The critics say…

Posted by Marc Hodak on November 24, 2008 under Executive compensation | Be the First to Comment

Citigroup has made a deal with the government. The way it’s reported, it sounds like the bank will get over $320 billion in capital and guarantees if they agree to curb senior executive pay to the tune of about $0.03 billion.

OK, so this version of the bailout deal is kind of a warped narrative, but no more warped than the prominence that this aspect of this transaction is getting in the popular press. I believe that all this attention illustrates as clearly as anything how the debate about executive compensation is really two debates. One debate is about dollars; the other is about process.

The more interesting debate by far–the one about dollars–draws most of the unnamed “critics” into the public light, those merchants of outrage cited in the breathless reports in the media. These critics’ attitudes are well summarized as such:

The public wants “strict limits on executive pay,” said Sarah Anderson, a pay expert at the Institute for Policy Studies, which has pressed for executive pay curbs.

IPS is one of those progressive think tanks that provide a ready stable of pay critics (or, in this strange rendering “pay experts”) whenever the subject of compensation comes up. Their critique is simple: the people want limits on pay.

I’m not sure what percentage of the public on whose behalf they speak would describe themselves as progressive (or it’s close cousin, socialist), but a hallmark of any collectivist ideology is that it presumes to speak for “the people.”

In any event, the progressive case presumes that the economy is kind of a zero-sum game, where wealth creation just happens, and wealth distribution is the result of arbitrary decisions by those in power. Such a view naturally leads to the conclusion that higher paid people get theirs at the expense of other, presumably lower paid, people. If you buy these premises, then the solution to “excessive executive compensation” is to define whatever the higher paid group makes as excessive, i.e., in need of “strict limits,” then give “the people” (read: the government) the power to decide how this excess should be distributed.

The idea that certain individuals might have some hand in creating the revenue from which their pay is derived does not enter into the equation. If a salesman’s commission revenue has dropped 50 percent, “the people” may think he deserves nothing, regardless of the commission structure that top executives, the board, or the owners may think is reasonable. Let’s put it up to a vote.

The debate about process is very different. It centers not on how or how much, but who–who gets to decide? The sensible answer is that the people with the most specific information and most direct stake in the outcome should have the say as to what mechanism is used to distribute the wealth.

Process-focused people tend to view wealth distribution and wealth creation as somewhat dependent on each other. They hire people like me to devise these mechanisms, people whose training and experience tell them that incentives matter in wealth creation. To be sure, incentives also matter in wealth destruction, and some of the incentives that have led to the current debacle have been perverse in the extreme. But few of those incentives were created at the firm level. Most of them, in fact, were created at the policy making levels of government–the same government that is now charged with influencing the incentives of the companies in which they have made significant investments.

So, who are these process-focused reactionaries? One of them is Arthur Levitt, one of the “others” in counterpoint to the “critics”:

Others, though, say the government should not get in the business of dictating exact limits on executive pay at Citigroup or any other firm taking part in a federal rescue.

If the government goes that route, says former U.S. Securities and Exchange Commission Chairman Arthur Levitt, it may find itself micromanaging companies, something he says it should not be doing.

No one would mistake Bill Clinton’s head of the SEC for a right wing ideologue. But he actually has some relevant experience in corporate governance, unlike the “pay expert” quoted above.

Alas, the government is involved in a big way. When you accept someone’s money, you accept their rules. As a condition for offering government, i.e., taxpayer, capital (in Citigroup’s case, they actually want those funds) the government attached certain conditions.

The basic problem Levitt was referring to is that government is attempting to serve “the people” in two incarnations–as voters and as shareholders. The government is inherently more responsive to “the people” as voters because voters express their preferences every two or four years. If politicians mess that up, they are out. Voters care about things like who is sleeping with whom, is Joe the Plumber licensed, and how much did that CEO make.

The accountability of politicians to “the people” as shareholders is much less pressing. People aren’t anywhere near as sensitive to whether the government’s is getting a good risk-adjusted return on their investment in Citigroup. History teaches that the loss of mere billions due to poor government oversight, including instituting poor incentives, is virtually invisible to the public. And if their investment eventually blows up because of government incompetence, well, that’s most likely a problem for future administrations.

In the meantime, given the peculiar incentives of government agents, it looks like the most vocal, dollar-focused “critics” trading on voter outrage will continue to have far more influence on management pay than the process-oriented critics thinking hard about shareholder value, but whose stories simply don’t make compelling copy.