Image: The Daily Show

One of the consequences of the global credit crisis has been an unprecedented focus on executive salaries. Particularly when government funding has been used to secure corporate viability, public outrage has been extraordinarily swift and brutal. The bonuses paid to AIG executives hit an especially sensitive public nerve.

It seemed to matter little that AIG had been contractually bound to make the payments and that they had been paid by a new CEO appointed with the blessing of the US government, the company’s new owner, to restructure the business.

Paying according to corporate well being is a radical
departure from the principle of equal pay for equal
work. That goes down the drain. The notion of a living wage is also
sadly diminished…

The idea that the bonus payments would help retain key executives was aggressively rebutted by the likes of New York Senator Charles Schumer, Representative Barney Frank of the House of Representatives Financial Services Committee, and other US politicians publicly interrogating the proponents of bonus payments. According to these politicians, everyone is replaceable. Besides, unemployment is rising. Withhold the bonuses and see if the bonus recipients go or stay.

We will see how far this principle extends at the next election when Schumer and Frank have the choice of conceding electoral success to their opponents or using their incumbency to collect millions of dollars in campaign finances. We will see whether they are replaceable or suddenly become uniquely qualified for the task at hand and an indispensable source of legislative wisdom. Nonetheless, for the time being, they are aboard the electoral bandwagon.

President Barack Obama, as inclusive a national figure as one has seen in recent years, has barely tried to quell the rage. He is on the bandwagon, too. The American people are entitled to be angry, he said. His only qualification was that anger should be directed constructively. Apparently none of his moral advisers have pointed out that historical examples of constructive anger are rare.

Executive tenure is now subject to public endorsement. Just ask Rick Waggoner the ousted chief of General Motors, or Vikram Pandit and Kenneth Lewis who are hanging on grimly to their leadership positions at Citibank and Bank of America, respectively.

Pity, too, the acting chief financial officer of government-supported mortgage lender Freddie Mac, who has apparently committed suicide without there being a hint of legal wrongdoing on his part, so great were the pressures with which he had to contend.

The hypocrisy of the blame game

Many corporate executives have been stunned by the savagery of the reaction against them. And, to some degree, their incredulity is understandable.

The anger has not always been directed against corporate wrongdoing. Given the scale of the economic devastation, there are extraordinarily few accusations of criminal conduct. This is very different to the corporate failures of 2000-01 such as Enron which were due to financial shenanigans culminating in criminal charges or the collapse of the 200 year old Baring Brothers merchant bank in 1995 due to unauthorized trading activities which also resulted in time in jail for the perpetrator and the demise of the firm.

Large trading losses have certainly been incurred but not through dishonesty. They have happened largely for the reasons they always happen: people simply failed to understand fully the macroeconomic environment in which they were trading as they kept betting on the most recent conditions persisting indefinitely.

There is also an element of hypocrisy among those complaining. Few objected to risky trading activities as long as the valuations of their houses or equity portfolios were rising. The cheer squad for these outcomes was a large one extending well beyond North America to Europe and the Pacific.

Despite Australia appearing to be well away from the epicenter of the financial quake and the Australian Prime Minister self-deludingly sheeting home blame for the crisis to others at the recent G20 meeting, Australians had readily grasped the benefits which came with soaring commodity prices, another by product of over-leveraged investment funds fuelled by lax monetary conditions.

The risks from betting national prosperity on increasingly large speculative positions on the world’s commodity exchanges barely registered. The Australian government would have been delighted to have had the frenzy go on indefinitely. They were planning on it happening and Australians were looking forward to more tax cuts as one of the benefits. More hypocrisy here, too.

In a sense, we were all happy to take the upside but reluctant to accept that high returns always come with greater risk. Now, finding someone to blame might help allay our own complicity in causing the crisis.

Success, the new remuneration principle

Congressional hearings, going down the same track and not having uncovered any significant wrongdoing, have converged on a culprit and a new remuneration principle: executives should be paid according to the success of the organizations for which they were responsible. If you run a failing company, expect public scrutiny and a pay cut.

This begs the question of what constitutes corporate success. There is nothing in western country corporate laws to define success. Those laws typically define catastrophic failure (i.e. bankruptcy) and its consequences but never success and there are no legislative criteria to clarify whether one company is more successful than another.

