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Brooks Wilson's Economics Blog: Prosperity Without Wealth

Tuesday, June 16, 2009

Prosperity Without Wealth

I previously suggested that the Obama administration might use the campaign slogan, "No Citizen Gets Ahead."  I have a suggestion for a campaign slogan for Congressmen on the House Financial Services Committee, "Prosperity Without Wealth."  Jim Kuhnhenn, an AP reporter who wrote, "US government seeks to rein in executive pay," explains that Congressmen
...on the House Financial Services Committee said Thursday the administration's efforts to hector the private sector into reining in executive pay might not go far enough.

The administration contends that excessive compensation contributed to the U.S. financial crisis, but rejects direct intervention in corporate pay decisions.

Instead, the administration plans to seek legislation that would try to rein in compensation at publicly traded companies through nonbinding shareholder votes and less management influence on pay decisions.

"I do differ with the administration in that hope springs eternal and their position seems to be that if we strengthen the compensation committees we will do better," said the committee chairman, Rep. Barney Frank...

Rep. Brad Sherman...said that instead of giving shareholders a nonbinding voice on pay, their votes should be binding on boards of directors.

[these Congressmen] and administration officials agreed that companies across the private sector need to adjust compensation practices to avoid damaging the economy.
Please note, as did Barney Frank, that the administration's rhetoric is stronger than the brief description of the legislative proposal.  The administration claims without evidence that excessive compensation contributed to the financial crisis, but rather than limit executive compensation, the administration proposes nonbinding shareholder votes and less management influence on pay decisions.  The new rules might increase executive compensation.  Michael Jensen and Kevin J. Murphy (CEO Incentives--It's Not How Much You Pay, But How," Harvard Business Review, May-June 1990, No. 3) make just this
Paying top executives "better" would eventually mean paying them more...There are serious problems with CEO compensation, but excessive pay is not the biggest issue. The relentless focus on how much CEOs are paid diverts public attention from the real problem--how CEOs are paid.
The administration's proposal as presented by Kuhnhenn aims to change how CEO's are paid and many economists see problems with the corporate incentive structure that determines pay.  Lucian Bebchuk and Jesse Fried ("Executive Compensation as an Agency Problem," Journal of Economic Perspectives, Vol. 17, No. 3, 2003) describe list several reasons why corporate directors may overpay executives: directors generally like to stay on boards, and CEO's play a big role in nominating directors for the board; directors typically have a small equity interest in the firms they serve; market forces are not sufficiently well defined as to guarantee optimal contracts.  They recommend a solution that does not involve government action.
The conclusion that managerial power and rent extraction play an important role in executive compensation has significant implications for corporate governance, which we explore in our forthcoming book (Bebchuk and Fried, 2004). It is important to note, however, that this is an area in which widespread recognition of the problem might contribute to alleviating it. The extent to which managerial influence can move compensation arrangements away from optimal contracting outcomes depends on the extent to which market participants, especially institutional investors, recognize the problems we have discussed. Financial economists can thus make an important contribution to improving compensation arrangements by analyzing how current practices deviate from those suggested by optimal contracting. We hope that future studies of executive compensation will devote to the role of managerial power as much attention as the optimal contracting model has received.
Bebchuk also explains how government action may create perverse incentives (Cari Tuna and Joann Lublin, "Risk vs. Executive Reward," Wall Street Journal, June 15, 2009). 
Mr. Bebchuk, who directs Harvard's corporate-governance program, worries that federal officials are pushing banks to adopt practices, such as granting restricted stock and giving shareholders an advisory vote on executive pay, that may make the problem worse. That is because many banks' share prices are now so low that shareholders, with little to lose, may support executives' taking big risks.
When markets are self correcting, and government action could damage market performance, government officials should opt for the wise policy option of doing nothing. 

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