Pay Controls Do Not Work at Any Level-Becker

Several big banks and other companies have badly fumbled their public relations during these difficult times, such as the big three auto makers who took their private jets to Washington to beg Congress for a bailout, or the board and CEO of Merrill Lynch that granted generous bonuses to their executives just as the company was avoiding bankruptcy through being taken over by Bank of America. However, anger, even when justified, is not a good reason for ceilings on the pay of top executives at companies receiving assistance from the federal government. The main problem with wage (and price) controls is that they never work, although governments have imposed them throughout history. They will not work in this case either, where the plan includes a salary cap of $500,000 for top executives at companies taking "extraordinary assistance" from the federal government, restrictions on when these executives can cash in the stock they will receive, limits to their severance pay, and monitoring of fringe benefits, like company jets. There are no good guides to a priori setting of either the form or the level of compensation to employees in any occupation, including top executives. Competition, with all its defects (which I discuss later), is still the best mechanism available for setting salaries and other prices. Pay caps will encourage companies that take government aid to hire high priced lawyers and accountants to devote their expensive time trying to find loopholes in these caps. Loopholes include reclassifying some employees to positions below top executives so that their pay would not be subject to any government pay caps. Most loopholes center on various forms of deferred payments and non-monetary benefits. For example, companies started to provide free medical coverage to its employees during World War II as a way to circumvent controls over wages. This fringe benefit has persisted as a tax advantage that is usually not available to workers who pay for their own medical insurance. The plan for executive pay caps already includes restrictions on several fringes, including the ownership of corporate jets by companies taking government assistance, even though company jets are often valuable savers of the expensive time of executives who do a lot of traveling. Able lawyers and accountants will discover many other fringe benefits that can help circumvent the pay caps. Companies that take government assistance do so because they fear going bankrupt. Sometimes that is because they were badly managed by the CEOs and other executives in charge. What many of these companies need are new executives who can take a fresh look at their problems. Unfortunately, pay caps that leave total pay considerably below what able executives receive in other companies make it more difficult to attract these executives to companies in distress because they can earn more, and work with considerably less government interference, in companies that do not take or need aid. Moreover, severe limits on severance pay help to lock in incompetent executives who then might refuse to leave voluntarily because they would not receive any significant financial incentives to leave. Apropos of turnover of top executives, I believe many company boards, and also boards of universities and other non-profit institutions, fail in their most important responsibility: to determine when top management should be replaced. This is partly because many board members spend very little time on board activities, and also because many members are friendly, or at least sympathetic, to the top executives. As a result, they are either too ignorant of how the companies they oversee are really doing to overrule top management, or they are too close to management to make the hard decision to fire them when they perform badly. Of course, one reason caps on the pay of bank top executives are popular is because of the general perception that boards of directors also overpaid these executives, and thereby failed in this duty to protect stockholders. Perhaps they did, but even if the pay of top executives at many banks and funds were well above what they would receive in a well functioning competitive market for executives, that could not explain the devastating hit taken by stockholders of these companies during this crisis. For example, even a 100% overpayment to bank executives would usually have only a small direct effect on bank profits since their pay, however large in an absolute sense, was rather small compared to the normal profits of these companies. Another criticism of the compensation of the top executives of banks and other financial institutions is that it encouraged excessive risk-taking because their pay was excessively loaded toward stocks and bonuses. In retrospect, obviously, top executives of many financial companies took risks that turned out to be catastrophic for stockholders and employees. Yet, since the value of the stocks owned by these top executives also dropped sharply, and since their bonuses have been sharply reduced or eliminated, most top executives did suffer greatly along with stockholders when their risky decisions failed. So any distortion in the pay structure toward risk taking was surely limited.

Comments

[modgen]

As a taxpayer, there is no chance that I will approve of even $500K of my money going into the trough of a failed corporate pig, pretty much regardless of the consequences.

Quite honestly, I believe many of these scoundrels and looters should be hung (after a duly constituted tribunal of course).

I am a lifelong Republican and staunch free market advocate.

[Patrick R. Sullivan]

Barack Obama may have more personal culpability in this mess (from his days as a community organizer-extortion artist) than any banker. Peter Wallison explained how it all worked.

[Patrick R. Sullivan]

Barack Obama may have more personal culpability in this mess (from his days as a community organizer-extortion artist) than any banker. Peter Wallison explained how it all worked.

