The end of the party or the start of a new one? Observations on the financial crisis.

It has been a busy time for academic economists in the past few weeks. Every lunch break has been dominated by talk about all the goings on in the markets and the government plans that are coming thick and thin. We are trying desperately to remain more knowledgeable about the crisis than the next journalist calling the school for a ‘considered opinion’. It will be months before the vague policy announcements will actually have been written down and implemented, and it will be years before we fully digest the train of causality of the last few weeks, so any lessons are by necessity preliminary. What we can do is to spot the winners and losers from the last few weeks:

  1. (for households) Those with big mortgages win, those dependent on stocks or interest rates lose. It is thus a bad time for pensioners and others who have paid off their mortgage and see their housing prices go down. It is a good time for young, relatively poor, couples with high mortgages, or even solvent families looking to buy a house: interest rates have gone down and can now be expected to drop another percent or 2 in the next year, and house prices will be low for a while.
  2. (for economists) Boom time for economists, bad times for financial analysts. The demand for economic advice and our products has never been so high. As a profession, we are on the news all the time, taxi drivers ask for our opinion, long-lost family members suddenly rediscover us as a source of advice, etc. We are all expecting the student numbers to go up again next year as economics is in the news so much. Though it sounds like being an undertaker at a massacre, it must be said that its an exciting time to be an economist. Financial analysts however can expect tough times. There is almost undoubtedly going to occur a shake-out of analysts and financial advisors, if only because the profit margins are squeezed from which these analysts live.
  3. (for regulators) A bonanza for regulators. Calls to increase the number of regulations on the markets are almost universal. Australia is doing it, the US is doing it, Europe is doing it. Great times to be a lawyer or a regulator of markets. The control of the state over the economy looks certain to increase, certainly in the short run. Indeed, apart from the Brits, none of the other countries seem to have given much thought to how to get rid of the regulation after a while. The structures now being built in the US or Europe (direct interference) to regulate the financial markets may be with us much longer than we would like.
  4. (for economic theory) The return of Keynesianism. Animal spirits are back. This financial crisis is universally regarded as a bank run and a wave of pessimism. No-one believes this is a Real Business Cycle fluctuation, or that the bout of unemployment we are going to see shortly is due to workers taking a holiday (which, believe it or not, is still a dominant idea in economic theory land). In the background, the anxiety about bankruptcies and unemployment probably heralds an increased role of networks in our theories of the economy: what gets destroyed in a bankruptcy is not education, physical capital, or technology, for they all survive. Hence, classic production factors wont go down and wouldnt be able to explain the coming slowdown. What are destroyed in bankruptcies are the relations between suppliers and consumers, between intermediaries and final good producers, between workers and specialist machinery. I expect more theories to emerge reflecting the importance of the specificity of these links. The notion of trust, which has been all but declared taboo in economic journals recently, also looks certain to make a glorious return to the fold.

Apart from this array of winners and losers, the financial crisis has thrown up a whole set of questions about what to do next. It is hard to say with any certainty what will and should happen, but here goes for a best guess:

