The Bailout Crisis: Compensation Restrictions Are Not Just a Matter of Fairness

The so-called bailout package contains controversial restraints on executive compensation. Some may think these restrictions are just about getting even with the financial community. But this issue is not just about fairness. Compensation excess is at the heart of this crisis.

Are the people managing financial firms provided incentives to encourage them to manage these firms efficiently and for the long-term benefit of owners? That is the goal of good compensation. Reward executives -- the owners' agents -- for jobs well-done. Economists call this an "agency problem."

But in the financial community, and increasingly in the corporate community, executives were able to game the system. They produce short-term benefits for themselves that are not aligned with the long-term good of the firm. Meantime, they pumped up the bubble and took undue risks. They were given incentives to mismanage their firms and the nation's finances.

The free market purists believed they solved the problem long ago by aligning compensation with the stock price by giving options to execs. The stock price, they argued, rationally rewarded the executive because it accurately reflected the long-term value of the firm. It was Chicago school oversimplification, yet again. Stocks are subject to fads, a point efficient markets theorists for the most part disputed.

Now we are all paying a price for this ideological excess. Investment firm execs kept buying risky securities knowing that most likely at some point the music would stop. But meantime, they would take their enormous personal profits. When the music did stop, they wouldn't be asked to give the money back.

When it comes to finance, however, incentives to mismanage financial credit-making institutions -- which is what the system amounted to -- affects us all. The excesses of finance can and usually did bring the American economy down. Every major recession of the 1800s was preceded by speculation and a burst financial bubble. That is why America has had disputes over how to operate a central bank since Alexander Hamilton. It is really about regulating the financiers.

Because outsize short-term compensation for financial executives affects us all, such compensation requires scrutiny. To repeat, don't think that such restrictions are simply about fairness or about punishing those who got rich making this crisis. Restraining compensation goes to the heart of a stable economy and sustainable, optimal rapid growth. How to restrain this compensation is not easy and, though the issue should be addressed now while the government has the political leverage to do so, a comprehensive solution as to how to do so can wait. Restrictions must be part of the comprehensive re-regulation of Wall Street. But the concerns, it should be clear, are not just griping about the rich.

Comments

[Indedave]

I would be all for paying these crooks if they could demonstrate that running the country over a cliff was hard work. The Current Occupant has very eloquently demonstrated that such is not the case.

[AshevilleVoice]

The limits to compensation in the bailout are a total joke!

On sept 29, there was a conference call by the Treasury with selected investors. An audio is now on youtube.

check it out:

http://www.youtube.com/watch?v=uXmFADm61Rc&feature=related

This treasury official just explained to analysts from various financial firms why CEO compensation caps in the BAILOUT BILL will not effect them. . You have to sell more than $300 million worth of your trash into the fund to be effected by that provision and even then it only applies to future employment contracts not any existing contracts.

[MEC43]

Good post, but fairness has to be the backbone of any economic system. The concept applies to compensation for finance executives, manufacturing executives, middle managers, salaried personnel, hourly personnel and anyone else who works. Middle America's anger over the bail out is directly attributable to the gulf between the fortunes of executive and everyone else that deregulation, outsourced jobs and Bush tax policies have brought. Unfortunately, fairness tends to be a concept that is in the eye of the beholder. Job number 1 for the next President is to work to "reach across the aisle" and "build consensus" to determine what "fairness" means in a host of contexts. Given the candidates' respective track records during the campaign (and McCain's tendency to use the Nixon/Rove playbook that caters to the right wing base, stokes fears and divides the electorate) I'm more confident that Obama will listen to the range of viewpoints and work to put fairness back at the core of his administration's policies. He won't always succeed, but at least he'll try.

[ConProphet]

While everyone has been focused on the Bailout
Has anyone noticed the recent change to Fox News Politics page
Now that Obama is in the lead
The once promenent Poll results
Have disappeared......

[tonycoyle]

I'm a compensation specialist - and design compensation packages for a living. I've been appalled for years by the excesses of wall street, and of the executive suite across America. They have made my job much harder - because there is only ever so much money to go around - and if the top floor get 80% of the budget - that makes my job much harder (impossible) and makes realistic compensation (pay for performance) a joke.

It's way past time for a correction - in the boardroom, in the executive suite, and in American life.

As someone once said TANSTAAFL (There ain't no such thing as a free lunch). It's time for the fat cats to pay up.

[Loki1967]

Great post!

[Rockerbabe]

No bailout. If there is to be a rescue with taxpayer money, then let's rescue the people facing foreclosure of their homes and business. Let's refund the Small Business Association to extend loans to more business for growth. Let's extend money to kids going to school. Let's assist local governments adversely impacted by the abandonment by business for foreign locales.

[Skua]

Jeff, everything you say about what CEOs do is true, but what about the "owners"? The firms involved in all this are mainly publicly traded, which means that "owners" have no more loyalty to them than the CEOs do, and are just as interested in short-term stock market profits as the CEO is. The CEO realizes the value of his options, the "owner" sells out to some dupe, and both get safely away before the music stops. If the class of "owners" had not been profiting handsomely from all this, they would have gotten more reliable overseers for their plantations long ago.

[RoveRoveRoveYourBoat]

...the crisis is artificial. Cooked up by the swindlers in the white house. Bank lending has been restricted over the last few weeks by the feds. We need investigation of this entire attempted heist!!!!