The Magazine

Pay Day

Why it makes sense to worry about executive compensation.

Aug 31, 2009, Vol. 14, No. 46 • By IRWIN M. STELZER
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We have learned, too, that most Americans are unappalled by big pay packets, so long as they are at least arguably related to performance. No one is calling for the lynching of Warren Buffett, who made a bundle on his save-the-day investment in Goldman Sachs. Or Bill Gates, whose billions result from his having invented a company that changed the way business is done and daily life is lived. Even Barack Obama, who capped pay and perks for executives at "firms receiving extraordinary help from U.S., taxpayers," and who thinks that upper-income Americans had it so good in the Bush years that they are obliged to be enthusiastic supporters of his plan to raise their taxes, has said, "This is America. We don't disparage wealth. . . . We believe that success should be rewarded." Either he means it, or feels it necessary for political reasons to say it. No matter. The point is that if this president sensed a wave of revulsion at high incomes, he would surely ride that wave. He doesn't, so he hasn't.

The most important and troubling lesson we have learned is that it is not how much executives in the financial sector are paid, but how that pay is structured. "Incentives matter" has long been a mantra of conservatives eager to allow the invisible hand to work its magic, rather than rely on government to direct economic activities. It was that belief in the ability of proper incentives to produce socially desirable behavior that underpinned conservative plans for welfare reform. With incentives and the public interest properly aligned, markets, not men, should decide on the allocation of a nation's resources, and on the division of the rewards for economic effort. Unless . . .

As Stanford professor Roger Noll put it in a communication he has generously allowed me to quote:

The financial whizzes did nothing illegal and were responding to the incentives they faced. The system of large cash bonuses for gains coupled with no penalty for losses leads them to play games in which the short-term probability of gain is high but the long-term probability of loss also is high. This is the basic underlying fact behind every financial crisis in the last 25 years. If we persist in a system in which a company makes X a year every year for ten years but then loses 25X in the eleventh, and we give Y in bonuses in the good years and zero in the bad, the whizzes will still prefer boom and bust.

When the pursuit of such incentives harms innocent bystanders, it is difficult to argue that there is no role for government to play in correcting what economists call market failure resulting from externalities, even at the risk of introducing government failure. We don't allow 8-year-old children to spend their days digging coal only because we are humane, but also because such an assault on the health and educational opportunities of these children imposes costs on society that are not borne by mine owners. We don't allow manufacturers to pollute if that damages the health of innocent bystanders, imposing costs on society. And we now know that the structure of financial incentives can lead to risk-taking that has serious consequences for society--for Main Street as well as Wall Street. If compensation is structured so that the rewards of risk-taking go to bankers and their shareholders, but the costs of failure are borne by a wider group, the bankers will take more risks than are economically efficient. And that is without giving weight to Adam Smith's shrewd observation that men tend to be excessive risk-takers even without a skewed reward system: "The overweening conceit which the greater part of men have of their own abilities, is an ancient evil. . . . The chance of gain is by every man more or less over-valued, and the chance of loss is by most men under-valued."

The argument that incentives and inclinations exist that lead to excessive risk-taking is not a moral argument, or a political one, or an argument in favor of a more equal distribution of income and wealth. It is solely an economic argument: Compensation structured as it has been in the financial sector results in an uneconomically excessive amount of risk-taking, just as a failure to make a polluter internalize the costs of pollution provides an incentive for him to produce more than if he had to pay all the costs he imposes on society.

Mortgage brokers have an incentive to write NINJA mortgages--no income, no job or assets--because they are paid up front, and then pass the risk on to banks. Banks immediately wrap these risky mortgages into securities, and sell them to investors who are reassured by the triple A ratings conferred by the rating agencies--who earn a fee only if the deal gets done. Everyone has an incentive to do the wrong thing--no surprise that they do just that. Not because they are law-breakers, not because they are antisocial, not because they can't wait to see the undeserving evicted from their homes. Simply because they are following the incentives embedded in the compensation packages that do not reflect the costs to society of their errors.

