February 8, 2009
Pay Controls Do Not Work at Any Level
Pay Controls Do Not Work at Any Level-Becker
Several big banks and other companies have badly fumbled their public relations during these difficult times, such as the big three auto makers who took their private jets to Washington to beg Congress for a bailout, or the board and CEO of Merrill Lynch that granted generous bonuses to their executives just as the company was avoiding bankruptcy through being taken over by Bank of America. However, anger, even when justified, is not a good reason for ceilings on the pay of top executives at companies receiving assistance from the federal government.
The main problem with wage (and price) controls is that they never work, although governments have imposed them throughout history. They will not work in this case either, where the plan includes a salary cap of $500,000 for top executives at companies taking "extraordinary assistance" from the federal government, restrictions on when these executives can cash in the stock they will receive, limits to their severance pay, and monitoring of fringe benefits, like company jets. There are no good guides to a priori setting of either the form or the level of compensation to employees in any occupation, including top executives. Competition, with all its defects (which I discuss later), is still the best mechanism available for setting salaries and other prices.
Pay caps will encourage companies that take government aid to hire high priced lawyers and accountants to devote their expensive time trying to find loopholes in these caps. Loopholes include reclassifying some employees to positions below top executives so that their pay would not be subject to any government pay caps. Most loopholes center on various forms of deferred payments and non-monetary benefits. For example, companies started to provide free medical coverage to its employees during World War II as a way to circumvent controls over wages. This fringe benefit has persisted as a tax advantage that is usually not available to workers who pay for their own medical insurance. The plan for executive pay caps already includes restrictions on several fringes, including the ownership of corporate jets by companies taking government assistance, even though company jets are often valuable savers of the expensive time of executives who do a lot of traveling. Able lawyers and accountants will discover many other fringe benefits that can help circumvent the pay caps.
Companies that take government assistance do so because they fear going bankrupt. Sometimes that is because they were badly managed by the CEOs and other executives in charge. What many of these companies need are new executives who can take a fresh look at their problems. Unfortunately, pay caps that leave total pay considerably below what able executives receive in other companies make it more difficult to attract these executives to companies in distress because they can earn more, and work with considerably less government interference, in companies that do not take or need aid. Moreover, severe limits on severance pay help to lock in incompetent executives who then might refuse to leave voluntarily because they would not receive any significant financial incentives to leave.
Apropos of turnover of top executives, I believe many company boards, and also boards of universities and other non-profit institutions, fail in their most important responsibility: to determine when top management should be replaced. This is partly because many board members spend very little time on board activities, and also because many members are friendly, or at least sympathetic, to the top executives. As a result, they are either too ignorant of how the companies they oversee are really doing to overrule top management, or they are too close to management to make the hard decision to fire them when they perform badly.
Of course, one reason caps on the pay of bank top executives are popular is because of the general perception that boards of directors also overpaid these executives, and thereby failed in this duty to protect stockholders. Perhaps they did, but even if the pay of top executives at many banks and funds were well above what they would receive in a well functioning competitive market for executives, that could not explain the devastating hit taken by stockholders of these companies during this crisis. For example, even a 100% overpayment to bank executives would usually have only a small direct effect on bank profits since their pay, however large in an absolute sense, was rather small compared to the normal profits of these companies.
Another criticism of the compensation of the top executives of banks and other financial institutions is that it encouraged excessive risk-taking because their pay was excessively loaded toward stocks and bonuses. In retrospect, obviously, top executives of many financial companies took risks that turned out to be catastrophic for stockholders and employees. Yet, since the value of the stocks owned by these top executives also dropped sharply, and since their bonuses have been sharply reduced or eliminated, most top executives did suffer greatly along with stockholders when their risky decisions failed. So any distortion in the pay structure toward risk taking was surely limited.
Against the Pay Caps--Posner
The government has decided to impose a $500,000 ceiling on the senior executives of banks and other financial institutions that accept bailout money. This is a bad idea, though politically inevitable because of public indignation at financiers, thus illustrating a point I make in my forthcoming book about the depression--for I insist that it is a depression, and not a mere recession, that the country is in--that a depression is a political rather than just an economic event. (The book is entitled A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, and will be published early in April by the Harvard University Press.)