In the vacuum, two populist standards have emerged: success measured by absolute profit and success measured by share price movement. Technically, neither of these has much merit.

It matters a great deal whether a $100 million profit came from investing $10 billion dollars or $10 million, for example. The outcome from the first investment should be considered far less successful than the result of the second investment despite the resulting profit from the first investment being ten times greater than in the second case.

As for stock prices, we know that the same company could trade at plus or minus fifty percent of yesterday’s share price, depending on the future macroeconomic environment, without the company changing what it is doing in the slightest. Why should executives be rewarded (or penalized) for share price movements over which they have had no influence?

New pay rules are needed. At one level, paying people in line with their financial contribution seems justifiable enough. Post a loss and you are shown the door. Make a profit and be rewarded. Basic economics advocates something similar. It suggests paying everyone according to their marginal product (i.e. in accordance with what each contributes).

Economists also argue that economic growth is slowed and welfare damaged if companies are forced to pay workers without regard to the financial viability of the businesses employing them. Hence economists almost always criticize centralized tribunals fixing nationwide wages. Some even oppose national minimum wages as damaging employment growth.

However, paying according to corporate well being is a radical departure from the widely adopted principle of equal pay for equal work. That goes down the drain. The notion of a living wage is also sadly diminished further if a company’s financial position dictates what someone should be paid and not the person’s needs.

The new principles cannot be quarantined to only the most senior executives. Everyone will be brought within the same guiding principles eventually. The new criteria will spread well past the executive floor once governments endorse the change and there are no longer philosophical or legislative barriers to clear when introducing them to the shop floor. The commercial incentive to do this will simply be too great.

We are already seeing workers at all levels being asked to take pay cuts to match the abilities of companies to pay in a recession. Those workers luckily employed by more profitable enterprises are being paid more than those employed in less profitable firms.

Discarding the social responsibility model

Despite the populist overtones to the remuneration revolution which is unfolding, hardnosed economists are likely to be quietly pleased as the world heads toward success oriented pay. This is a reversal of the direction previously being urged on western companies.

Since the mid 1990s especially, there had been rising pressure on business executives to step away from financial outcomes as the primary sign of corporate success and principal goal of their decision making.

Some called it the triple bottom line. Others tagged it corporate social responsibility. Whatever its name, it involved recognizing that rates of return on investment were not adequate measures of corporate impact. There were social and environmental impacts that also needed to be taken into account in assessing the performance of a company.

By definition, a triple bottom line is no bottom line at all. One of the challenges for the triple bottom line advocates was to come up with an objective framework by which to trade off financial, environmental and social outcomes whenever there were any inconsistencies. They never did come up with a workable methodology but that did not detract from the moral force behind the argument.

However, if companies were to be more than simply cash registers, executives had to be empowered to make choices. Directors needed to decide how the value being created should be divided up: how much to employees, how much to suppliers, how much to shareholders, how much to deserving community organizations and at what cost to the physical environments in which the company operates.

In making the company more socially responsible, executives needed to be able to make a judgement that an employee or supplier, for example, did what was asked of him and deserved to get rewarded despite the overall financial performance being unsatisfactory from the perspective of a shareholder.

Under this model, the satisfaction of the shareholder was an important but not the primary concern and executives needed the freedom to exercise judgements about the right balance.

Unfortunately, this is precisely the discretion being stripped from the repertoire of the modern corporate executive as he is forced to make an unequivocal commitment to financial success.

The pressures in this direction seem unlikely to abate quickly. Governments will spend the next decade looking to maximise the financial returns from their recent equity purchases as they spruce up their holdings for sale. Executives will be trying to repay loans as quickly as possible as they seek to extract governments from their boardrooms. Meanwhile, employees will remain too scared to dissent while their jobs remain under threat.

Out of all of this, we might end up with a better system; we might not. Right now, it is a little hard to tell but the risks are pointing to a much harsher and more financially oriented world for all of us and not just for the elites in the executive offices who have been the targets of so much public anger.

John Robertson is an economist and corporate investment adviser. He has had over 25 years experience in international financial and commodity markets, corporate strategy, financial and business evaluation and government policy in Australia, London and New York.

John Robertson

John A. Robertson is a consulting economist with a background in investment management, corporate strategy and public policy. He writes the weekly ‘From the Capital’ column for London-based Mining...