Until now, economists held that the fear of "reputational consequences" would deter such behavior. But most of these transactions that originate with a broker paid up-front are one-off--the same customer is unlikely to return, or learn soon enough the consequences of his brokers' behavior to warn others. Executives who bring down their institutions leave with golden goodbyes and access to talk shows on which they unashamedly--shame being in short supply these days--justify their actions en route to a game of golf at a country club, dues paid by the company from which they departed but at which an office and staff support are still available to make their transition to a new life friction-free.

I exaggerate: Not all cases fit that description. But almost all have one characteristic in common: The cost of the pursuit of the incentives contained in a compensation package, when that pursuit leads to major loss, has not been borne by the pursuer, but by thousands of people he has never met.

Since society bears the cost, society, as represented by its elected officials and their appointees, must have something to say about how to eliminate or at least mitigate incentives that are causing such woe to the innocent. Translating that general conclusion into effective regulation is no easy chore. The House hopes to accomplish the goal by improving corporate governance, making executive compensation subject to more effective review by shareholders and boards of directors. No harm there, but neither the shareholders nor the compensation committees of boards have any incentive to internalize the social costs of excessive risk-taking. The solution is made no easier by political posturing by representatives of both parties. New York attorney general Andrew Cuomo continued his undeclared drive for the Democratic gubernatorial nomination by revealing his horror at discovering that nine banks that received government aid paid out nearly $33 billion in bonuses last year. Which is not particularly relevant if the bonuses were paid pursuant to contracts or to employees whose divisions turned a handsome profit.

Equally unhelpful are the Republican opponents of any interference in the structure of pay packages. Reacting to the House bill, Representative Spencer Bachus of Alabama said that the government should not interfere in the operation of private-sector companies, adding, "Government bureaucrats don't know what's best for America," which is undoubtedly true (cf. health care reform), but not particularly relevant in a circumstance in which private-sector companies exist only because the government has seen fit to pour billions into them, and private-sector bureaucrats have an incentive to ignore the public interest.

So, like it or not, we are faced with a situation in which government regulators will have to try to figure out how to align private with public interests. Here the watchword must be, "Get the incentives right, and if huge bonuses flow to the skilled or the merely lucky, so be it." Step one is to make sure that every player has his own skin in the game. Lenders at all levels must be made to bear some of the cost of loans they make that go sour. Recipients of bonuses must have their entitlements based on longer rather than shorter time periods. And be subject to recapture under certain conditions. Or perhaps the system adopted by Credit Suisse might be used: Five billion dollars in bonuses were paid in January from a fund consisting of the bank's toxic assets--a plan called "eat your own cooking" by one banker. So far, the value of bonuses is up 17 percent since the plan was instituted, far less than the 75 percent increase in Credit Suisse shares, in which bonuses were paid in the past.

Rating agencies must also be required to have skin in the game, perhaps by being forced to take part of their compensation in the securities that they are blessing, and better still, by being subjected to the competition from which government rules and practice now shield them by making entry into the rating business unnecessarily difficult. And it wouldn't be a bad idea to have a portion of the pay of regulators held in escrow, to be returned to the taxpayers if their regulatory schemes prove inadequate.

Will even a perfect scheme of forcing financial institutions to internalize the costs their pay schemes now impose on society eliminate future financial crises? Of course not. The "animal spirits" that John Maynard Keynes said animate capitalists will always at times result in excessively exuberant behavior. Absent a taste for structural reform on the part of the administration, the banks that are too big to fail will remain too big to fail, creating moral hazard that even the most wisely crafted compensation scheme cannot offset. But some progress is better than none, some reduction of systemic risk better than none, some correction of incentives that leave society holding the bag while risk-taking executives escape unscathed better than none. And, most important, ardent capitalists should agree that some reform, however imperfect, that restores faith in their preferred economic system is better than none.

Irwin M. Stelzer, a contributing editor to THE WEEKLY STANDARD, is director of economic policy studies at the Hudson Institute and a columnist for the Sunday Times (London).