Executive Compensation and Capital Markets

There is a substantial discussion these days about the need to reform executive compensation in the financial industry. In particular, recently The Wall Street Journal headlined a story about the Federal Reserve Board's thinking on the subject. I tend to agree that there needs to be restrictions on the composition of executive pay. I don't think that it would be constructive to impose absolute caps on the levels of pay. Don't get me wrong, I feel as much envy and moral outrage at the centi-millionaires created by Wall Street as anyone. It inflames every fiber of my egalitarian soul. However, it is impossible to ignore the fact that incentives matter throughout the economy.

To understand the direction that control of executive pay should go, a brief history lesson is in order. The corporate form of organization, as it exists today is largely a product of the 19th Century. The corporate form permitted investors to pool their capital in large and risky ventures while at the same time insulating them from some of the risks of those ventures. However, as documented by Gardiner Means and Adolph Berle in their classic, The Modern Corporation and Private Property, over the course of time the stockholders (owners) lost effective control of their property to the day to day managers of the corporations. Some, but only some, of these abuses were palliated by the Securities and Exchange Act and subsequent regulation.

Economists who look for incentives the way that the superstitious look for four leaf clover, next suggested that what was needed was to provide executives with incentives that aligned with the interests of the shareholders. This solution had two parts. First, an active market for "corporate control" where malfeasant or non-feasant corporate managements were replaced with more effective managements through hostile takeovers of offending corporations. The other strand of the solution is the creation of equity based compensation for executives. The idea was that executives will want to see increases in stock prices since they benefit directly from them when they are awarded company stock as a share of their compensation. This, of course, benefits shareholders too, since in modern times much more of the return to an equity investment comes in the form of increased stock price than dividend income. (More on this later.)

On the surface these ideas look good. The market triumphs yet again! The problem is that shareholders don't really exercise any direct control over executive compensation. The Boards of Directors of the firms exercise this control. Who sits on board of directors? Three groups, executives of the firm, distinguished business executives from other (non-competing) firms, and other distinguished notables including the odd academic economist. Now the self-interest of the first two of those groups lies a lot more in the area of pumping up executive compensation than it does in taking care of shareholders. The final group is typically a minority and basically intended as window dressing. Since membership in a corporate board is lucrative and not very taxing, they are unlikely to rock the boat, if it means being thrown off the gravy train.

The result is generous stock option programs (and not only for financial firms) tied to goals that are easily achieved. Even if the benchmarks aren't achieved boards are very considerate of the self-esteem of their executive subordinates and often reset the goals to something more achievable. There is an even more egregious feature to stock options. As the exercise dates approach, executives have powerful incentives to juice up the reported performance of the company to make the shares they are about to receive even more valuable. This is a variant of an old stock market scam known as "pump and dump" wherein a group gets control of stock in some obscure firm and proceeds to spread rumors that increase demand for and thus the price of the stock. Thus stock based compensation becomes an exercise in "heads I win, tails you lose." Managers are incentivized to seek out gains which are both risky and likely to pay off in an extremely limited time period. They want and need to raise stock price in the short run, the long run consequences be damned.

In an ideal world, shareholders of corporations could stop this nonsense and tell executives something like this, "We will reward your efforts for our firm with a generous salary that reflects the responsibilities and prestige of your position. Because we want you to have incentives to do the best possible job for us, the shareholders, your bosses, we will provide bonuses to you that reflect your accomplishment in making us wealthier. However, our interest is in long run growth of capital and income from our investments, so your bonus compensation will be deferred until well after you have left our employ." However, as noted above, shareholders have been systematically stripped of their rights vis a vis management, which means to achieve a sensible reform of executive compensation government must be involved.

What are the elements of such a reform? There are two different sorts of reforms required both with executive compensation and in taxation.

In some ways, the the executive compensation reform is the easiest. Bonuses for executives should always be deferred until the executive leaves the labor force. The motive for wealth creation is to provide income for life after active labor market participation, so this should be uncontroversial.

