Regulating Executive Pay Can Reduce Systemic Risk
If they are the right executives
Filed Under: Guest Column • Headline
Tags: Ben Bernanke • ceo salaries • executive compensation • executive pay • G-12 • John Mack • Ken Feinberg
Late last month White House pay czar Ken Feinberg unveiled executive pay rules for 175 key players in the nation’s seven-firm TARP-assisted sector. The new rules generated different bundles of base and incentive pay for the affected executives, along with a good bit of grumbling and grousing. Unsullied by the frowns and accompanying warnings that stumbling organizations will have even greater difficulty keeping high-performing executives on the reservation, Fed Chairman Bernanke followed Feinberg’s action with an announcement that thousands of banks nationwide—large and small—will be subject to a set of Fed-generated pay regulations. On hearing that his firm might be on the way to becoming a regulated public utility, Morgan Stanley CEO John Mack said: “From my view, I’m a capitalist, I think it should be left to us.” Mack later suggested that international coordination of executive pay rules would be desirable.
An executive pay cartel seemed to be in the making.
Bernanke did not accept the proposition that market-generated information is superior to what a bevy of GS-12s can develop in Washington. The Fed chief indicated that past compensation practices “led to misaligned incentives and excessive risk taking,” suggesting that just such mischief contributed to the world financial meltdown. The time of centralized pay control was at hand.
Representatives of some of the affected firms sought to practice their First Amendment rights and petition the government to limit the new meddling. Their action was not celebrated in the White House. Commenting on the apparently unwanted politicking, President Obama said: “They’re doing what they always do — descending on Congress, using every bit of influence they have to maintain the status quo that has maximized their profits at the expense of American consumers, despite the fact that recently a whole bunch of those same American consumers bailed them out as a consequence of the bad decisions that they made.”
Feinberg and Bernanke may be on to something. But they have the wrong targets.
Yes, it is high time that pay and investment guidelines be mandated for all top level executives who may in the normal course their daily work push the entire economy too close to or even over the edge of systemic risk falls. If nothing else, this Great Recession has taught us that top executives can practically capsize the economy.
But the chief concern is not with presidents and vice presidents of too-big-to-fail banks and other bailed-out enterprises. As large as they are, they are small potatoes relative to the big generators of systemic risk. The critical concern is with top government executives who can create national and international panic, lay the groundwork for international inflation or deflation, and just by voting and writing regulations can change the risk profile of entire industries.
We taxpayer/investors demand a set of risk-sensitive compensation guidelines that will mandate pay and wealth-management rules for all federal government top executives starting with the president of the United States and all cabinet members and their deputies. While we’re at it let’s include all members of Congress and every member of the commissions and boards that manage the nation’s independent agencies, including, of course, the board of governors and chairman of the Federal Reserve System.
To properly align incentives of these elected and appointed executives (and others), we demand that each and every one be paid a base pay — some 75 percent of the current salary — plus incentive pay — the remaining 25 percent — based on improvements in real GDP growth over a five-year period that begins the day of their appointment or election. The base pay would be provided on the normal Office of Personnel Management pay schedule. The incentive pay, with recommended details worked out by Feinberg, would be provided on the basis of a three-year rolling average gain in real GDP, which means that the first incentive payment would be received three years after an executive’s first day of office.
But this deals with just part of the incentive misalignment. We must align incentives associated with government executive wealth.
Elected and appointed government executives routinely place their personal investment portfolios into management by a blind trust. While this action satisfies those who may be concerned primarily with ethics and upright behavior, simply being blindfolded as to capital gains and losses does not get to the systemic risk problem, which of course, is our chief concern here.
All high government officials described earlier must have their personal portfolios invested in a visible S&P 500 index funds, not to be redeemed until one year after leaving office. We taxpayer/investors do not want our executives blindfolded as to gains and losses. We want them to know exactly what is happening to the Great American Bread Machine, our economy, while they are in office. We want them to feel our pain and our gain.
