Reforming CEO compensation — how much is enough?

Lonesome Hobo Economics

… Kind ladies and kind gentlemen …
Stay free from petty jealousies
Live by no man’s code
And hold your judgment for yourself
Lest you wind up on his road …

– Bob Dylan, “Lonesome Hobo,” 1967

Compensation over the long run reflects the market value of labor as a commodity. The market value oscillates around the cost of production, and sustainability – of the worker. Many factors influence the oscillation. To this writer it seems important to consider that advancing technical, artistic, athletic, scientific and leadership skills requires advancing social wealth and increasing social investments in human potential. This principle holds true for both capitalist and socialist societies and reflects an important objective feature of the socialization processes that any advanced and highly integrated technological/economic foundation must strongly favor.

Wherever the products or services of creative labor are in demand – labor that cannot be alienated from a human brain, or cannot be effectively or permanently appropriated via employer copyright or patent (the subject matter of much of what is now called “human capital” and “intellectual property) – these labor markets are not exchanges of labor-power as in classic manufacturing scenarios. They are exchanges for the full market value of a service or product.

In the case of a CEO, the owners (via their board of directors) negotiate a contract that aims to align compensation with their interests. Sustained, maximized profitability is the dominant interest. However, in practice, in order to win the “best” CEO, the contracts have been compelled to reward short-term profit maximization, usually in the form of stock options and bonuses.

The awards of stock options in particular have encouraged high-risk behavior that pushes up the stock price in the short term (quarterly) but often undermines the long-term interests of the corporation. Further, a struggling company in the market for a CEO has difficulty enticing the “best” candidates without handsome “golden parachutes.” The reason for this difficulty is simple: why would a successful CEO leave a successful company for a struggling one? Answer: very high bonuses, and an escape clause (parachute) in the event of failure.

The result of the bargaining process is a CEO whose interests are in fact NOT aligned with the long-term interests of the company. In economics this is called the “principle agent” problem, and it has made a substantial contribution to the still ongoing financial crisis. It also has damaged many other non-financial enterprises – like auto. The short-term incentive dilemma is passed down to other top executives, whose interests are also aligned with short-term results.

Three proposals for reform of executive compensation are being considered, both in the U.S and globally. The first is to mandate that bonuses be paid on longer-term performance. The second is to set caps on executive compensation via regulation, and the third is higher tax rates. The last won’t have much effect on improper risk decisions – but will help society protect everyone else from the crises that high-risk behavior favors. All will certainly generate across-the-board resistance from the financial lobbies.

The problem with caps is that they may not be effective unless applied universally, and globally. Otherwise we might quickly find most of the financial industry operating from the Cayman Islands, instead of Wall Street. High tax rates have been the favored solution in most European countries, and they have certainly made it possible to afford much greater social protection against economic crisis there than in the U.S. But even with high tax rates, the UK, for example, had a substantial financial meltdown, and is now very highly leveraged.

Obama’s position emphasizes the longer-term bonus solution. The opposition of Wall Street to this is mostly born of greed. There is a broad consensus among a large and influential group of very skilled people opposed to accepting significant rollbacks in their lifestyles. They argue there is an objective downside to long range as well. Just like weather prediction is notoriously inaccurate beyond a week, economic prediction and planning in the real world is also hardly scientific beyond the fiscal quarter year. They argue the result of long-term bonus restructuring may lead to an excessively low-risk economy, an unresponsiveness, or sluggishness in responding quickly to economic opportunity, undermining investments in much needed innovation.

It is easy to discredit this argument by pointing to the absurdity of Bush economics, but it would not be completely true. The dilemma of what to emphasize in top-level leadership, enterprise, cultural and scientific incentives is profound for both socialist and capitalist economies, by the way. It may seem like a planned economy is less vulnerable, but the vicissitudes of nature, and society at large, tend to undermine the best laid plans. Adaptability to changing conditions, and much better forecasting tools, will return big value.

Nonetheless, for the next few decades, we have all had quite enough “financial innovation” – and its horrendous unregulated consequences. And we definitely need revenue for the big unmentionable – global climate change. I would recommend forgetting the caps in the U.S., and going for the long-term bonus restructuring – at least in the financial services and banking sector. Higher taxes on the rich, of course, are needed regardless, to restore positive income growth for working people. A fundamental change of direction in the distribution of wealth is needed – even if, no matter what rules we put in place, eventually someone will likely find a way around them. But we could do with some possibly slower but more stable growth for a while!!

John Case (jcase4218@gmail.com) hosts the morning radio show “Winners and Losers” out of Shepherdstown, W.Va.