[jonm]

So, apparently unlike modgen, I read all this agreeing right the way through until the last sentence: "So any distortion in the pay structure toward risk taking was surely limited."

How, exactly would you back this up? Unless essentially all of the wealth of the chief executives is tied up in company shares (i.e. not leaving millions of dollars for an affluent retirement) then they have a large risk-inducing distortion relative to equity, and equity holders in turn have a similar distortion because of bankruptcy.

I work in the front office of an i-bank. At the desk level, the equivalent distortion is known as a trader's put and it looks a lot to me like many higher-ups took a giant punt on the MBS market.

In addition to the loopholes you mention, I think there will also be a lot of hedging compensation restricted to shares to a cash equivalent.

[John Campbell]

The main problem with wage (and price) controls is that they never workSpoken like a true arm chair economist. What do you mean they don't work? Don't work politically? You must be kidding. Since when do equity/debt holders *not* get a say on executive compensation? My pay is decided by my bosses, and when the US government becomes an equity holder, they get a say on compensation. If the banks don't like this, they are welcome to return the TARP funds and enter bankruptcy proceedings.For example, even a 100% overpayment to bank executives would usually have only a small direct effect on bank profits since their pay, however large in an absolute sense, was rather small compared to the normal profits of these companies.You have got to be kidding. Investment banks have historically paid up to 50% of *revenue* in bonuses.

[Jack]

John you have me wondering how our Profs here would take to Joe the Plumber, teachers, police and all expecting 50% "performance" bonuses.

Just 25 years ago CEO's averaged 50 times working folk's pay, say a figure of about ONE million today; have we all been brainwashed to accept these guys carving off tens of millions or more?

[Jim]

Hail Caesar. Release Barabas and crucify the other guy.

[furious_at_wall_street]

Some of the comments made are laughable: "Moreover, severe limits on severance pay help to lock in incompetent executives who then might refuse to leave voluntarily because they would not receive any significant financial incentives to leave."

If all the corporations started giving significant financial incentives to get rid of incompetent people, people would start falling over to each other to prove their incompetence to get the golden parachutes.

This blog is typical of the arrogance personified by Wall Street who think they are the masters of the universe and are not accountable for anything.

[Anonymous]

The problem is not that the government is setting wages in the private sector. The problem is that the government is giving tax money to the private sector. Do you think that we should not impose any restrictions to those firms that receive help from the government? If we don't then it is just a transfer from the tax payer to some of member of the firm. I in fact happen to agree with the restrictions, and I would even like to see more distortive restrictions imposed. The worst it is for the companies to accept government money, the least likely they will accept it (in particular if the restrictions fall on executives), the end result being less of my tax dollars being channeled to firms that should have gone out of business already.

[Mark A. Sadowski]

Price controls are never the solution However there is a fair amount of evidence that executive compensation in the financial industry is not competitive.

In 2006 Thomas Philippon and Ariell Reshef published a paper showing that compensation, adjusted for education, in the financial sector was 40% above the national average. They also demonstrated that this excessive compensation was correlated to deregulation in the financial sector. And, they further showed that this had happened before, in the years leading up to the Great Depression:

http://pages.stern.nyu.edu/~tphilipp/papers/pr_rev15.pdf

There's also some forthcoming research by Thomas F. Cooley and Gian Luca Clementi that evidently will show that in the financial sector, CEO wealth is far less sensitive to changes in shareholder value than in any other sectors, in spite of the fact that equity holdings are a more important component of compensation. In other words top managers of financial firms do not suffer as much when their firms perform poorly.

I suspect that corporate executive compensation in the United States in general is not competitively determined. It is much more extravagant than elsewhere in the world and yet there is little evidence our corporations are better managed. One factor may be that we allow management the power to determine which state to incorporate in, and needless to say they chose states whose corporate laws maxamize management power versus shareholder power. A federal law that gave this power to shareholders would improve accountability and probably result in executive compensation coming down to the level of mere mortals. But it seems we have this debate everytime corporate compensation comes under scrutiny and nothing is ever done about it.

[Ray]

The talk about whether Obama's pay cap is correct or justifiable misses the point. The cap is absolutely wrong because it applies the same cap to all companies. You don't need to be a free-market fan to see that.

