The goal of Congressional legislation to control executive compensation should not seek to punish executives but achieve an incentive structure that benefits the American economy.

Malcolm-Wiley Floyd, Staff Writer
Ideology: Moderate Democrat | Writing From: New York City

When the financial crisis of the past year unfolded last September, there was naturally a good deal of public outrage. The media pitted Wall Street against Main Street. It certainly seemed as though the misdeeds of large financial institutions had doomed the entire country to a recession, or perhaps an eventual depression, and innocent, hard-working Americans were going to have to pay the price. This outrage was merited, but it at times manifested itself in inefficient ways, such as with the outrage over executive compensation. Now that the crisis has mostly run its course, banks have rebounded and the economy has begun to pull up from its nosedive, a lot of the public outrage over executive compensation has passed, but the House still passed a bill to let the government regulate pay, which has been passed on to the Senate. In their deliberations, we must hope that the Senate finds a way to respect the productivity of the executives, and regulates pay neither to punish executives, nor to achieve fairness or combat inequality. Instead, the goal of regulating pay should be to achieve an incentive structure that is not destructive to the American economy.

During the crisis, it was easy to demonize executives, especially those who accepted gargantuan bonuses despite their companies’ poor performance. The crisis was spectacularly complicated, and there were no shortage of “bad guys.” Of course, executives at big financial institutions took large risks with borrowed money, but rating agencies were responsible for rating that risk low grade. Then there were the subprime borrowers who took out mortgages they had no legitimate chance of honoring, and the lenders who gave them the money anyway. Not to mention the irresponsible fiscal policy of the Bush administration (yes, I know the Obama administration has taken on much more debt, however, the previous administration served during a time of almost unprecedented wealth and stability), and the overconfidence and shortsightedness of the academic economic community, including the Federal Reserve.

There is something easy about villainizing financial executives, and going after their big paychecks to punish them. However, we must remember how bold the choice to regulate pay really is. In a functioning market, workers are paid what they make for their firm, what economists call their marginal revenue product. In finance, the pay is so high because these executives are responsible for millions of dollars in profit for these companies. It is a fair argument that much of this wealth was illusion. However, that is the best argument for concentrating regulatory efforts on increasing transparency in these large companies, and for strengthening the rating agencies like S&P and Moody’s.

However, the government, specifically the U.S. Treasury said that they want no part of the rating agencies. Even though those two companies, the biggest rating agencies raked in huge profits for giving AAA ratings to questionable debt, the government won’t touch them. The relationship between rating agency and debt issuers is definitely one that needs more regulation than that between the executive and the financial institution. Whether the issue was the lack of transparency on the part of the big banks and financial institutions through questionable accounting and opaque balance sheets, or the lack of due diligence on the part of rating agencies who refuse to bite the hand that feeds them, this issue is more crucial to our economy’s health and security than compensation.

Moreover, even if our government is convinced that the heart of the problem is with compensation, they must respect that executives should be paid in a way that reflects and rewards the often immense they have on their companies’ bottom lines. Reform must not be incarnated as a series of artificial ceilings on pay. Talent will leave big companies for small companies, or switch industries, and the result will be inefficient for the economy at large. Instead, reform and regulation in pay structure should ensure executives are properly incentivized to take appropriate risks.

In the current format, executives are heavily incentivized to achieve short term profits, with little respect for long-term security, so that they might inflate their stock price by beating quarterly projections. Since these executives are often loyal first to their shareholders, and they will be rewarded highly for pumping up the stock price, why should they worry about long-term growth, especially when they know they can abandon ship, with the comfort of a golden parachute? The solution is to increase the proportion of their compensation that is a standard salary, and decrease, bonus and stock options. Reforms and regulations like this respect the productivity of executives, bow to the power of free-market forces, but still realign incentives for actors so that the overall economy is more stable. These are the only reforms and regulations the Senate should consider when they review the House’s bill this fall.