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Why, Yes, We Do Have to Regulate Some Executive Pay

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The House of Representatives has committed some fumbles this year, but the legislation passed last week to regulate executive compensation in large public companies is sorely overdue. By any plausible standard, compensation for the very upper reaches of American business has been out of control for a long time. In 1991, candidate Bill Clinton scolded corporate America for rewarding the average CEO 80 to 90 times what their average worker earned -- compared to a pay gap of just 10 times in Japan. Today, the gap here is 250 to 300 times, and it has indirectly contributed to the economic turmoil affecting us all.

There's an untold story here that shows how genuinely hard it is to regulate how wealthy institutions and their executives conduct themselves, especially when it goes directly to their personal interest. Back in the fall of 1991, the young and still largely unknown Bill Clinton agreed to deliver three major policy addresses at Georgetown University, designed to dispel any doubts in the press about the depth of his knowledge and the breadth of his intellect. (It succeeded brilliantly: By December, the media had anointed him as the frontrunner.) The first address was on the economy; and on the appointed day, George Stephanopoulos (then Clinton's new top personal aide), Bruce Reed (the campaign issues director) and myself (the chief economic advisor) met to go over last minute changes. Clinton wanted to add a new section on executive pay and offered up his solution: Limit a company's right to deduct salary expenses to, say, $1 million for each individual.

The economist in me warned that this approach probably wouldn't work: Most companies would find ways to reward their executives outside the limit, and most companies wouldn't care how much of it was deductible. So, I ventured an alternative: Require a shareholder vote to approve the annual compensation of executives earning more than, say, $1 million (it was 1991). After all, the shareholders are a company's actual owners. If the owners were okay with a $200 million payday for a successful executive or $20 million for another who drove the company into the ground, who are we to complain -- especially since the pay packages ultimately came out of the owner's own dividends. In practice, the prospect of annual shareholder votes could effectively constrain executive pay, since most companies wouldn't dare to award their senior people pay packages that their shareholders would publicly reject.

My idea was overruled by the political gurus, who concluded it would be too subtle for the public. So the candidate stuck with limited deductibility, which we now know had no effect on out-of-control executive compensation.

The financial crisis could change all that. Barney Frank -- who has truly come into his own as chair of the House Financial Services Committee during this crisis -- last week convinced the House to require a "shareholder advisory vote" on executive compensation. The proposal is weaker than it could be -- the vote should settle the matter, not be merely advisory -- but the basic idea is right: Let a firm's owners decide how much its executives are worth.

The current arrangements have two glaring defects. The first involves self-dealing or what might be called "crony compensation." In the cozy arrangement of most large public companies, the pay packages for top executives are set by a firm's compensation committee, whose members are drawn from the board of directors. As it happens, most of those directors are also chosen by the executives whose pay they then determine; and to top off this mutual back-scratching, the committees often set compensation for the directors, including themselves. The results leave everyone involved a lot richer -- except the shareholders -- and may account for as much as one-third to one-half of the current cavernous gap between executive and workers' pay. That's why it makes eminent sense to have shareholders review these self-interested decisions. Frank's legislation, which also directs that compensation committees be comprised entirely of "independent" directors (those who are not also executives of the company), would be at least a step forward.

The second defect goes to the particular ways that many executives, in effect, reward themselves: Their compensation arrangements pay them handsomely for short-term gains, with no adjustment or recourse if the same decisions end up producing large losses down the line. The obvious losers, once again, are the shareholders, who pay the dealmakers princely sums for decisions that may end up costing the company dearly. But as the financial crisis has shown, these arrangements can deeply distort these managers' incentives, focusing them on investments and other decisions that produce a quick payday but also involve large long-term risks. When reckless risk-taking becomes endemic -- for example, creating trillions of dollars in unsound securities and trillions more in their derivatives, as Wall Street has done in recent years -- the fallout can pull down the entire economy. That makes it all of our business, and the Frank legislation also directs federal regulators to define and ban "inappropriate or imprudently risky compensation practices." It's a beginning.

There may not be much time, because the old practices that got us into this mess still go on. Goldman Sachs and other financial titans which a few months ago happily took tens of billions of dollars in direct and indirect taxpayer bailouts are already preparing to dole out billions of dollars in new bonuses to their executives and top traders, based on new deals which have generated large, short-term profits but also are said to involve large, long-term risks. It's no surprise: The compensation committees and their practices haven't changed, and now they also know that whatever happens, they'll be bailed out. Ironically, the bailouts that saved us from a second Great Depression may also bolster some of the distortions that threaten to produce it. If we want to avert another, even worse crisis, basic economics tells us that these compensation practices have to go.

Cross-posted at the NDN Blog.