Wednesday, 15 October 2008

Is the War on Greed as misdirected as the War on Terror?

George W Bush had a response to the September 11 terrorist attacks on the US. He declared a "War on Terror". We all know how well that's going.

I'm not advocating that the US should have done nothing in response to the September 11 attacks. I'm saying that when you suspend clear thinking and honest debate in favour of blind belief and misguided loyalty, you get the totally misdirected Iraq war rather than the focus on Afghanistan (the home base), Pakistan (the training ground) and Saudi Arabia (the financier) that the response should have comprised. A proper response would have been messy and complicated, to be sure. It would have involved embarrassing investigations into two nominal US "allies" and brought out into the open the obvious failures in US foreign policy over the years. I believe that the longstanding US policy of cozying up to dictators instead of strengthening ties with democracies led ultimately and inexorably to 9/11. Yet nobody who knew better could talk sense to President Bush, because those who weren't with him were against him, remember? The world is in a fine mess thanks to expediency and moral certainty, combined with a knee-jerk reaction to crises.

Are we in danger now of reacting to the recent financial crisis with similarly misdirected populism? Australian Prime Minister Kevin Rudd today essentially announced a "War on Greed", by attacking the excessive pay packets of corporate executives as one of the negative aspects of what he called "extreme capitalism". And sure, he's got a point, a very valid point. But he's also in danger of being way off the mark, to the detriment of all of us.

Attacking excessive remuneration appeals to everyone (everyone, that is, except those in the top levels of the corporate world). Last year, Macquarie Bank's CEO Alan Moss took home 33 million big ones. This year, Macquarie caused quite a few jitters among investors. CEOs take home the big bucks, and when their enterprises threaten to fall over, governments have to rush in and prop them up with taxpayers' money, because the economy will suffer otherwise. It's like the fat cats have a gun to everyone's head.

So attacking executive remuneration understandably attracts animal howls of approval from the gallery. (Mind you, many of those in the gallery don't even pay taxes! They've nothing at stake, and it's probably just petty jealousy at work.)

Let me make my position clear. I'm a taxpayer, and my money is being used in these bailouts, so I have a legitimate right to voice my opinion about the way the system is run. But perhaps surprisingly, I'm against placing limits on executive remuneration. It indicates a mercantile mindset that believes in rationing out scarce resources. What we need is a capitalistic mindset that recognises wealth to be potentially limitless. The capitalist worldview recognises the need for appropriate systems that incentivise us to apply our ingenuity and industry to continue to create wealth out of nothing, exactly as we have been doing since we left our caves thousands of years ago.

Having said that, there are clearly limits to executive compensation that exist, not absolute dollar limits, but limits that are dictated by the ability of the enterprise in question to pay those salaries and bonuses. If an enterprise pays its top executive $466 million and then collapses, then in hindsight, it clearly couldn't afford the payout.

Many people may miss a crucial portion of Rudd's statement: "Regulators should set higher capital requirements for financial firms with executive remuneration packages that reward short-term returns or excessive risk-taking." (emphasis mine) I agree with the way Rudd is proposing to tackle the problem, which is to impose higher standards of capital adequacy on firms that show short-termism or risky behaviour in pursuit of profits, but there is a deeper aspect to the problem, which I'll come to in a moment.

I do believe that one of the fundamental things wrong with the brand of capitalism practised today (apart from its hostility to competition) is that it rewards companies for showing short-term profits. It encourages CEOs (who serve relatively short tenures) to under-invest in the future and show unnatural returns in the short term, then depart with huge payouts as a reward for such stellar performance. Every new CEO announces that things have been left in very bad shape by their predecessor (true), and then proceeds to write off huge losses at the start of their tenure. Not only does this clear the decks of all past losses, it also takes the share price to a comfortably low level, so that the new CEO can demonstrate impressive share price gains from this low point. Repeat ad nauseam. The enterprise and its shareholders bear the brunt of this short-term and self-serving behaviour. The technical term for this is "agency risk". The goals of the agent (the management) are not aligned with the goals of the principal (the shareholders).

To my mind, the problem of "extreme capitalism" (as Rudd would call it) is the tendency to reward short-termism. So it's not executive salaries per se. If a way can be found to link executive remuneration to an enterprise's long-term performance, then by all means, shower your executives with gold. For example, go ahead and give your CEOs generous stock options, but ensure that they vest only after 5 years or later. That'll make them more careful about the long-term effects of their decisions.

So I've no real argument with Rudd's proposal, as far as that goes.

Is this the root of the problem, though? Perhaps there's really no agency risk here! Perhaps the agents' goals are in fact perfectly aligned with their principals' goals.

We need to look within ourselves as shareholders. What kind of shareholders are we? Are we true investors, who buy stock and hold on to it, wanting a share of the profits of the enterprise in the form of dividends? Or are we just speculators, who buy shares in the hope that we can sell them at a higher price? Speculators don't care what happens to an enterprise after they sell their shares.

I think short-term performance benchmarks rule the market because the market is dominated by speculators.

If we want enterprises to be healthy, we need to encourage long-term behaviour from all concerned. The goals of the principals (the shareholders) must themselves be aligned with the long-term health of the enterprise rather than its short-term performance. Then the goals of the agents (the management) of these enterprises will automatically be tuned to the long term.

Executive remuneration is the Iraq of the War on Greed. It's an expedient target, but likely to prove a costly diversion. The real problem is more messy to target. It's short-termism, and we're all guilty of it as speculative shareholders. To quote Walt Kelly, we have met the enemy, and he is us.

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