10/31/2008 05:12 am ET Updated May 25, 2011

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.