[Ian Thorpe]

The problem with bonuses and unrealistic salaries banking industry was that they came to be seen as an entitlement rather than a reward.

"I'm a banker, I made $5billion for my bank last year" deserves a $50million bonus.

"I'm a banker, that alone entitles me to $50 million bonus" deserves a punch in the face.

In the days of free market madness this attitude spread to industry as well. Thus there was no relationship between performance and reward.

Obama's pay cap will be counter productive. What is needed is self discipline and a return to reality.

[Anonymous]

دردشة صوتية

[Thomas Brownback]

I would be surprised if Mr. Becker did not oppose the stimulus under similar analysis provided by Kevin Murphy, something along the lines of "f(1-L) here on the Freakonomics blog).

If one opposes the stimulus, is it really even sensible to quibble over such terms? The wage controls are optional, firms can simply not participate in the stimulus without them. This will drive the stimulus towards smaller institutions and large institutions with a great deal of legal and accounting competency, and away from some firms who do not actually need a stimulus for reorganization (and it may drive some firms out of the market).

Providing some pressure on firms to reject stimulus money seems a key part of any stimulus, and the form that pressure takes seems largely irrelevant. Taking stimulus money should have some cost, the nature of that cost barely matters.

Even if the wage controls cause a great misallocation of resources in a few firms, the loss due to wage controls seems a tiny footnote to the inefficiencies of the stimulus overall.

A far greater impact on our economy right now is manifested in the less optional wage controls on the low end. We're heading towards unemployment and deflation, it's time to reconsider minimum wages to help workers adjust to the situation without being forced completely out of work.

[Thomas Brownback]

My equation and link got a bit shredded in the html conversion. For more on Kevin Murphy:
http://freakonomics.blogs.nytimes.com/2009/02/03/chicago-economists-on-the-stimulus-package/

[Jack]

Ian you got it exactly right in regard to the well deserved punch in the chops; but assuming no punch, how would you expect the prospective punchee to "return to reality" and develop any self-discipline? It strikes me that the lure of getting more in ones paycheck in a month than a median household would EARN in two decades would make giving up the habit voluntarily, difficult for most.

Ha! Mr Brownback: Do you want to take this opportunity to beat down one of the lowest minimum wages in the developed world to yet lower levels than what has taken place as Congress failed for so many years to adjust it for inflation? Could there be any other effect than that of putting more folks on welfare or making them more dependent on the bevy of inefficient transfer programs?

[Tony Daysog, Alameda, CA]

This is a cool blog.

[neilehat]

!!!NewsFlash!!! Wall Street and its minions thumb noses at President and Congress after reports on actions for responding to the Economic Crisis by falling in excess of three hundred points.

Doesn't anyone see a problem here? And here we sit discussing the virtues or lack of, regarding Price and Wage controls. The Corporatocracy has won and relegated the Government to the position of an anachronism.

Long Live the Corporatocracy!

[Jake]

Well reasoned post above, Prof. Becker. Likewise as to your testimony before Congress this week.

[Corwin]

I can't disagree with your post..But,what about pay caps for univ presidents.I think every school (except Hillsdale?) has students taking Fed money.Why shouldn't there pay be capped?And I propose starting with Mary Coleman,at U of Michigan.She makes our new football coach look good.
And I'm half serious here.Why not restrictuniv administration pay?

[redmund sum]

Often we hear teachers complain "…if a society sees it fit to pay its garbage collectors more than its teachers…" I always wonder why those teachers don't sign up to be garbage collectors. The same principle holds for corporate executives, as hard to believe as it may seem. In our imperfect model, the board decides who the CEO is and how much the CEO gets paid. If the company is public, they all are accountable to shareholders.

If you want to be paid a bundle, quit your job and set up your own business so you can appoint yourself CEO and pay yourself as much as you want.

The argument is valid that since the government holds equity in these companies under "rescue," the government must have a say on how the exec are paid. This is precisely why the government should not "rescue" these companies (by owning a piece of them) to start with. Lacking the profit instinct, the government cannot be a good business manager. Attempting to cap compensation is just the first folly; wait till the government starts to tell the auto companies what cars they must build and which cars people must drive! I argue that if not for the fact the government compelled banks to write subprime loans and urged Fannie and Freddie to buy them up, we would not be in such deep yogurt today. Such is the track record of government intervening into the private sector.

