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Economic Sense

RSS By: Matt Bogard, AgWeb.com

Matt's primary interest is in the biotech industry and ag policy.

Greed, Envy, and Compensation

Nov 15, 2009

By Matt Bogard

To me, we have seen a lot of hypocrisy lately in the public discourse regarding the issue of compensation. The underlying premise for much of the call for capping executive compensation has been that executives are overcompensated. That compensation structures have provided too much incentive for excessive risk taking. When you combine these pay structures with greedy executives, you get all of the problems that characterize the recent financial crisis. Since they had a lot to do with our current problems, they should not be rewarded with generous compensation or bonuses.

I deem this line of thought as hypocritical in the following way. I think much of the popular support for new regulations regarding executive salaries has to do more with envy, than economics (which I will discuss more below). Often political leaders will attempt to exploit envy from below, in order to create a larger movement for social control from above. Envy is just the desire to have more, and often more of what someone else has. Lately, envy has meant begrudging others of what they have and has led to having government take it away. How is that so different from greed?

Are executives really overcompensated? Research from the Journal of Political Economy by Jenson and Murhpy indicated that for every $1000 of value created for a company, executives were only compensated by $3.25. It hardly appears that they are overcompensated. There has also been the criticism that capitalism, and greedy executives, has lead to too much concentration on short term gains without concern for long term outcomes. This too is without merit. Research from the Journal of Applied Corporate Finance indicates that near term cash flows account for only a small percentage of a firm's capitalized market value. Only 18% of share value can be attributed to short term expectations of profits within a 5 year window. Expectations looking 10 years out account for up to 35% of share value. In other words, capitalism, or markets place greater value on long term gains than short term wins.

A major challenge in corporate finance and compensation structures has been to actually encourage, not discourage executives to take calculated risks. A basic principle of finance is that with greater risks come greater returns. A leader that consistently abstains from taking risks will not create value for any organization. Large bonuses and golden parachutes aren't just the product of greed, but are designed to give executives the incentive to take prudent risks and create long term value for their firm and its shareholders.

Is too much risk taking really a problem? Some people claim that deregulation in addition to greed lead to excessive risk taking and our current problem. The only problem with that point is that we have not had a single act of deregulation by congress in well over a decade, and that was during the Clinton administration. But this deregulation ( the Gramm-Leach-Bliley Act) in fact helped create stability in the recent financial crisis, instead of being a source of the chaos. As quoted from the Wall Street Journal ( Oct 18,2008)

'Indeed, it allowed Bear Stearns and Merrill Lynch to be acquired by J.P. Morgan Chase and Bank of America, and allowed Goldman Sachs and Morgan Stanley to convert to bank holding companies to help shore up their positions during the mid-September bear runs on their stocks.'

But I do agree, that excessive risk taking did have a huge role to play in the current crisis. Market interest rates check excessive debt accumulation and risk taking. However, the artificially low, socially planned interest rates of the fed upset these natural checks and balances. Risky projects that did not offer a return high enough to offset risks under market interest rates, became profitable at new artificially lower interest rates. Businesses took on more risks and more debt than market fundamentals otherwise would have supported, and suddenly we have the makings of a rational bubble and the inevitable crash that followed. Implicate greed and risk taking if you will, but don't take it so far as to blame salaries and deregulation in the process.

What are the effects of our current stance on salaries? Now, of all times is when we need the best talent to lead us back to positive returns. If we really want the bailed out companies to ever be in a position to repay taxpayer dollars or regain their independence from government control, we need the top leaders to put them in that position. We won't get off cheap doing it. Already Bank of America is having trouble finding executives willing to be their CEO at the government imposed $500,000 pay cap. ( Wall Street Journal Nov 14, 2009).

Having not addressed the root causes of the financial crisis, and implementing more regulations that decrease risk taking, decrease compensation, and decrease investment incentives will only prolong the crisis and lead to stagnant long term growth.

If greed has ever been a problem, then it will be our envious regulatory response that keeps us from solving it.

References:

'Most Pundits Are Wrong About the Bubble-The repeal of Glass-Steagall has helped us weather the storm.' Wall Street Journal, Oct 18,2008. Charles Calamiris.

'BofA Hits Pay Snag in its CEO Hunt.' Dan Fitzpatrick. Wall Street Journal, Nov 14,2009.

Michale C. Jenson and Kevin J. Murphy."Performance Pay and Top Management Incentives," Journal of Political Economy, 98 No. 2 (April 1990) p. 225-264.

J.R. Woolridge, "Competitive Decline: Is a Myopic Stock Market to Blame?" Journal of Applied Corporate Finance, Spring 1988. p. 26-36

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COMMENTS (2 Comments)

Matt Bogard
"The biggest problem is the persons responsible are now emboldened by government bailouts. In the past they never would work again, now they'll just switch to company B and do it all over again." I think that is a great point. Not many people seem to understand that. In fact, I think we're setting up to do it all over again.One of the most recent financial reforms that just passed the house sets up a slush funds particularly for those companies deemed 'Too Big to Fail' making the possibility of more bailouts business as usual. The only difference is this time we are forcing some of these companies to foot the bill ahead of time. But I think the fund is limited to 300 billion, with taxpayers picking up the rest of the tab. But, the effect will still be the same. The existence of this fund will do exactly as you say, and embolden even more risk taking.
8:06 PM Dec 14th
 
Anonymous
Sorry, I fail to agree that excessive greed was not the problem, but who's greed? Stock holders were not complaining when their mutual funds were going up 20% every year. The problem isn't "the other guy", It is everyone. Everyone. Farming is no different, greed runs up inputs and rents (both by landlords and renters) until the bubble burst. The biggest problem is the persons responcible are now emboldened by government bailouts. In the past they never would work again, now they'll just switch to company B and do it all over again. I would not hire the CEO of AIG to work for me even as a manual laborer. One part of your life spills over into ALL other areas.
When will we all be satisfied with what we have within reason? My Hope is for that day.
12:37 PM Nov 16th
 

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