in today’s very challenging environment. “If the key is to get banks up and running again, we want bank CEO contracts with lots of bonus compensation on the profit upside and those contracts are more important the ‘worse’ is the bank.  Ouch.” Cowen thinks that economics may have to trump ethics, but he does acknowledge the sting.