  1. Is this the end of capitalism, i.e. growth fuelled by greedy private entrepreneurs looking to gain personally from their endeavours? Of course not. Whilst the capital markets are in difficulty, the overall economic story of this decade is the 7% sustained growth in India and the 10% sustained growth in China, both fuelled by raw capitalism. Neither of those countries look like killing the goose that lays the golden eggs quite yet. The balance of power between state and private enterprise will shift a bit further to the state within OECD countries for a couple of years, and that is probably all that will happen.
  2. Are we going to curtail CEO pay? This is probably the deepest and trickiest issue of all. CEO pay has been increasing relative to other workers for decades now, and despite a lot of banter in the media about it, the politicians have let it happen. The basic problem is that pay has probably increased because managers have more control now over their organisation, yet they dont own the organisation and hence have needed to be excessively bribed by the owners to do the right thing. The underlying reason for the pay increase is probably that managers have become more powerful in their businesses: advances in internal information technology has meant most big organisations have been able to get rid of middle-management, with only a small layer of top-managers now pulling the financial strings of large organisations, aided by various automatic accounting levers and loads of low-level bureaucrats enforcing their wishes at lower levels. The loss of middle management means the loss of true internal alternatives to current management: only current management knows what goes on and is hence to a large degree irreplaceable. Yet, managers usually dont officially own the company, so the actual owners have no real alternative but to agree to enormous pay packages for CEOs. The basic problem of control being increasingly in the hands of people who dont own the organisation is what in my opinion has lead to greater CEO pay and its hard to see what can be done about it for most large organisations. The various options on the table all have their own problems:
    1. If you base pay on long-run performance (for instance by paying them for the stock value 10 years later) in the hope of putting the incentives towards the long-run then you run into the problem that this will be sabotaged by the managersm, who want the rewards whilst they are still young enough to enjoy it, not after retirement.
    2. If you base the pay on stock performance in the next two or three years in order to use market signals to inform the level of pay, you have the difficulty that this is a short-run incentive which the managers can game (i.e. they know much better than anyone else how to make the short-run profit streams look good even if the long-run health of the organisation is being jeapardised). Indeed, this is what has happened.
    3. Direct prohibitions on pay can be circumvented in many ways, for instance by having the organisation buy assets of the CEO at greatly inflated prices as part of the performance contract. If you wish to counter all the ways in which direct pay measures can be countered, you will thus need extensive legislation on nearly all the deals made by managements. This would involve interference in nearly all parts of the business.
    4. If you put government representatives on the Executive Boards of companies in order to keep an eye on the managers and circumvent the issue of buddies appointing each other to these Boards, then this is first of all a direct political interference in business but also means that the government becomes an even bigger target for political coopting, eventually undermining the credibility of government.
    5. Perhaps the best way out is to simply allow for high CEO pay but to have punitively high taxes for high incomes. Managers who then move abroad because of higher incomes are the kinds of managers you didnt want in the first place (because they are solely money oriented and hence were the ones most likely messing up the business for personal gain). Also, the market does have some mechanisms for self-correction, such as increased ownership concentration giving a single shareholder an incentive to monitor the CEO more carefully, though these appear not to have had much effect on CEO pays so far.
  3. Rule Brittania. I fully agree with Ingolf’s piece . The plan of the Brits to recapitalise their backs by means of voluntary additional preferential share floats is by far the most practical and best plan I have seen.
    1. Its voluntary nature means banks can opt out. Because the government only buys those shares the market doesnt buy at the going rate, the correct price is given by the market and existing investors are enticed to start investing again.
    2. It is also the option that has a clear exit-strategy: as soon as stability returns, the government can sell the shares on the open market and hence cease its interference.
    3. It is furthermore one of the few plans that dont mean the taxpayer is bailing out rich investors or managers. Indeed, I expect the Brits to make money on their plan since the value of the banks will rise fast once it is clear they wont fail, implying that the government can expect to make a tidy profit for the taxpayer on this plan. In all ways, the Brits got it right. The distance between high-class economists and policy makers in England has proven itself to be very small, something both the Americans and the Australians can learn from.
    4. Compare this to the abysmal plans of the Americans (and I fully agree here with Nick’s observations though I am less positive about detecting some hidden brilliance in Bernanke’s support for it). The original plan to have a reverse auction for bad assets of many diverse banks is incredibly hard to implement. You can only implement a reverse auction if the assets bidding against each other are roughly equal in terms of risk, which means you have to carefully credit rate all the assets sent to the auction. That cant be done in a hurry. You need a long time to credit-rate all the bad assets into homogeneous groups so that you can actually organise the auctions. There are immense lemons-market information asymmetries in the whole scheme, relating to the assets the banks will put forward and those they will actually bid for. Even once they are sold, the split in servicing and ownership (as I understand it, the original banks keep servicing the assets but cease to own them) creates free-rider problems. The heavy political interference also gives rise to immense opportunities for lobbying and political rent-seeking because the allocation of assets to risk-groups is highly sensitive to corruption. The original plan is thus an implementers nightmare and the plan is best forgotten altogether. It probably will be implemented in some form simply because too many people would lose face if it is not (including Bernanke and the US Senate). The combined plans of the Europeans via the G7 and G20 appear mainly made up of smoke and mirrors, so there is less to worry about there.
    5. The deposit guarantees handed out by various countries, including Australia, are far more difficult and onerous than they seem and should not be seen as good policies at all. If you truly guarantee all deposits, then the whole risk pricing system gets incredibly distorted and you end up with the danger that everyone sends you the bad assets because you guarantee them, whilst the good assets go elsewhere at higher rates. To be able to differentiate between private\bank deposits, national\international depositors, savings\non-savings is possible ex ante but is heavily subject to gaming after you introduce your guarantees. Hence the nitty gritty of these guarantees is full of thorny issues and I would hate to be the Australian lawyer having to draft this legislation. There are so many ways it can go wrong, that I almost hope these guarantees will quietly leave the table before they are implemented. Lets hope this was one of these spur-of-the-moment plans that dont actually happen or else have some self-destruct clause in them.
  4. Are we going to see some international system of financial regulation, like Bretton Woods? Despite the calls in this direction, I cant see it happen. The coordination would require developing countries to be on board too. At the end of the day, each individual country will opt out of anything they see as against their interests, with various countries benefitting from laxer financial regulation to the others. Hence a truly joint plan looks dead in the water before it is even floated. Good ideas, like the old Tobin tax idea to put a small tax on every financial transaction so as to discourage frivolous money flows and hence avoid the endless repackaging and re-selling we saw this time around, are still good ideas but the coordination needed is too much to ask for.

