I sympathize with all the people who are upset by the very large bonuses, stock options, and other compensation received by heads of some financial institutions that ran their companies into the ground through bad investments. However, I also believe it is a big mistake to have a pay czar, Kenneth Feinberg, impose sharp cuts over the salaries and other compensation of the seven financial institutions, like Citibank, that received the most government bailout money. The Fed has made matters even worse by proposing to implement pay controls over thousands of banks as part of its regular review of their performance.
General controls over wages have frequently been tried in different countries. The usual motivation for wage controls is to reduce inflation by keeping labor costs, and therefore prices, from rising rapidly, although wage controls are invariably combined with general controls over prices as well. Inflationary fears were certainly behind the wage and price controls in almost all countries during World War II, and in the US under President Nixon from 1971-1973. These measures sometimes succeeded in suppressing inflation temporarily, but they also led to rationing of various consumer and producer goods because of weak incentive to produce or work when prices and wages are kept below their market values.
Companies can still compete for employees when higher pay cannot be offered as inducements by increasing fringe benefits to employees, such as longer vacations and subsidized lunches and other meals. US companies began to offer free health insurance to employees during World War II as a way to get around the wartime control over wages. The American health care system has suffered badly since then from this artificially induced connection between employment and subsidized health care.
In some respects, the effects of controls over pay are even more harmful when they apply only to a small subset of all employees, such as the proposed sharp ceilings on management compensation at the seven companies that received the largest amount of government assistance, or the scrutiny of pay of top executives at the thousands of financial institutions under the Fed's supervision. The most talented individuals at these firms will tend to leave because they will receive much higher compensation packages by financial and other companies that do not have their pay set in Washington. So the financial companies that received much government assistance and other banks would lose many of their best people just when they need talented management to help put their companies under a more solid financial foundations. Without the requisite talent, many of these companies may either go under, perhaps not a bad idea, or more likely the government will bail them out once again-not a pleasant prospect.
o prevent an exodus of whatever talent is left and to attract new talent, Feinberg and the Fed may try to differentiate between more and less able executives, and allow much higher pay for the best of them. But can a czar or the Fed perform that task better than the forces of market competition for talent? History indicates that is highly unlikely.
These controls over pay not only will cap salaries, but they would also reduce bonuses and stock options, and prevent the executives affected to cash in options for several years. The reasoning is that this will force executives to take a longer-term view of the risks and other decisions that they take. One irony is that, as pointed out by Yale's Jonathan Macey in a recent Wall Street Journal op-ed piece, Congress in a 1992 Act prevented corporations from deducting as a normal business expense any salaries that exceeded $1 million. As a result, corporations were encouraged to shift their pay to stock options, which received more favorable tax treatment.
I have not seen convincing evidence that either the level or structure of the pay of top financial executives were important causes of this worldwide financial crash. These executives bought large quantities of mortgage-backed securities and other securitized assets because they expected this to increase the average return on their assets without taking on much additional risk through the better risk management offered by derivatives, credit default swaps, and other newer types of securities. They turned out to be badly wrong, but so too were the many financial economists who had no sizable financial stake in these assets, but supported this approach to risk management.
The experience of other financial crashes also does not indicate that either the level or form of compensation of top financial executives were major factors in precipitating these crashes. Thousands of banks failed during the Great Depression, as did hundreds of American savings and loans institutions during the 1980s, without heads of these institutions in either case getting particularly high pay, or pay that was mainly in the form of bonuses and stock options. My impression is that this same conclusion applies to the Mexican bank crisis of the mid 1990s, and the Asian financial crisis at the end of the 1990s.
The generous bonuses and stock options received by financial executives may often have been unwarranted, but they are being used as a scapegoat for other more crucial factors. Financial institutions underrated the systemic risks of the more exotic assets, and apparently so too did the Fed and other regulators of financial institutions. In addition, large financial institutions may have recognized that they were "too big to fail", and that they would be rescued by taxpayer monies if they were on the verge of bankruptcy because they took on excessively risky assets.