It is a bad idea for three reasons. First, it directs attention away from the really culpable parties in the depression, who are not the financiers. They were engaged in risky lending, that is true; but the fact that a risk materializes does not prove that it was imprudent. A small risk of bankruptcy--a risk that almost every business firm assumes--can be, when it is a risk faced by most firms in an industry and the industry is financial intermediation, catastrophic. But the responsibility for preventing catastrophic risks to the economy caused by a collapse of the banking industry lies with the Federal Reserve, other regulatory bodies, and the Treasury Department. A banker is not going to forgo a risk that should it materialize would wreck the economy, because his forbearance would have no consequence, as long as his competitors continued running the risk; it is a classic case of external costs, requiring government intervention. Because the Federal Reserve under Alan Greenspan pushed interest rates too low and kept them low for too long, and because regulation of financial intermediaries had over the years dwindled and became especially lax during the Bush Administration, the bankers were allowed, and competition forced them, to take risks that could have and have had disastrous results. If the government thinks that shaming the bankers and capping their pay will prevent future banking disasters, it will be distracted from making the regulatory changes that are necessary to restore effective public supervision of a vital industry.
Second, the pay cap contributes nothing to getting us out of the depression. That can be done only by an active monetary policy, by recapitalizing the banking industry, and by a stimulus program (because the first two policies are not working well)--that is, by trying to stimulate demand for goods and services by putting unemployed or underemployed labor and other resources to work, as by a public-works program, the idea being that if private demand falls below supply, the equilibrium can be restored by substituting public demand for the missing private demand. The pay ceiling does nothing along any of these lines. One reason it does not is that the problem of overcompensation in the banking industry is more serious at the trading level than at the senior management level, since it's the traders who make the transactions. I give an example in my book of how it can pay a trader to make an extremely risky trade. The pay cap doesn't reach down that far in the corporate hierarchy.
Third, and worst, the pay ceiling will retard the recovery of the banking industry. Not, I think, because it will drive the ablest executives into other fields; for the demand for their services in other fields is apt to be weak, though some may retire early rather than work for what they are apt to regard as a derisory salary. But some will be hired by banking firms to which the pay cap does not apply because they do not want bailouts. And those who remain in their present jobs and are subject to the cap will be distracted from their work. They will have to make changes in their personal finances to adjust to their lower salary, and, human nature being what it is, they will spend time seeking ways to evade the ceiling--efforts that no doubt will be met by bureaucratic regulations designed to foil them. Their time and attention will be deflected from the challenges facing their companies.
The pay ceiling will be more than a personal distraction, however. It may cause senior management at some banks to refuse a bailout, to the detriment of recovery from the depression. Worse, it will increase the volatility of the political and regulatory environment of the banking industry (a term I use broadly to include financial intermediaries in general, since the traditional barriers between banks and other such intermediaries have largely been taken down). Critics of the bailouts complain that banks aren't lending the money that the government has given them, but instead are putting it in the pockets of their executives, in the form of high salaries, bonuses and perks. All that money that is going to the executives, however, is just a drop in the bucket. The banks are not lending the capital the government has given them not because they've squandered it on their executives but because the demand for loans is weak in a depression, because loans in a depression are at a high risk of default, and because the banks are still undercapitalized. Having railed against the banks for taking too many risks, the government now wants them to take more risks!
A compelling criticism of the bailout programs is that their erratic administration has left the banking industry uncertain as to what is coming next. Are the banks going to be taken over by the government? Or subjected to new forms of regulation? What strings will be attached if they need additional capital? Will they be forced to lend money even though they are undercapitalized? If so, and they get into trouble, will the government bail them out again? Will they be made scapegoats for lax regulation? All else aside, a firm operating in so uncertain an environment is apt to hunker down and hoard its cash, for it must be prepared for anything. The pay ceiling adds to the uncertainty of their environment by suggesting that they are to be subjected to populist regulation as well as to regulation singlemindedly concerned with getting us out of the depression as quickly as possible.
All this said, I don't deny that there is such a thing as executive overcompensation, owing to the weak incentives of boards of directors to police compensation. But that's a long-term problem, rather than anything to do with fighting a depression.