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Professor Roger Bowden

The 1% balance and Belshazzar’s Feast

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They straggled past down Cuba Street, an odd collection of gaunt activists, earnest ladies and scruffy alternative lifestylers, waving handwritten signs ‘WE ARE THE OTHER 99%’, and handing out cyclostyled bits of paper on the scourges of capitalism. It seemed hard to take them as any kind of threat to the social order. But what started out as the ‘Occupy Wall Street’ protest movement shows every sign of becoming an international movement, with much larger marches in London, Paris, Rome, Berlin, at times violent. Are these just the same old woolly minded agit prop socialists, or do they have a point? And if so, what if anything, should the policy makers do about it?

The OWS movement seems to have two things in mind. The first proposition is that executives are too highly paid, and this is bad as a matter of ‘social justice’, whatever this means. Proposition 2 is that the consequential pursuit of such enormous personal rewards has precipitated the economic meltdowns that have engulfed the rest of us in horrifically expensive public rescues. In what follows I’ll look largely at Proposition 1; that’s enough without writing a book on the consequences, which have still to be played out.

One thing is for sure, that over past twenty years or so, there has been a sea change in remuneration relativities. The average CEO in the U.S. now gets paid 50 times the average wage and salary earner. Just in case you think that’s just President Obama’s problem, think again. Last year, the local NZ boss of Westpac raked in about NZ$5.5 million, which is roughly 100 times the average, while the big boss in Australia pulled in a package worth a whopping $55 million. Dynastic wealth in the making, so to speak, and it’s a story repeated over a whole range of companies, not just financials.

It’s a far cry from even the late ‘eighties, where the CEO of Westpac was thought well paid at a mere AUD400K (and was not even their highest paid staff member). How did all this happen? And is it a case of good ideas gone bad; so that instead of Alfred Doolittle’s undeserving poor, we now have the undeserving rich?

As usual, you can blame the ‘academic scribblers’. In the mid to late ‘eighties, several influential writers in economic agency theory, notably Michael Jensen, argued that senior managers were in fact systematically underpaid, in terms of what they could potentially add to shareholder value. Variable pay components, based on stock options and the like, could be used to incentivise managers to take risks. Managers could lever up their rewards if they habitually got it right – but could be fired if they got it persistently wrong.

After a slow start, the idea took off like a rocket, for it was an idea that corporate executives wanted to hear. It was helped along by the explosion of market making in derivative financial products at the time, which offered enormous scope for rewards based on the mark to market value of trader portfolios. And a bit later in the early 00’s world interest rates fell, putting huge pressure on banks and investment funds to generate shareholder returns. By then CEO’s and other senior managers had levered themselves up over the traders they managed, while the movement spread to executives of all manner of firms.

With the general public, however, the penny had started to drop. Academics turned downright critical when they noticed that executive rewards had taken on a life all their own. In particular, executive remuneration had become dislocated from the company’s stock performance, so that even badly performing companies continued to pay their CEO’s like Midas.

Even if this had not been so, operational questions could have been asked. Is it the case that the firm has done well because I am there? Or have I done well because the firm is there? In other words, does my package reflect attributable value that the firm derives from my unique presence; or could just about anybody do the job, and I am stratospherically paid simply because I have lucked out in being there and pushing the right buttons on the way up?

Unquestionably, some executives are worth every penny, or even more. Just think of Steve Jobs with Apple, or Lee Iacocca, the man who saved Chrysler two decades earlier. Their special skills or marketability are economically comparable with those of a Michael Jackson, or Elvis Presley for Iacocca’s generation. Economists would call it an economic rent, a return to a valuable factor in limited supply. Likewise, some market dealers are genuine talents in finding and pricing trades. They may be obnoxious people, but this is economics we’re talking about here, not Dr Phil.

But if special skills of this kind are rare what, then, has been ratcheting up executive remuneration packages to such extremities, for what in so many cases are quite ordinary talents? Lucian Bebchuk, of the Harvard Law School, identifies the problem as one of influence and relationships, in particular as between remuneration consultants and the company remuneration committees that hire them to advise on executive pay.

My own take on the problem is that the remuneration consultants have established comparator comparisons as their stock in trade. The position, not the person, has become the arbiter. If company X down the road pays their bosses $5m a year it would be a brave consultant to recommend anything less for their client company Y. And a claimed requirement for intercompany comparability is a convincing way to counter objections from pesky dissenting shareholders at the annual general meeting. But to base any kind of action on inter-agent comparisons is a great way to generate contagion, and indeed economists have recently been modelling such effects in the context of executive remuneration.

Likewise, consultants cite executive pay conventions based on such statistics as the value of assets (good for bank executives!), the annual turnover, or the number of employees. I suspect the latter is why university vice chancellors in NZ are getting such big pay hikes, no matter that in reality they are little more than functionaries. Statistics, in other words, can be used as an apparently objective tool to come to unwarranted conclusions. Remuneration consultants have to this extent become unwitting agents of contagion.

So what, then, can or should be done to dampen down a spiral of pay expectations, given its potential to generate damaging social unrest? The global financial crisis precipitated a brief flurry of regulator activity, aimed in part at excessive and counterproductive executive bonuses in the finance industry. The main outcome was to lengthen the vesting period of stock options, meaning that a trader now has to wait longer to make sure that his apparent mark to market trading gains don’t go belly up a year later.

It looked good at the time, but had little real effect. Even post the GFC, much the same stories were emerging: of large bonus guarantees to hire or retain traders in fields such as commodity trading or shipping, or of resurgent bonus pools in the trading of asset backed securities and credit default swaps. Moreover, the attempts of finance industry regulators have done nothing to dampen social perceptions that senior executives in other industrial sectors are feeding from their own trough.

Taxing the trough feeders is one possible way to go. President Obama’s proposed tax hikes for the rich won’t ever do much for the US budget deficit, even were the US Senate to relent about blocking them. The social underclass is just getting too large, and things in the US and Europe will get still worse as global economic changes continue to impact upon regional production and incomes. I see the main benefit of the Obama tax proposals, were they ever to be accepted, as signalling a willingness of the part of them that hath to support them that hath not. Call it what you will: a social compact, social bribery, or whatever. One thing the Occupy Wall Street movement might just succeed in doing is to bring home to the Republicans that it might just be in their longer term interest to realise that no man is an island. Otherwise, Obama and his advisers are on to a good thing for the next elections.

The tax system aside, it’s difficult to see what else the government of the day can do to fix the problem of ballooning income inequality and the social stresses that will inevitably result. Here in NZ, a reference to the new Financial Markets Authority might help to delineate reasonable principles and evidential criteria to apply to executive pay, at least in so far as this applied to public companies. Likewise, the State Services Commission might care to take a more critical look at contagion with respect to public servant packages.

But in the last analysis, the only thing that can really work is shareholder activism and publicity, founded on good healthy scepticism, both about the attributable value of the executives’ contribution and the role of the remuneration consultants. Minority shareholders at AGM’s can be a nuisance, but they do have a valuable social role. And so have newspaper columnists; right on there Brian Gaynor, for drawing our attention to the ratcheting up of directors fees 1.

None of this should serve to hinder exceptional rewards being paid to exceptional people for exceptional contributions. The ragtag Cuba Street mob, or some of them, might even agree to that. It’s just an identification problem, the kind of thing I used to write about in my early days as an econometrician. Rest easy, Steve Jobs.

  1. NZ Herald, Saturday 22 October 2011