Thursday, February 05, 2009

Wall Street & CEO Pay Issue Revisited

Back in 2006, I wrote a post defending high CEO pay. Yesterday I wrote a post mocking the ludicrous arguments advanced by Meredith Whitney for the excessively high Wall Street pay levels.

Am I being inconsistent? Or have I changed my mind on the issue? No, I am not being inconsistent nor have I really changed my mind (though I did err in not explicitly specifying the context), because the issue concerns two very different contexts: the context where high CEO pay can be defended is the context of firms competing in the market place. Wall Street companies today by contrast, are nearly all government subsidized enterprises. And that changes (almost) everything.

(Also, with regard to Wall Street companies, I was referring to the general pay levels, not just that of CEO's)

If you go back to the post you could see that I advanced two arguments for high CEO pay:

1. Because a CEO's decisions are so important for the well-being of a company, it is far more important to ensure that the most competent person is hired, than to minimize CEO pay.

2. If a CEO is overpaid, this doesn't really concern other employees, much less the rest of society, because the people who lose from it are the shareholders, not anyone else.

I still think these arguments are true, but only within the context of firms competing in the market place. With regard to Wall Street today, neither of these arguments are applicable.

Judging by their to say the least dismal performance, the extremely well paid people on Wall Street weren't selected on the basis of competence, but on other grounds, such as nepotism. In a free market economy, firms that hired people on such basis would eventually be weeded out as their objectively irrational hiring criterias would cause them to make decisions that made the companies go bust and out-competed by more rational companies.

But that hasn't happened, and the reason why this hasn't happened brings us to the other way in which the market context defense of high executive pay is not applicable. Namely, the fact that all of these Wall Street firms averted collapse because the government has bailed them out and now in effect pays for their continued operations.

Because Wall Street companies are now on government life support, this means that the people who lose if Wall Street employees are overpaid are the people forced to finance government, which is to say tax payers. And that means that there is a general interest to prevent excessive Wall Street pay.

And as these irrational corporate hiring practices persists because of the bailouts, this means that the usual case for tolerating higher pay (that higher pay will mean more competent employees) is no longer applicable. And that is the key fallacy of some libertarian critics of Wall Street executive pay limits such as David Kramer and Robert Wenzel makes. They don't realize that the competence argument for high pay levels isn't applicable here. Limiting executive pay in a sector dependent on government aid is really no different from limiting the amount paid out in welfare.

While we can presumably all agree that the key problem is the existence of the bailouts, it is simply not the case that government supported companies can be analyzed from the same perspective as market based companies.


Blogger Ke said...

I totally agree. This is the same argument that I use when confronted with friends who are against the 500k cap.

11:33 PM  
Blogger said...

Generally, I agree with your view that very high pay for people who create a lot of profit for the company should really not be an issue. However, as you indicated in your post, in reality high pay & bonuses are anything but fairly distributed.

There is a second issue that should be addressed: experiments have shown that the quality of one's performance in any given task does not change if you give him a high salary instead of a moderate one. But there is a change if you give someone a very high salary. Performance drops significantly. This experiment was run in India. So you could defend giving someone a high salary to avoid defection to the competition, but paying a very high salary is hurting your business performance.

2:30 PM  
Blogger stefankarlsson said...

Marc, that doesn't sound very plausible, and I could hardly trust an unknown study from India with an unknown methodology and with no known theoretical basis.

And if that had really been true, then outside of government subsidized industries, firms that offer low pay would have won out in the competition.

4:10 PM  
Blogger said...


The experiment was conducted IN india. It wasn't an Indian study. Anyhow, here's the link.

What I said was not that low or moderate pay increases performance, just that excessive pay lowers performance.

11:51 PM  
Blogger stefankarlsson said...

Mark, generalizing the performance of 87 Indian village people in a few games to that of real life executive performance in large companies is not valid for several reasons.

The theory behind it appears to be that if you're too motivated then this will make you focus wrong. That may be valid in a few delimited contexts, but is clearly not universally valid for all tasks. In my experience, I am more productive when I have a strong motive for performing well.

7:52 AM  
Blogger TokyoTom said...

Judging by their to say the least dismal performance, the extremely well paid people on Wall Street weren't selected on the basis of competence, but on other grounds, such as nepotism.

Stephan, nice try, but what you were missing in 2006 and are still overlooking is the fact that both traders and executives were had gamed the system so that they could capture upsides while passing downside risks to others. This was especially true of the Wall Street firms that went public, but was true generally once the SEC substantially loosened caps on leverage.

The Fed-created bubble of course lit a fire under people`s natural greed, but once should also not miss the problem of mis-governance in public firms. Shareholders simply did a poor job of overseeing their CEOs and executives and the risks they took on.

3:58 PM  
Blogger TokyoTom said...

Stefan, sorry about the misspelling of your name.

3:59 PM  
Blogger stefankarlsson said...

TokyoTom, what are you trying to say? That because they expected taxpayers to take the losses, they were really acting in a way which was good for the company? I don't agree with that since owners have lost a lot of money anyway. And even if true, that is certainly not an argument for taxpayers to be more tolerant of them.

9:33 PM  

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