Cross-posted at the NDN blog.
It was an auspicious week for the touchy issues surrounding executive pay. One after another, President Obama's pay czar, Kenneth Feinberg, announced new restrictions for AIG executives; Goldman Sachs was reported to be putting aside $23 billion from this year's bonus pool, the largest anywhere, ever; and Elinor Ostrom from Indiana University shared the Nobel Prize in economics for her breakthrough work on how large companies organize themselves, often in ways that encourage executives to put their own financial interests before those of the shareholders.
Starting with Goldman, it's obvious that a sheaf of annual bonuses each equal to 10 or 20 times what an average American earns in his or her entire lifetime, coming from a firm which recently received huge, direct and indirect taxpayer-funded assistance, is certain to spark outrage. That reaction isn't misplaced, and there's a sensible response to it based on the core tenets of capitalism which we will get to shortly. There are other serious matters at stake here, too. In particular, how does a financial services firm like Goldman Sachs earn such huge profits in difficult times? And since the operations of Goldman and a few others like it matter so much to the economy -- which is why they got their federal assistance -- how do the arrangements which produce such huge bonuses affect those operations and thereby the rest of us? The answers suggest that even as Goldman's top executives and traders put away enough for a royal retirement, their decisions could lay the foundation for future financial turmoil that would leave the rest of us a lot poorer.
We didn't need this latest and most conspicuous instance of greed at Goldman to know that the compensation provided to the uppermost echelons of American business is out of control. Since 1990, the pay of American CEOs has jumped from 90 times the average workers' pay to 250 times -- compared to 15 to 30 times for British, French and Japanese CEOs. Nobel Laureate Ostrom's work helps us understand why: CEOs name their own top executives and strongly influence who ends up on their boards of directors -- and consequently on the committees that set the terms for all of their compensation. How much they decide to pay themselves, therefore, is essentially limited by the intersection of their own avarice and any vestigial sense of shame they might have. And the shame is pretty easy to dispose of, since the terms of their compensation are rarely disclosed publicly.
There's a fascinating account of some of these pay packages in a current New Yorker article chronicling the efforts of Nell Minow and Robert A.G. Monks to reassert shareholder rights over these modern robber barons. Almost everywhere, most of the pay comes in stock or stock options, so they're only liable for the 15 percent capital gains tax. (The Goldman executives who will claim stock bonuses worth tens of millions of dollars this year will report taxable "salaries" of less than $300,000.) And if the stock price falls under these executives' leadership, their options contracts are often revised at a lower strike price. These packages may also include huge "retirement" bonuses for CEOs that leave voluntarily -- like the one federal contractor Halliburton gave Dick Cheney when he left to run for Vice President -- and even "retention bonuses" for executives who end up in prison. Then there are the extravagant perks. It took public divorce proceedings against GE's Jack Welch for shareholders to find out that on top of the many hundreds of millions of dollars Welch received in stock and salary, his friendly board had also awarded him lifetime use of the company's 737 and helicopters; lifetime floor seats for the Knicks and lifetime box seats for the Red Sox, Yankees and the Metropolitan Opera; exclusive lifetime use of a sprawling Manhattan apartment, including fresh flowers, dry cleaning service and even the tips for the doorman; and a catalog of lifetime golf and country club memberships. His and most other executive contracts also now include "gross-ups," which means that the shareholders pick up federal and state taxes owed on the executives' various perks.
These are all examples of what economists call the "agent-principal problem," in which the interests of agents -- they're the executives -- diverge from those of the principals, who here are the owners or shareholders. It's pretty simple: They enrich themselves at the expense of the shareholders who they ostensibly work for -- and those shareholders now include a majority of all Americans. The simple democratic answer to all this, derived directly from the essence of capitalism, is to empower the owners by requiring that boards disclose all aspects of the compensation package of senior personnel and subject the terms of those compensation packages to mandatory shareholder votes, every year.
Last week, I proposed this step on a CNBC business show. The other guest predictably squawked about government control - and then the moderators also tried to dismiss the idea as "impossible." Come again? Shareholders vote every year on lots of measures -- check out your proxy statements. And the mere threat that shareholders might publicly reject a CEO's payday should moderate the greed of at least some compensation committees. The House passed a weak version of this proposal recently -- annual, "advisory" shareholder votes on compensation. The Senate should strengthen it with stricter disclosure requirements and an annual vote that actually decides the matter. Why, precisely, shouldn't a company's owners determine what their executives are paid? And does anyone think that Goldman's shareholders, including strapped pension plans and charitable institutions, are eager to see $23 billion in potential dividends go to the firm's top tiers?
This particular agent-principal problem also affects the rest of us, since the stock and stock options that make up most of these compensation packages are often tied to the short-term gains associated with an executive or trader's work, without regard to the transactions' long-term returns. So, hundreds of traders and executives at Goldman and other places on Wall Street have closed transactions and other deals that booked large paper profits this year -- and will take home huge bonuses tied to them -- but bear no consequences if those deals go sour next year or the year after and cost the shareholders billions. These arrangements directly encourage them to take on enormous long-term risks for their firms and owners, in pursuit of the short-term paper gains that generate their own bonuses. Since risk and return are closely related, these arrangements help explain how Goldman earned enough this year to dole out that projected $23 billion in bonuses. And by creating such strong incentives for risky investments on a large-scale, these same arrangements were a core element of the meltdown that nearly pushed the U.S. and global economies into a genuine Depression, and cost shareholders and taxpayers trillions of dollars.
To prevent a recurrence that could ruin almost everyone, these arrangements have to end. J.P. Morgan Chase has said it will include new "claw-back" provisions that would reclaim part of the bonuses when a deal's long-term returns are less than expected. It's a nice gesture, but it's hardly enough. We need laws and regulations that directly limit the risk levels of the portfolios of institutions deemed "too large to fail," and specific, claw-back guidelines from the SEC that all public companies will have to follow. The outstanding question is whether Congress has the cajones to force the country's richest people and institutions to change the ways that made them so wealthy in the first place.