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Executive Compensation: A Critique

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For me, the iconic image of the Great Recession -- encompassing the corporate largesse and irresponsibility, as well as the resulting widespread discontent of this period -- is one that I've conjured up in my head from news reports of former Lehman Brothers CEO, Dick Fuld, knocked out cold and laying motionless on the floor of the company gym, the victim of an attack by a disgruntled employee of the failed bank. Fuld had collected more than $500 million in salary, bonuses and stock options during his 14-year tenure as head of Lehman, during which time he'd stewarded the firm and its 26,000 employees into a mess so great that the fallout from its collapse teetered between destabilizing and debilitating the American financial system -- ultimately falling somewhere in between. So much for performance-based compensation.

The recent attacks around executive compensation represent a new chapter in a perennial story which dates back to Ancient Greece, where Plato addressed community concerns of an increasing wage gap by declaring that the highest wage should not exceed five times its lowest. Between 1890, at a time when J.P. Morgan was pulling in close to 20x what his employees were, to the early 1990s in which the average CEO salary exceeded that of an average worker by 140x, to today where CEOs earn more in three hours than what a minimum wage worker pulls down in a year, main street has been engaged in a losing war, with little to show for its efforts.

Yet, even in the midst of financial ruin, bankers are quick to defend themselves and their wide-ranging compensation packages, even as the pitch-forks and torches are driving them to testify before Congress. At one end of the spectrum there are appeals to the American spirit of individualism and equality of opportunity, with claims that executive pay inspires all employees -- from the vice presidents to the company janitors -- to strive in the hope that they too will one day find themselves atop the corporate world. The arguments at the other end of the spectrum are purely selfish, as bankers declare their compensation to be commensurate with performance, even with Wall Street crumbling.

By and large, the responses to the chorus of the bankers has been infused with raw emotional, and often times vitriolic, responses. This is understandable and warranted. But it might be time to turn away from the incoherence of Barney Frank, the sensationalism of Michael Moore, and the mixed signals of the Obama administration, and begin to develop a new, united front.

Dan Ariely, a behavioral economist out of Duke University has a new book that could be a valuable tool in the reformulation of this strategy. In The Upside of Irrationality Ariely tests the effectiveness of financial incentives as a device for enhancing performance - looking in particular at whether offering very large bonuses increases performance, as we typically expect. Through a series of experiments Ariely determines that pay does motivate workers in a positive way, but only up to a point. In fact, those workers who are on the high end of the compensation structure actually see their performance taper off, and even decrease, as the prospects of excessively high compensation packages tend to distract as they are left thinking about what opportunities and possessions their income affords them.

The lesson here, and one that warrants repetition in every Op-Ed, press conference and Congressional hearing: excessive executive compensation isn't just irresponsible; it's irrational.