There are some truly staggering events that have taken place the last few weeks for which it is hard to give a satisfactory explanation. Perhaps most baffling of all is the behaviour of the US congress with respect to a half-baked rescue plan that entailed a direct transfer of the taxpayer (i.e. the middle classes) to the fairly well-off (your average investor). Just think about the basic message they swallowed: there is this thing called market confidence which my crystal ball tells me will return (i.e. no evidence at all) if I give money to the rich and tax the poor. Then market confidence can go back to saving the poor, even though it hasnt helped them the last 30 years (relative poverty has gone up in that period). The degree to which Democrats were lulled in relative high numbers to support staggering transfers to the rich says something about the gullibility of the elected. The alternative explanation, i.e. that they knew full well whose pockets they were lining in return for promises without guarantees, is too awful to contemplate. As the Brits show, you can devise a plan to restore confidence that costs the rich and probably means a benefit for the poor, rather than the other way around.

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39 Responses to The end of the party or the start of a new one? Observations on the financial crisis.

  1. JC says:

    A small issue on executive pay. You probably are aware that by far the largest portion of total factor comp is stock options based; with the options being set on at the money strikes. How would you prevent the stock from rising in order that the executive doesn’t enrich him/herself from the well performing stock? Honest question.

  2. JC,

    One reason of giving CEO options is to give them high-powered incentives to improve the value of the firm for which the option is like a multiplier with the de facto counterpart a participant in the market (i.e. its like a one-sided bet where the CEO wins big if the stock value goes up and the firm loses a bit if it doesnt). Another reasno is to hide from others that you are paying them exorbitant wages. I cant see regulators preventing either reason. Essentially, you are not going to prevent the stock from increasing and I am skeptical that we will outlow option packages. This is a political judgment call though, what’s your reading?

  3. JC says:

    Look Paul, to be honest and just reading in between the lines the government has a right to be pissed off with one listed bank. The model was based on a debt trap and now the RBA is quite possibly having to fund a hole in their balance sheet or they would have gone bust and taken a good portion of the markets with them. Meanwhile the ex-Ceo and the present dude are walking away like bandits sucking on the public tit assisted with overnight funding because no one will lend to them.

