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.
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.
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.
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.