This week the Obama administration, acting through Secretary of the Treasury Geithner, appointed a pay czar to review, reject, and possibly set the pay of companies that received large amounts of federal assistance during the financial crisis. No appeals will be allowed from his decisions. The Czar, Kenneth Feinberg, will have broad authority over compensation for the top executives and 100 top employees at Bank of America, Citigroup, American International Group (AIG), General Motors, and a few other companies that received large federal bailout monies. This is surely one of the more preposterous ideas to come out of Washington.
The title of my post, "The Fatal Conceit", is taken from the title of a book published in 1988 by Friedrich Hayek. In this book Hayek attacks socialists for "the fatal conceit" that government officials can effectively determine prices and production through various forms of central planning without having the incentives and information available to firms in competitive markets. A closely related conceit is behind the belief that someone sitting in Washington can determine the pay to hundreds of executives and other employees.
The social purpose of competition and private enterprise is to provide quick responses to constantly changing market conditions. These responses include determining and changing the salaries, bonuses, and stock options of employees and top executives. Companies get into trouble and even fail when their decisions, including decisions on the quality of employees and their compensation, are less effective than decisions of their competitors.
All the companies that will have the pay of top employees under the control of the Czar compete against companies, both domestic and foreign, that will be free to set the pay of their employees. If these companies offer higher pay than the Czar allows for companies under his jurisdiction-whether this higher pay takes the form of bonuses or other forms, or whether fully justified or not-the controlled companies will lose their best employees to competitors, and they will have trouble attracting employees who are highly capable. The Czar could even be making serious mistakes if he just allowed the pay of companies under his control to match the pay offered by competitors. For it is plausible that companies in hock to the government may have to pay more than competitors to entice capable persons to take on the task of resurrecting these companies. This is especially likely since Congress and the Treasury will be calling them to testify and second-guessing their decisions.
The background of the Czar, Kenneth Feinberg, is not reassuring in these respects. A lawyer, he first worked for the federal government, and then during the past several decades headed a law firm based in Washington. Since he apparently has never been an employee of any company other than the government and Washington law firms, how can this background prepare him to set the pay of large companies, such as AIG or GM, that are in highly competitive industries?
In recent interviews Mr. Feinberg claimed that excessive risk-taking fuelled the crisis, and that this risk-taking also led to excessive compensation. Surely, risk-taking has essentially nothing to do with the problems of GM and Chrysler, two of the companies under his wing. Growing leverage by banks of their limited capital base did contribute to the crisis, and perhaps that also greatly increased the pay of bank executives. However, even if this claim is entirely correct, I do not see how that can help him efficiently determine the pay of the (fortunately) few companies under his jurisdiction when their competitors can set the pay of their employees much more freely.
Defenders of the selection of Mr. Feinberg point to his almost three years spent as a pro bono Special Master of the fund that compensated victims of the 9/11 terrorist attacks. I do not know how well he carried out these duties, but determining compensation of victims is entirely different from what is required to set compensation of executives. As Special Master he had to assess the value of losses due to wrongful deaths and injuries. Although that assessment is not easy- it depends on lost earnings and other aspects of the so-called statistical value of life- it really has little to do with determining employee pay in a few companies engaged in highly competitive and changing industries.
The same fatal conceit behind the setting up of a pay Czar is also responsible for the belief that members of Congress and Washington officials are capable of steering GM and Chrysler toward profitable directions. This is behind the government pressure on these companies to shift toward small fuel-efficient cars, even though GM and Chrysler have been best at producing trucks and larger cars. Perhaps they will be able to make this shift, but it is far more likely that Honda, Kia, Toyota, and other foreign auto manufacturers that have been making small cars for decades will eat their lunch.