The other principle is that the deferred compensation should be split into two tranches. One tranche would be invested in an index fund tracking the overall composition of world equity markets with dividend reinvestment. This tranche would meet the argument that managers must dispose of some of their stock awards in order to diversify away from excessive concentration of their wealth in their employer. With diversification thus achieved there will be no need for the executives to sell their awards. The other tranche would be divided among the different instruments that the firm uses to acquire its capital. (I.e if the firm had 40% equity capital and 60% debt, the executive would receive awards reflecting that distribution.) This new approach to bonuses limits the incentives for executives to excessively leverage the firm in hopes of generating out-sized returns to equity.

The capital markets and taxation portion of the reform starts with a controversial step. I would propose eliminating the taxation of corporate profits. I can imagine my fellow progressives heads exploding as they read this, but let me explain. There are two benefits to this, the first as noted above is that instead of paying dividends out of profits, corporations retain earnings which leads to higher stock prices. This is encouraged by the favorable treatment of capital gains which are taxed at a lower rate than ordinary income. For this reason, along with elimination of corporate profits tax, there should be a very high tax on any retained earnings. Thus dividends would once again be the principle source of reward for shareholders and subject to regular income taxation. This change would result in improvement in capital markets because firms would have to go to capital markets regularly to raise funds for new projects. Having multiple eyeballs on a firm's projects is likely to lead to better results than the corporate empire building that often lies behind projects funded by retained earnings.

The other benefit of this is that eliminating corporate profits taxation will begin to refute the pernicious idea of corporate personhood. If tax liability attaches, as it should, to the owners of a firm and not to a legal fiction, it becomes more difficult to assert that the corporation is a legal person entitled to the same rights as natural persons.

My Grandson and God

Due to parental scheduling conflicts, I was schlepping my 5 1/2 year old grandson to athletic practice the other day. On our way home, he asked me, "Is God magic?"

This is a tough subject for me. Our family is almost entirely secular in outlook. (I don't know where the God talk is coming from (probably just the regional culture) but it has been popping up a lot lately.) I, personally, am a theistic agnostic. (I.e. I believe there is a god, but don't know what that implies for worship, prayer, etc.) However, I respect sincere religious belief, even when I don't comprehend it. Consequently when God comes up with the grandson, I treat the subject with respect and sympathy. (Sorry atheist chums!)

So I answered that God is supernatural. That God exists outside of the world that we can see or hear. This seemed to satisfy the boy. However, I can't say that it satisfied me.

It is true that our ordinary conceptions of God are supernatural, existing outside of the physical, empirically accessible world that we inhabit. However, religious believers insist upon the existence of miracles where God actually does act in the physical world. They, in fact, take these miracles as proof of their faith. The miracles they cite also tend to over-ride aspects of physical reality of which the believers disapprove. As an empiricist, I have to ask myself how that is different from magic, defined as some action in the physical world not capable of explanation in terms of physical causes? I am reminded of the Arthur C. Clark quote to the effect that any sufficiently advanced technology is indistinguishable from magic. In other words, our current understanding of the world would not provide us with an explanation. Anyone visiting the United States from the 15th Century would certainly consider much of what is daily commonplace to be magical.

Meditating about religion and magic while walking the dog the next morning, brought to mind Heinlein's Stranger in a Strange Land. There is an episode in the novel where the main character who was raised by Martians, finally appreciates the nature of his humanity. After this epiphany, his first impulse is to share the knowledge which he gained as a Martian foster child. Knowledge which is "magical" from the point of view of existing earth society.

Where does this take us? Remembering that I am economist, I fall back on a fundamental premise of my profession, "There is no such thing as a free lunch." (Incidentally, a favorite aphorism of Heinlein's) It is in human nature to seek "magical" solutions. We desperately want solutions that cause us little pain for much gain. The sad fact is that religion too often offers the "magical" solution as an alternative to the hard work of providing actual solutions. I can't reject religion out of hand as some of my friends do, to much of beauty and value has been created in service of religious impulse (e.g. Gothic cathedrals, Buddist stupas, Japanese Shinto shrines) for me to think religion irrelevant. But we sure could use a lot less "magical thinking."

Rationality and Opportunity Cost

UPDATED BELOW

Paul Krugman has an article in this week's New York Times magazine about the disarray in macroeconomic theory. In simplest terms, neither the New Classical nor New Keynesian economic theories are able to explain how the American economy got into its current parlous condition. Krugman identifies, correctly, the root of these problems in the economics profession's insistence on grounding economic models in perfectly rational behavior.