    In fact these banks get into trouble and then go crying to the RBA to help them.

    This is where things start to turn in such a way that is almost impossible to untangle. However if they are sucking on the public tit and receive protection there should be a firm clamp on their comp.

    What about someone like Chaney the Ex-ceo at Westfarmers a firm which would never receive government support and did an excellent job of building a terrific firm?

    How would another firm be able to attract someone of his calibre if they wanted to poach him while there are all sorts of restrictions on comp? Dunno.

  4. the problem of one-sided risks in banks has been talked about for decades in economics, i.e. the virtual certainty that states cant let big banks go bankrupt. This is an important reason to put such high collateral demands on their loans. This is also an important part of Basel 1 and Basel 2 (the accords regulating bank reserves in much of Europe) and to a certain extent entitles the governments to some level of interference with bank CEO pay.

    However, there is actually a direct way the goverment can do something about these payments: governments can legislate emergency laws to tax these specific individuals for specific reasons. I think you can actually do that: you can simply come up with a law saying ‘John has in our opinion given himself money to which he is not entitled hence I am going to define a new tax John has to pay’. Such arrangements are quite normal historically and I can see no really good reason why we shouldnt re-invent them now. Hence the reason we dont interfere with CEO pay is not really because we cant, but rather because, at the end of the day, there is not the political will to do so, probably for fear of precedents. Once they’ve extracted the funds from the organisations in whose interests they were supposed to work, our system is reluctant to punish them ex post for it. For other reasons, I am having a hard time imagining they will truly prevent it happening ex ante by means of necessarily extensive legislation.

  5. JC says:

    I can see you point about bank CEO pay, but about the other CEO’s where the bailout option is never available/ What about those guys?

    the problem of one-sided risks in banks has been talked about for decades in economics, i.e. the virtual certainty that states cant let big banks go bankrupt. This is an important reason to put such high collateral demands on their loans. This is also an important part of Basel 1 and Basel 2 (the accords regulating bank reserves in much of Europe) and to a certain extent entitles the governments to some level of interference with bank CEO pay.

    I think the other issue is that the Basel agreement actually contributed to this mess. It created a huge amount of hubris. Securities were supposed to be the panacea to the problem of illiquidity in the balance sheets of commercial banks which is why securities received very kind treatment for capital allocation imputation compared to a straight loan. In fact, although the reasons were perfectly understandable as great deal of this mess lies there as it expanded balance sheet capacity.

    So why not look at the regulatory mistakes and move from there. Wouldn’t it be far better to leave the comp side alone and let the market figure it out while focusing on what I see as the real problems.

  6. I agree that bad regulation, particularly with regards to the US mortgage market, has been part of the problem, but the basic impossibility of letting big banks go bankrupt means that without any regulation they would take insane risks (indeed, they would go for high-variance, negative expected returns), so there is no real question that you have to regulate. Good regulation is not easy to come by because its all so complex and tied in with the tax system. I dont think there’s an economist alive today truly on top of it all, because there is just too much to track, so I am afraid that regulation will remain a hit-and-miss business.

    As to CEO compensation, I am skeptical that someone who works 100 hours a week for 200 million dollar a year would truly work any less hard or well if you pay them 2 million a year. Hence, from a sheer efficiency point of view the real question is not about work incentives, but about the incentives for non-owning CEOS to wreck the companies. The basic market failure that is now widespread in our governance models for organisations is that the CEOs are not the owners but have large asymmetric information versus the owners. We dont really know how to deal with this as economists. Maybe perpetual liability on the part of the CEO for any action they dont disclose to shareholders? Its a tough one.

