Pay and the Free Market
It came up again in conversation today: someone was offended and upset over the level of compensation of some senior executives in the U.S. economy. I have to admit I just do not understand the anger. And I have a fundamental lack of respect for the arguments that have been served up thus far in support of the position.
I have tried to resist drawing the conclusion that the anger is born of envy, but I am very close to throwing in the towel on that one. Why should we begrudge anyone who earns a healthy salary, especially in an economy that provides each of us the opportunity to aspire to the same?
Even if there were reasonable ways around the practical issues and costs associated with legislative caps on salaries — how to set them, who sets them, using what measures, what value judgements — it simply makes no sense. It is the antithesis of a competitive market economy where individuals have the incentive to learn, grow, work hard, and succeed. It ignores the role played by capitalism in creating a strong and vibrant private economy that provides endless opportunities for all who want to put in the hours and the effort to succeed.
U.S. corporate governance rules provide the framework for determining the compensation for senior executives, and it works remarkably well. Each shareholder, or owner of the company, gets one vote on material issues such as reorganization. The Board of Directors is responsible for hiring and firing senior management on behalf of the shareholders. If the shareholders do not like the decisions of the board, including those that set the level and form of compensation for senior management, they have at least two, very effective choices. They can either sell their shares in the company or they can vote to replace the board members. The board can take several steps if, after negotiating the compensation package for senior management, the executive fails to perform. The board can withhold the bonus, renegotiate the terms of the contract, or fire the executive. Then the long, mostly objective arm of the competitive labor market will determine the market-clearing value for the skills and experience of the recently fired executive.
One thing I’ve never quite understood is why the market doesn’t seem to exact more punishment on senior executives who run their companies into the ground. Maybe there is an old boys network that looks out for ex-executives; maybe my observations are biased; maybe I notice only those cases where failed executives rise again. But it’s an empirical question, in any case; we can gather data on the issue and study it objectively.
Regardless of the conclusions of such an analysis, however, decisions about executive compensation must remain in the labor market where your ability to produce economic value still reigns supreme over your ability to curry votes and political favor.
By Sherry Jarrell
Learning from Dogs 
The argument should relate, surely, not so much the absolute level of reward, but to the question of what is being rewarded.
If short term risk-taking or opportunism is rewarded to the long term detriment of a company and/or society as a whole, then we have identified some part of our recent ecomonic woes.
The trouble with letting the market decide, is that invisible hand can occasionally deliver a hard and painful slap.
The trouble with letting the politicians decide on matters of remuneration is that they have voters to persuade and please, and the voting public are an ignorant bunch that love the idea of retribution for the fat cats, but don’t really understand the underlying issues…
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Well said. But how to distinguish “opportunism” from valuable investments, or “short-term” investments that create value later, and those that don’t? And who makes the distinction? A well-functioning, active stock market helps to uncover the consensus market opinion about value creation within publicly traded companies. I realize there are disagreements over how well the stock market performs this function — that is wonderful fodder for another topic another day.
On the topic at hand (pun intended!), I will take the freedom and self-determination associated with the occasional slap over the incarceration of decision-by- political-committee any day!
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In the case of the banking community, and the investment banking community in particular, the question is whether those responsible for determining remuneration truly understand the nature of the risks being incurred by their organisations.
In the world of derivative products, it has been my experience that as each succession of new instrument is born, banks have consistently rewarded based on the opening of the position, rather than understanding the long lifetimes and complex multi-event nature of the products.
They did it with interest rate swaps in the 1980s and they were still doing it was CDS and TRS products last time I looked.
The stock market, which you refer to in several of your postings, doesn’t really “price” OTC products or value credit risk very well. Mark-to-Market accounting doesn’t really do the risks justice either so investors are in the dark too.
It’s an old an recurring story. Occasionally (as in the case of Hammersmith and Fulham LBC v Hazell [1992] 2 AC 1), it is the clients that claim not to be able to understand the products being traded – more recently, it is the banks themselves that have been burnt.
One thing is for certain, if you remunerate “up front” those who trade products with a long tail, you are cruising for a bruising.
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Very interesting.
May I make sure I understand what you are saying before I comment? Are you speaking of transactions costs, for example, fees for the execution of a trade, rather than the net-of-fee price for the underlying asset?
Thanks!
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I did contemplate a response detailing the many complex costs and operational steps associated with managing the lifecycle of (say) a Credit Default Swap by comparison to a simple equity, traded in its nice coherent stock market. But I am not sure that this helps in, what is in essence, a discussion of laiser-faire versus interventionalist regulation.
It can be argued that intervention in Bank salary and bonus policies is unnecessary because to borrow your phrase “I will take the freedom and self-determination associated with the occasional slap over the incarceration of decision-by- political-committee any day!
The counter-argument is that the “slap” can occasionally be very hard, and may have enormous social consequences which fall way beyond the “fat cats” on the Street.
The question is, when does regulation become too much? Many would argue that there is manifestly too little effective regulation of banks at the moment. Are we in danger of going to far in the opposite direction when we talk of regulating bankers’ salaries? Possibly, but the argument against such regulation has to be more wholesome than the tired old line that any interference with market forces is a bad thing per se.
Such an argument is right up there with the thought that we shouldn’t regulate airline maintenance, because in due course market forces will intervene and airlines which under-maintain will lose customers (pun intended) and exit the market.
Thinking around the regulation of our financial markets and institutions need to be careful to avoid the same shallow logic.
