The economics commentator, Irwin Stelzer, has an excellent, plain-spoken article in the Weekly Standard on the issues of executive compensation in the financial institutions. Pay Day. It is an interesting article in part because Stelzer takes as his audience conservatives who are skeptical of government-established restrictions on compensation in the banks and financial institutions:
The Federal Reserve Board's monetary policy gurus are making cash available to banks at almost no cost, it can be re-lent to desperate borrowers at mouthwatering margins, and if anything goes really wrong, the government stands ready to bail you out. Free cash, or almost; high and rising charges to borrowers and consumers; bailouts if assets become toxic--what more can a bank president and his board want in this best of all possible worlds? Freedom to set compensation, that's what.
Stelzer then walks, looking to an audience skeptical of the idea of a government compensation czar, the consequent problems of moral hazard in bank compensation arrangements:
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.
But the solution need not, and should not, be the government pay czar sitting down and figuring out how much is "too much." The point is not how much, but in response to what incentives, what risks, and in what time frame. The fundamental problem is to unite short term and long term horizons. It will have to be less genteel than in the past, for a reason that Stelzer discusses with great acuity - the loss of "reputation" as a deterrent to externalizing losses. Stelzer means this in the classic economist's sense that "reputation" matters if one plans to be a repeat player; lost in the thicket of securitization and complexity and circle-jerk derivatives was any sense of repeat play and attendant reputation.
But Stelzer adds that other sense of reputation - one that interests me a great deal, as it goes to my view that the markets are anchored rather more by a shared, foundational, legitimizing, affective body of the 'moral sentiments' than is typically admitted in economic models. Says Stelzer:
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.
Addressing the problem of executive compensation moral hazard through quasi-populist regulation of 'how much' will come to several kinds of grief, in my view. One is that, yes, it is welfare-maximizing, to say the least, to have highly compensated expert risk takers; compensation levels as such are not the issue, moral hazard is.
Second is that such systems of non-market regulation rapidly - are already - leading to crony capitalism, whatever grand names one wants to put on it. Fannie and Freddie showed us the way, and the result is spectacular misallocation of capital, labor, and the loss of investment in the ways most likely, given all the uncertainties, to produce the growth the next generation will desperately need, after paying the costs of seeing off my Baby Boomer generation to its final rest.
Third, I say "quasi populist" because the effort to regulate pay as such is not really about true populism - it is, as David Brooks pointed out a few months ago, much more the revenge of DC's Ward 3 over the bankers of Wall Street. He meant by that the opportunity for the regulatory class of lawyers and senior civil servants of my neighborhood in Washington DC - 20016 - to humble the financial class that for years made them seem like The Stupids for not being on Wall Street. Brooks is best when he skips politics as such to focus on these kind of comic-Veblenesque-sociological reads of the economy, and he captures something exactly. I guess one would call it the deliciousness of a DC government lawyer, well compensated by any standard other than Wall Street's, being able to set, or threaten to set, compensation for these people.
The appeal is irresistible to a certain professional New Class but not exactly populist. The reason these "populists" are stretched is from trying to make tuition payments to Sidwell Friends, National Cathedral School, or St. Alban's - all of whose annual tuitions, so far as I can gather, are slated to hit around $50,000 a year in current dollars by ten years from now. But what appeals to these technocrats is not devising a structure of incentives - it is the naked exercise of moralizing power over paychecks, one group of professionals, exercising political power in the political sphere, over another, the previously untouchable and in every way advancing, winner take all, professional class of financiers.
(More another day on this crucial, under-discussed issue of the New Class. But the social conflicts that Brooks describes, exemplified by the executive pay issues, are really struggles among professionals within the New Class, rather than the New Class versus everyone else.)
(Update, bringing up a comment of mine into the post: The third point is to say, and perhaps I wasn't sufficiently clear, that the people who as the bureaucracy, the permanent government, would have to carry out a program of setting pay as such, do not act as populists in the classic sense - and, this being the point, that affects how they see their interests and motivations in carrying such a policy. It might, I suppose, be a good policy or a bad one - though obviously I think it a bad policy, setting compensation as such. But my third point says, or anyway is intended to say, that it does matter to know the motivations, class background, class interests, and so on of the people to whom such policy is committed. If you assume it is simply that of populists, you might find a very different understanding of What Is To Be Done than if you see them, as I do, as part of the new professional class. The struggle over compensation policy is an internecine one. And did I say that to be a libertarian-conservative in no sense deprives one of Marxian analysis? :)