  7. rog says:

    Its a problem, now that the defenses are down all sorts of inappropriate theisms are floating around – BBQs are surrounded by financial advisors and suddenly everybody is an expert and emotive populists can erroneously shape the future

    Another fine mess you have got me in Mr Magoo

  8. JC says:

    Hi Paul;

    I think that regulation caused excessive risk as a result of Basle in the way securitization is treated vs straight loans.

    The government should eventually step way and let the market segment and specialize.

    Compensation is very interesting and used to be one we were always discussing in terms of how to comp traders.

    At both extremes you have:

    1. Very high salary no bonus
    2. Very low salary open ended bonus.

    There’s a big reason we always went for no.2 and why the i-banking world was very much tied to that form of comp. Profitability was very variable so we wanted to tie comp on income variability and try to turn comp into a variable cost rather than fixed.

    In some firms there was what was called a “draw”, short for draw down which was a way sales people were compensated as they created next to know risk. A draw allowed the person maximum upside while allowing a minimum draw down in months where sales was slow. The draw down was debited back to the firm in the good months. I actually think outsiders could gain some knowledge in really looking at how Wall Street comped people as “variablizing” incomes could raise total comp for people.

    To my mind there’s a real lacking understanding how wall street functioned over the issue of compensation. It was and always had been a declared strategy on the part of firms to link compensation to:

    1. Individual performance
    2. individual comportment in terms of how the person related to the rest of the team.
    3. Company performance
    4. Competition from competitors for your traders.
    5 How ho the area was.

    I would actually argue that the variability of income is something that most firms outside of Wall Street would love to see particularly in very cyclical businesses such as…. well airlines etc.

  9. Hi Jc,

    well I agree that pay packages always have some rationale about them though I do not know the intricacies of the financial pay packages you cite. The question for economists though is why the pay packages for CEOs have risen so much faster than for the median workers and whether there is any market failure involved. My preferred answer of shifting balances of power between the owners and top-insiders, indeed involves a clear market failure, i.e. asymmetric information. Because the asymmetric information is so local though, its not straightforward to see how a blanket regulation on compensation packages is going to ‘correct’ the underlying shift, which is why my vote would go for either tackling the wages ex post via the tax system, or else toy with liability rules.

    Markets tend to specialise if there are clearly different consumers, so I’d surmise one reason they havent segmented that much sofar is that most institutions are chasing the same thing (high returns with risk spread around). The reality that that is what the investors want would seem to limit the degree to which one can expect specialisation in the future. Sure, one can chop up the business in various forms of services (assessment, management, procurement, etc.) but the usual complementarity argument would seem to apply again as an argument for why they would be bundled into one organisation.

  10. JC says:

    My reference to market segmentation refers to the question of safety, or the degree of safety people would like.

    I witnessed various examples of that in the early 90’s when Republic National Bank was selling itself as being the only triple A bank with an equity to debt ratio of 4:1. If people wanted almost certain safety but with much lower rates RepNat your bank.

    Legislating salary caps would produce two outcomes as far as I see. It would make it more difficult to attract a new hire as the risk of leaving one firm for another carries some really steep risk and if you’re at the top and fail it’s very hard to get another job. The other problem that there will be a big push towards privatizing (outside of banking.

    Lastly how does one morally justify telling a person to sell his/her labor below market rates? We would then be demanding people sell their labor service below what they could obtain otherwise. That’s wrong.

  11. derrida derider says:

    The debate about Basel is interesting. I’m too ignorant of the issue to have an opinion either way (unusual, I know; ignorance is not normally a barrier to opinion for me or anyone else). But if indeed the effect of regulation of balance-sheet risks was just to create a market for off-balance-sheet risk then it seems a fine illustration of Goodhart’s Law (which law is one of the reasons regulation is very hard).

    It’s a good post, Paul, and adequate comment on it would need a post about as long. A quibble – I’m no fan of RBC theory as it currently is (though I think DSGE’s are the future of macro), especially because of its inadequate explanation of unemployment in a recession. But that explanation is a bit more nuanced than just “workers taking a holiday”.