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So funny! By telling me what you were going to write but didn’t, you’ve communicated so much to me about your thoughts on this topic. Delightful!
I so agree with you that the degree of regulation needs to be very carefully thought out, as carefully as that on airline maintenance. I used to take flying lessons in 4- and 6-seaters, and no one was as important as the mechanic! If you will humor me, could you summarize the basic sorts of regulations you and others are thinking about when they call for further regulation of the banks and/or financial services industries, besides perhaps reinstating the Glass-Steagall separation of investment and commercial banking activities? I am being genuine: I was going to write about the regulations that I assumed you were talking about but then realized that I truly do not know, and my response would be so much “wholesome” if I did not guess.
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There were very high executive compensations voted by the shareholders during the European Middle Ages, but that was found to be counter-productive for the majority.
Initially it had started innocently enough, from equality in the division of spoils. But one thing led to another, in the march towards ever greater imbalances of wealth first, and power, next.
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Wondering who made the determination that it was “counterproductive” for the majority? Thanks!
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Sherry,
May I recommend some reading: “The Real Meaning of Money” by Dorothy Rowe.
In essence it goes to the many different relationships that people have with money.
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Sure. Thanks very much!
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Perhaps the anger is due to the appearance that the system is gamed, rather than being a free market. Boards are conflicted: friends of the CEO, or other CEOs recognizing that their compensation is determined by what other companies pay. Institutional shareholders are can also be conflicted, since they are often vying for business managing the company’s cash or pension accounts. Your post notes all the things that should, in theory, limit excess compensation, but the real world doesn’t work the way econ textbooks describe it. When CEOs make millions for only matching, or even trailing the market, that drives anger.
In addition, as Professor Mintzberg noted in today’s WS Journal (link below), tying short-term, or even medium-term, profits and stock prices to the overall health of the company is dicey at best. That touches on Nigel’s comment, which points out that short-term actions, whether taking excess risk or laying off quality employees, can bump up compensation while damaging the company in the long run.
http://online.wsj.com/article/SB10001424052748703294004574511223494536570.html
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I’m describing what I’ve learned first-hand over the last 25 years through my work with all levels of management and employees, and from a handful of careful research papers examining hundreds if not thousands of observations on the topic of compensation. I’ve summarized that work in a chapter on compensation in my book, Driving Shareholder Value (McGraw Hill, 2001). Here’s a link to the book:
http://www.amazon.com/Driving-Shareholder-Value-Sherry-Jarrell/dp/0071590005/ref=sr_1_1?ie=UTF8&s=books&qid=1259634013&sr=1-1
Ironically, the book was the result of four years of NSF-funded research into the strategic planning and resource allocation decisions at three Fortune 500 U.S. companies. My co-principal investigator and I referenced Prof. Mintzberg’s work, and our analysis basically picked up where Prof. Mintzberg left off in his 1994 book, “The Rise and Fall of Strategic Planning.” Prof. Mintzberg has long doubted the ability of research to demonstrate empirically the impact of strategic planning, of which compensation and incentives are a critical subset, on performance. In his view, the link is dicey, but he, like you, cites a handful of anecdotal exceptions to make your point. There is ample evidence to the contrary.
The “market” is not the appropriate benchmark for judging performance. The market is just the average of all companies at any given point in time. Organizations have rich corporate histories, and take many paths over time in attempting to create value. How the company would have done during that period under some other manager is the correct benchmark. It is difficult, but not impossible, to measure.
So who, in your view, should we put in charge of defining what is “excess” compensation? And to what performance metric should compensation be tied? I’d genuinely love to hear your ideas.
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The board, with major shareholders applying pressure as appropriate, is the right body to determine compensation, but it would need to be done by a subcommittee that is completely independent of the CEO and made up of people who are not CEOs themselves. And the big shareholders would need to step up, which would require things like mutual funds not automatically voting with management. I don’t think there is any single metric which can be used; a whole range should be used, which is why the board’s participation is so important. For example, matching market performance (and by market, I mean an index of similar companies) is easy to measure. But, as another example, making sure that short-term profits haven’t been achieved by gutting R&D, which will bite you 15 years down the road, can only be determined by an active and involved board.
I haven’t seen any studies that distinguish between truly disinterested comp committees and non-disinterested ones. Have you? That would be interesting. But asking CEOs to chime in seems guaranteed to generate self-interested commentary.
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Thoughtbasket: Fundamentally I believe that you and I agree that the labor market, in concert with all the elements of corporate governance (including boards, committees, voting rights, proxies, etc.), is best equipped to determine a fair compensation package.
We probably diverge on the best metric to use to determine the impact of management on performance, and we disagree on the usefulness of asking people with actual experience as (and with) CEOs to add their views to this discussion. (Note to readers: I posted a request on http://www.SherryJarrell.com asking CEOs to comment on this thread http://www.sherryjarrell.com/2009/12/corporate-executives-i-need-your-input.html).
Most CEO’s I know have held many different positions within corporate organizations. They’ve been on both sides of the hiring negotiations: doing the hiring, and being hired. And both sides of the firing negotiations. They’ve seen compensation as both personal income to be maximized and as a corporate expense to be minimized.
So I welcome CEO input. I trust that you and I and the readers are astute enough to tell when a comment rings true, and when it is full of hot air. I, for one, would love to hear what executives have to say on the topic. And if the request happens to generate more readership for my blog or for LearningfromDogs, that’s not a bad thing, selfishly speaking!
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