Feinberg and Bernanke should focus efforts on those whose actions can capsize the economy—the top executives and elected officials in Washington. The others are small potatoes.
Comment by Craig on 4 November 2009:
WOW! Accountability in government – hard to believe in a democracy.
Pingback by The virtues of limiting executive pay on 4 November 2009:
[...] great Bruce Yandle makes the case. He’s onto [...]
Comment by RL on 4 November 2009:
Yandle’s solution is incomplete. Most in Washington love power so much they would work for free. It’s not enough to limit their Congressional or Executive salaries. We need to be able to eliminate their perks and acquire their assets if their policies do not work as advertised.
Comment by Acad Ronin on 4 November 2009:
Great proposal. Will, of course, never come to pass. A Congress that exempts itself from all the rules it passes for others would never impose discipline on itself. The only case I am aware of of this sort of thing involves the salary of the Governor of New Zealand’s central bank, whose salary depends, in part, on his maintaining low inflation.
Comment by DavidG on 5 November 2009:
As suggested by RL, this is a start, but not enough. I would similarly limit their pensions — or eliminate them entirely.
Comment by MarshallB on 5 November 2009:
I would add,and this is important,especially for Federal Reserve
officials,their pay should be negatively indexed to inflation
by a rate of 2 to 1.So if inflation is 5%,their pay is docked 10%.
Comment by Jim Hlavac on 5 November 2009:
I had always thought that politician’s “blind trusts” are silly because they know what they have in their portfolios before getting into office; they are just locking in their known assets. And thus they can just make the policies to benefit themselves with this knowledge while they are in office, and when they get out they get to open their box of goodies. It’s obvious that most if not all come out of congress a lot richer than when they went in. It would be rather better if they had to liquidate all their investments and put that into cash at the local bank. Forbid them to purchase any investments while in office too. Then they could have their money and spend it, and only invest again when they get out, and oh, just to really cut down on chicanery, they can’t invest for at least five years in any industry for which they sponsored legislation.
After all, the position of congress member is a public service, not a cash cow or lottery ticket.
And like any work product produced at a private firm, all their memoirs should belong to the people. What they write in them they did while they were working for us, often while they were working for us. They seem to view it as part of their work product; they promote it as such while seeking higher office. In fact, require them to write a remembrance of times past for the national archive, it’s a public service after all. You know, a WPA History Project for the nation.
Comment by Andrew Battista on 5 November 2009:
I would love to hear Congress’ reaction to such a plan, although I feel quite certain that matters (meddling) would become far worse.
Comment by Flash Gordon on 5 November 2009:
Federal and state judges should be included. Their decisions and rulings also affect real GDP.
Comment by Ravi on 5 November 2009:
While this is witty, Yandle misses the point by a long shot. Do you think the president of United States is motivated by the measly $400,000 paid to him? His incentives are different: a palatial mansion; a pimped out jet; international recognition( automatic Nobel, if you are from the democratic party( sorry Mr.Clinton, you are on the waitlist)),; bespoke suits; an organic vegetable garden for the missus. The list is endless. Government executives could care less about their salaries when they can count on the dough that gets pumped in once they leave office giving inane speeches at universities, board rooms and anybody that got something when they are in the office. So sorry Mr.Yandle, this will NEVER work.
Comment by David Zetland on 5 November 2009:
Hear Hear! Four legs good; two legs better! Regulate ALL legs
Pingback by What We’re Reading… - Economix Blog - NYTimes.com on 5 November 2009:
[...] Can regulating executive pay reduce systemic [...]
Pingback by Coase Colored Glasses | Externalities Ahoy! on 5 November 2009:
[...] going to take a slightly different approach on the idea of externalities here. I read an article by Bruce Yandle about the recent government controls imposed on executive pay. When I refer to the executive pay, I [...]
Comment by KeithE on 5 November 2009:
A slight twist might be to lock all of our elected and appointed officials to a certain income percentile. Say, congressional representatives can be paid up to the 80th percentile of US household income, senators 85th, president 90th. They do better when we all do better.
