Monthly Archives: February 2009

Caps on Executive Compensation

There are a few things for the libertarian side of many of us feeling queasy about the Administration’s caps on executive compensation to ease that queasiness & anxiety:

1. Executive compensation as currently structured rewards very high-risk tasking behaviour, even when the probability of failure of an investment is high (the high returns are an attractive incentive). The sub-prime mortgage crisis is a prime example.

2. Risk-taking itself is not a problem, because it is balanced out by the risk of failure, but government bailout money takes away completely or reduces greatly that failure risk for companies: “the government will bail us out because we are “too big to fail”! This creates a huge moral hazard problem.

3. Nevertheless, bailout out money is a necessity at this time given the current economic conditions (so that banks keep lending and business can keep operating and the U.S. economy does not spiral down to a more severe recession). So government intervention is important in helping the markets, but it needs to address irresponsible risk-taking (via restrictions on executive compensation to companies receiving bail-out money). The fact they are receiving bail-out money means they would have otherwise failed w/o government intervention, and would have sustained a loss much greater than that imposed by executive compensation restrictions (e.g., be fired, file bankruptcy, close all together)… these stipulations of executive compensation are not a cap on innovative thinking, rather they are a form of accountability and moderation of the moral hazard problem… it provides an incentive for companies to restructure and become profitable again to return to higher levels of compensation… this time with a little more care in their risk-taking decisions, since low performance may mean that either they will fail or if the government bails them out again, a slash in their salaries… That sound like a sound incentive structure to me.

4. No doubt mechanisms to fine-tune this cap to the financial profile of a company will be in place (e.g., overriding the half a million per annum cap by shareholder vote & share options)

5. Executive compensation caps exist elsewhere in the world (whether imposed by intervention or out of normative corporate standards). For example, in Japan, it is framed as an issue of equality (or rather, of not promoting extreme inequality). The ratio between the lowest and highest paid employer is 1:10 in Japan, whilst it is around 1:50+times in the United States. It works: Japan is still on the vanguard of innovation in high tech products (their economic problems are due to other factors, including the fact that the Japanese save too much and they do not spend enough — that is certainly a problem we do not have in the United States!).

No, the Obama Administration caps will not thwart growth or innovation. Yes, they will provide responsible corporate governance.

Indeed it is due time to clip those golden parachutes…

by Maria Reyero


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