Friday, November 23, 2007

What is to be done ?

Reform corporate governance or executive compensation ?

Paul Krugman explains the problem

“What were they smoking?” asks the cover of the current issue of Fortune magazine. Underneath the headline are photos of recently deposed Wall Street titans, captioned with the staggering sums they managed to lose.

The answer, of course, is that they were high on the usual drug — greed. And they were encouraged to make socially destructive decisions by a system of executive compensation that should have been reformed after the Enron and WorldCom scandals, but wasn’t.

[snip]

another part of the answer lies in what hasn’t happened to the men on that Fortune cover — namely, they haven’t been forced to give back any of the huge paychecks they received before the folly of their decisions became apparent.

[snip]

The point is that the subprime crisis and the credit crunch are, in an important sense, the result of our failure to effectively reform corporate governance after the last set of scandals.


Note that he shifts from a criticism of current executive compensation systems to a proposal to reform corporate governance. The idea is that, since executive compensation is both directly costly and promotes reckless decisions and fraud, shareholders would reform it in their own interests if they controlled corporations in practice as they do in theory.

It is inconsistent with free market principles for the government to regulate executive compensation directly.

The problem is that it is very hard to reform corporate governance. The current problem is due to the fact that shareholders rationally diversify so they are rationally poor citizens of each shareholder's assembly. The only shareholders with clout are institutional investors run by managers who are compensated based on the illusion of success. That is, who will watch the watchers ?

I think that we will be able to inscribe "corporations must maximize shareholder value" on our banners about two weeks before we inscribe "from each according to his ability, to each according to his needs"

so What is to be done ? Hmmm how about raising taxes on high income individuals. Yes I know that this is my solution to everything, but this time I have an argument.

High tax rates on huge incomes can have exceptions for socially desirable forms of executive compensation. That is the state can perfectly well say "do it this way or give me 60% of the money" without offending against the constitution or anything.

So the idea is we decide how we want executives to be compensated and oblige them to compensate themselves that way or pay huge amounts of taxes.

The problem, as Krugman notes, is that executives can cash in before the crash and shareholders can't get the money back. This would not be true if compensation was in the form of stock or stock options which could not legally be sold, that is which are a non transferable claim on a stream of dividends. A bit extreme perhaps as it would clearly distort dividend payout policy.

A less extreme version would be a restriction on assets that executives could own other than own firm shares. That is ban cashing in by requiring executives to commit to not owning cash in order to not pay huge taxes. They would be allowed to sell shares of their own firm to consume the proceeds.

It would be necessary to restrict their giving too, so they don't give the shares to family and friends in exchange for secret informal claims on the proceeds of sales.

This proposal would absolutely prevent the housing crisis from causing a recession in the near future, as the way to invest while calling it consumption is to buy houses. The executives evading my scheme would suddenly claim that they want hundreds of houses to live in. Executive compensation laundering through investment in housing would get us over the current bursting of the bubble.

When the CEO's die their heirs would dump the houses on the market. Apres moi le liquidation.

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