[Thomas Brownback]

"Ha! Mr Brownback: Do you want to take this opportunity to beat down one of the lowest minimum wages in the developed world to yet lower levels than what has taken place as Congress failed for so many years to adjust it for inflation?"

As the minimum wage primarily hurts the working poor, yes.

"Could there be any other effect than that of putting more folks on welfare or making them more dependent on the bevy of inefficient transfer programs?"

Yes, as it is a price floor on labor, and as price floors cause surpluses, and as a labor surplus is unemployment, this would have the primary effect of employing more of those who need employment.

I am unsure what accounts for the widespread unfamiliarity with these outcomes. I find that unfamiliarity surprising, as Supply & Demand isn't a very novel theory, nor poorly tested, nor controversial among economists. I might recommend the Baumol and Blinder to familiarize yourself with its principles.

[Robert Macdonald]

Salary caps work in the Australian Football League Prof Becker. Constrained competition can work in the labour market.

The 'loss of talent argument' might be valid if the talent pool was so extraordinarily thin at the top end to suggest there were only a few dozen / couple of hundred executives in the world who could make a good fist of running a salary cap affected company. Wall Street attracts a global labour force; surely there are enough sufficiently talented finance/corporate experts in the world who would be attracted to the firms affected by the salary cap. This is a distasteful example I am loathe to raise, but did the professions of international trade/banking & finance come to a screaming halt after the terrible loss of life on 9/11/01? No. No will the US banking industry suddenly become dramatically less efficient because of the possible loss of a few people who think a salary cap is too much to bare.

[PQuincy]

@ redmund sum: "If the company is public, they all are accountable to shareholders."

It's amusing to see so many people interested in economics who have apparently never heard of 'rent-seeking' behavior. As a brief look at the actual power of shareholders quickly reveals, shareholders have extremely limited means to limit corporate executives on any issue at all, and such authority as shareholder votes do have have been systematically resisted, obstructed, blocked and impeded by executives and boards.

[Jack]

Thomas B, Thanks for the response. But I'm not only familiar with the principles of supply and demand but several of the flaws that have resulted in every advanced nation having farm price support programs, min wage laws, along with a variety of work rules.

There are quite a few chapters in all econ intros I've seen that deal with the facts of many unorganized sellers of generic commodities having so little market power against well organized (and influential -- see Archer Daniels and Dwayne Andreas for a revealing glimpse into the game) that prices are routinely bid down below the costs of production.

Unorganized labor of little or even moderately high skills face the same effect, though exacerbated by FRB and other policies that ensure a 5% stated (10% real) unemployment rate as a bulwark against "inflation" which is apparently defined these days as any growth in median or lower incomes, while the topical gleanings of CEO's and Wall Street rascals have soared by 400% or more during the same 25 years.

As for supply and demand of labor it would be a good exercise for any who like to play around with the graphs to draw one up reflecting the realities of our current situation including China having permanent MFN status. In short it would appear that the SUPPLY of generic labor as well as quite skilled labor approaches infinity, at least in the case of our nation which has but 5% of the world's population. Thus! with limited and falling demand for labor it looks as though the Price would be virtually zero.

Perhaps that is what you are seeking? You sort of ducked the question of "more on welfare and transfer programs". Does that mean that you think those programs should be dismantled? As it's obvious that were Walmart to further lower it's token wages that the amount of subsidy from taxpayers would rise from the current level of One Billion each year.

A recent study in low cost OK showed $18 as the minimum wage that would maintain one person at a very basic level, yet there are many who earn but half that amount. What do you propose as those not achieving even the most basic std of living increase dramatically?

Assuming a "let em eat cake" in your devil take the hindmost world perhaps it's worthwhile to reflect on how Taliban and warring drug lords are able to raise armies for the price of food, and look around at the rising gang problem of our own nation and nearby Mexico.

Lastly, were we as impoverished as Afghanistan our options too would be few, but we aren't; we still have one of the higher GDP's and a per capita average income of $32,000 that would provide the average HH of three with $96,000 per year.

I see NO future in running our nation as a nation of gilded wealth among the very few while those near the bottom work for half or less what it takes to maintain life and continuing to try to patch it up with costly transfer programs. Do you?