All Commentary
Wednesday, November 4, 2009

Regulating Executive Pay Can Reduce Systemic Risk

If they are the right executives

Late last month White House pay czar Ken Feinberg unveiled executive pay rules for 175 key players in the nation’s seven-firm TARP-assisted sector. The new rules generated different bundles of base and incentive pay for the affected executives, along with a good bit of grumbling and grousing. Unsullied by the frowns and accompanying warnings that stumbling organizations will have even greater difficulty keeping high-performing executives on the reservation, Fed Chairman Bernanke followed Feinberg’s action with an announcement that thousands of banks nationwide—large and small—will be subject to a set of Fed-generated pay regulations. On hearing that his firm might be on the way to becoming a regulated public utility, Morgan Stanley CEO John Mack said: “From my view, I’m a capitalist, I think it should be left to us.” Mack later suggested that international coordination of executive pay rules would be desirable.

An executive pay cartel seemed to be in the making.

Bernanke did not accept the proposition that market-generated information is superior to what a bevy of GS-12s can develop in Washington. The Fed chief indicated that past compensation practices “led to misaligned incentives and excessive risk taking,” suggesting that just such mischief contributed to the world financial meltdown. The time of centralized pay control was at hand.

Representatives of some of the affected firms sought to practice their First Amendment rights and petition the government to limit the new meddling. Their action was not celebrated in the White House. Commenting on the apparently unwanted politicking, President Obama said: “They’re doing what they always do — descending on Congress, using every bit of influence they have to maintain the status quo that has maximized their profits at the expense of American consumers, despite the fact that recently a whole bunch of those same American consumers bailed them out as a consequence of the bad decisions that they made.”

Feinberg and Bernanke may be on to something. But they have the wrong targets.

Yes, it is high time that pay and investment guidelines be mandated for all top level executives who may in the normal course their daily work push the entire economy too close to or even over the edge of systemic risk falls. If nothing else, this Great Recession has taught us that top executives can practically capsize the economy.

But the chief concern is not with presidents and vice presidents of too-big-to-fail banks and other bailed-out enterprises. As large as they are, they are small potatoes relative to the big generators of systemic risk. The critical concern is with top government executives who can create national and international panic, lay the groundwork for international inflation or deflation, and just by voting and writing regulations can change the risk profile of entire industries.

We taxpayer/investors demand a set of risk-sensitive compensation guidelines that will mandate pay and wealth-management rules for all federal government top executives starting with the president of the United States and all cabinet members and their deputies. While we’re at it let’s include all members of Congress and every member of the commissions and boards that manage the nation’s independent agencies, including, of course, the board of governors and chairman of the Federal Reserve System.

To properly align incentives of these elected and appointed executives (and others), we demand that each and every one be paid a base pay — some 75 percent of the current salary — plus incentive pay — the remaining 25 percent — based on improvements in real GDP growth over a five-year period that begins the day of their appointment or election. The base pay would be provided on the normal Office of Personnel Management pay schedule. The incentive pay, with recommended details worked out by Feinberg, would be provided on the basis of a three-year rolling average gain in real GDP, which means that the first incentive payment would be received three years after an executive’s first day of office.

But this deals with just part of the incentive misalignment. We must align incentives associated with government executive wealth.

Elected and appointed government executives routinely place their personal investment portfolios into management by a blind trust. While this action satisfies those who may be concerned primarily with ethics and upright behavior, simply being blindfolded as to capital gains and losses does not get to the systemic risk problem, which of course, is our chief concern here.

All high government officials described earlier must have their personal portfolios invested in a visible S&P 500 index funds, not to be redeemed until one year after leaving office. We taxpayer/investors do not want our executives blindfolded as to gains and losses. We want them to know exactly what is happening to the Great American Bread Machine, our economy, while they are in office. We want them to feel our pain and our gain.

Feinberg and Bernanke should focus efforts on those whose actions can capsize the economy—the top executives and elected officials in Washington. The others are small potatoes.

  • Bruce Yandle is dean emeritus of Clemson University's College of Business & Behavioral Science and alumni distinguished professor of economics emeritus at Clemson. He is a distinguished adjunct professor of economics at the Mercatus Center, a faculty member with George Mason University's Capitol Hill Campus, and a senior fellow emeritus with the Property and Environment Research Center (PERC).