As he points out, a brave band of the economics tribe has insisted for years that such approaches to behavioral modeling are deeply flawed. The basis for this assertion is (wait for it) observation of consumer and investor behavior that is (gasp) irrational. However, as a professor in my own economics doctoral program observed, "You can't bash a theory with facts, you bash a theory with another theory." The purpose of this post is to point out that the hyper-rationality in behavior which is the foundation of modern macroeconomic (and other economic) theories is based upon a profoundly uneconomic assumption.

The basic premise of theoretical economics is that scarcity is an inescapable fact of human existence. The resources available to perform useful tasks and create useful artifacts fall far short of the total number of useful tasks and things that we can conceive. In short, to quote Bob Seeger, we must decide, "what to leave in, what to leave out."

Two observations follow from this. First, societies develop mechanisms to facilitate making those difficult choices. (Ours is a market economy where the tasks and things are chosen by consumer's willingness to sacrifice the resources they command to see those tasks accomplished and those things created. As a card-carrying economist, I have to approve of this and do.)

The second observation is that there is pain involved in making choices. By choosing to produce left-handed cement stretchers, we commit resources that we can't then use for other desirable projects such as reversible doohickeys. We accept that pain as the opportunity cost of the choice. Scarcity shackles all of our actions with opportunity costs.

The great Nobel Laureate Ronald Coase pointed out over seventy years ago, that even desirable activities like pursuing gains from trade through market transactions have opportunity costs. (These are what are today termed transaction costs.)

The problem with rationality

Rationality in economics involves the assumption that individuals will adopt the most effective methods for achieving their goals. (Utility and Profit Maximization) One of the benefits of the rationality assumption for economic theory is that it permits employing the sophisticated mathematical tools in modeling maximization processes. However, there is an unexamined cost in doing so. (Remember, everything we do has an opportunity cost.)

The rationality assumption as usually employed has the effect of assuming that many of the opportunity costs of decision-making are zero. As noted above, this is a profoundly uneconomic assumption. Specifically, the first assumption about decision-making is that the costs of acquiring information are essentially zero. (There are some Industrial Organization models that do incorporate informational costs but the impact on theory seems to be quite limited.) The second assumption is that information processing capacity is unlimited and costless. Once again this assumption flies in the face of the foundation principle of scarcity. In the same vein, it is assumed that information storage capacity is unlimited and costless. Finally, the assumption is made implicitly that decision makers apply the appropriate model to the decision at hand. Where did that model come from? Apparently it dropped like manna from heaven (i.e. costlessly) into the cerebrum of our hyper-rational decider.

The prime example repeatedly cited by both Krugman and Brad Delong of this uneconomic modeling is the Efficient Markets Hypothesis, or at least its stronger versions. The logic of the weaker versions where price discrepancies are quickly eliminated through arbitrage is mostly unassailable. This does require that 1) individuals recognize the discrepancy, requiring both information and processing capabilities which are not free and 2) have sufficient liquidity to exploit those discrepancies, a point Krugman mentions in his article. It is worth noting here that one of the reasons economists like easily accessible, transparent, and liquid markets is that the operation of supply and demand in such markets generates information about opportunity costs in the form of prices which help decision makers get their decisions right.

The stronger version of EMH postulates that the price of a security at all times reflects all of the publicly available information about the present value of that security in terms of its future income flows. The problem with this is mentioned above, is there any guarantee that the model used to value those future income flows is the correct one? If the model is largely reality based, I'm sure that the price of securities comes very close to proper valuation. The difficulties arise where there is some "irrational exuberance" e.g. the Internet bubble when the mere existence of the Internet was going to change everything and the values of traditional "bricks and mortar" retailers consequently tanked.

In summary, an assumption of rationality completely unbounded is an assumption that ignores that problem of scarcity. In particular, it misses that most fundamental scarcity of all which conditions all others, the scarcity of the information and knowledge needed to make correct decisions.

Brad Delong links to Barry Eichengreen who discusses thinks in a similar vein and cites literature, something I avoid in a blog post.