Pingback by Executive Pay Caps We Can Believe In - Hit & Run : Reason Magazine on 6 November 2009:
[...] Writing at The Freeman, economist Bruce Yandle (listen to him talk about his famous “Bootleggers and Baptists” article here) makes the case for capping a certain type of executive pay: [...]
Comment by kjb on 6 November 2009:
I don’t think that Government should dictate pay at all to private firms. The private sector will learn how much it can truly afford to pay its employees for the job that they do. Accordingly, by all rights, the compensation packgages for a lot of the current banking executives should be $0. Have the banks that couldn’t survive on their own gone under, the salaries of the surviving bank executives would be more in line with what people may percieve as reasonable.
The bankers of the present are being rewarded by their shareholders for their ability to convince the government of the day to grant them incredible subsidies and bailouts. This is just a different form of investign I think and has earned them substantial benefits for which they should accordingly be compensated. So don’t blame the bankers and shareholders, blame those that made the decision to inflict this sort of moral hazard and bail every man and his dog out.
Pingback by A federal regulation of executive pay that we can support » Hodak Value on 8 November 2009:
[...] Bruce Yandle’s modest proposal: But the chief concern is not with presidents and vice presidents of too-big-to-fail banks and other bailed-out enterprises. As large as they are, they are small potatoes relative to the big generators of systemic risk. The critical concern is with top government executives who can create national and international panic, lay the groundwork for international inflation or deflation, and just by voting and writing regulations can change the risk profile of entire industries. [...]
Comment by Colorado on 9 November 2009:
Like Wall Street found out, it’s not about the pay. The pay can and will go through the roof. It’s about the prestige; being the alpha male, the smartest guy in the room. If you could find a way to pay politicians in that “currency” you would have them. So, it seems to me that controlling their prestige means controlling what information is put out on the politicians. If like now it is PR/media run, it can be spun. If it were more fact based the best and smartest would be properly rewarded. May the internet prevail.
Comment by Colorado on 9 November 2009:
Speaking of spin, have you seen the latest Newsweek cover: Al Gore the thinking man’s thinking man.
Comment by Venkat Venkatasubramanian on 11 November 2009:
First, thank you for the opportunity to participate, and share my two cents worth, in this discussion on a very important topic.
I thought this audience might be interested in a recent paper of mine entitled “What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions,” which appeared recently in the on-line journal Entropy. It is available for free downloads from the Entropy site at http://www.mdpi.com/1099-4300/11/4/766. A related story can be found at : http://news.uns.purdue.edu/x/2009b/091103VenkatasubramanianCEO.html
The abstract of the paper is as follows:
The high pay packages of U.S. CEOs in recent years have raised serious concerns about what would constitute a fair pay. Since the present economic models do not adequately address this fundamental question, we propose a new theory based on statistical mechanics and information theory. We use the principle of maximum entropy to show that the maximally fair pay distribution is lognormal under ideal conditions. The theory estimates that the top 35 U.S. CEOs were overpaid by about 129 times their ideal salaries in 2008. We also provide an insight of entropy as a measure of fairness, which is maximized at equilibrium, in an economic system.
Our analysis shows that a certain amount of seeming inequality of pay is inevitable in organizations. Given this reality, the lognormal distribution is the fairest inequality of pay. One may view our result as an ‘economic law’ in the statistical thermodynamics sense. The free market will ‘discover’ and obey this economic law if allowed to function freely and efficiently without collusion like practices or other such unfair interferences. This result is the economic equivalent to the Boltzmann distribution of the energy landscape for ideal gases.
I believe this is the first rational quantitative theory about fair compensation of employees, including executives, in an organization.
I’d be delighted to hear comments on this paper from this group. Thank you.
Best,
Venkat
Pingback by Recomendaciones « intelib on 4 December 2009:
[...] Regulating Executive Pay Can Reduce Systemic Risk, by Bruce Yandle At least for a peculiar subset of all executives… [...]