    But you’re right that the current downturn could be called “Keynes’ revenge”. It’s time to dust off the General Theory.

  12. Derrida,

    thanks for the praise.

    I think it unfair to blame Basel for the problem. There is simply no alternative to regulation because of the fact that the state cant walk away from being the de facto guarantor in case of a bank run. This inevitably means big financial institutions have an incentive to take risks for thing they wont eventually have to pay if it goes wrong. Of course regulating X means that the sector will then try to circumvent X, but that shouldnt mean you shouldnt regulate X in the first place. All that the reaction means is that you’re in a never-ending cycle of regulators versus people trying to dodge the regulation. It means regulation is not a one-off event but a continuous process.

    As to the quibble, you are right that there are many nuances in the many versions of RBC theory, but the bottom line of many ‘labour shocks’ in the models still being used is still mass holidaying by workers. Its more subtly worded as it uses terms like ‘shifts in the labour-leisure preferences’ or ‘shifts in the marginal cost of employment to labourers’, or ‘unanticipated ex post frictions in hiring’ but in plain English it still means workers taking a holiday.

    the point about blaming increased information asymmetries for the increase in CEO pay is that this would mean CEOs are not getting paid their marginal product. Rather, they are getting paid according to the marginal damage they are able to inflict on their organisations if they are not kept happy.

  13. JC says:


    I don’t think we need to have the state act as guarantor to the banks. this seems to be a recent invention. I don’ think people thought that way during the last banking problems we had in the early 90’s. It seems to be a bad habit we’ve picked up from the US. There was of course some help when Westpac and Anz were on the skids but it never looked as though they were going to be guaranteed.

    High or low income earners should have the right to sell their labor to the highest bidder when labor markets or sectors of the labor markets are relatively unhampered. It’s an injustice otherwise.

    Recall what we had in the past? The same establishment names showed up to collect what they thought was their entitlement. A meritocracy is so much better.

  14. Paul,

    I didn’t suggest Bernanke’s stance was the result of “hidden brilliance”, rather of evident weakness of character. (Or apparently evident weakness of character).

  15. Ingolf says:

    JC (and Paul), I think the executive pay problem is rooted in the fact that ownership is far too dispersed at public companies. In the absence of meaningful ownership oversight, the board and top management have gradually become a self perpetuating and self-serving cabal.

    I don’t think they’re really holding the companies to hostage, as you seem to imply, Paul; it looks more to me as if they’re simply looting them. Under the lax conditions of the last 20 years or so, the escalation of executive pay has become such a commonplace that I imagine most of them don’t even see it as such. It became self validating.

    Seems to me it’s a classic case of concentrated power vs dispersed power and is a more egregious case than usual only because, rather than having to lobby for favours, top management gradually gained control of the treasury themselves.

    There are, of course, many other contributing factors (the most idiotic of which may have been the idea that tying management remuneration to the share price would produce good long term results) but they all seem subsidiary to the ownwership/control conundrum.

  16. melaleuca says:

    “There are, of course, many other contributing factors (the most idiotic of which may have been the idea that tying management remuneration to the share price would produce good long term results) but they all seem subsidiary to the ownwership/control conundrum.”

    Well you’ve left out the cultural component- exec salaries outside the Anglosphere apparently haven’t exploded in the same way:

    ” Interestingly, hyperinflating executive salaries are an English-speaking phenomenon. Elsewhere, including Japan and continental Europe, executive salaries and the overall income shares of top earners have stagnated.

    While Canadian executive pay cheques have generally mirrored the American trend, in French-speaking Quebec they have not.–super-rich-are-back/2006/05/22/1148150186479.html?page=fullpage

    Cross cultural comparisons are always useful. The so-called free market is in part a social construct. It’s much more than that of course, but buying and selling nonetheless takes place in a cultural setting.

  17. Ingolf,

    I wouldnt put it as starkly as ‘looting’ but I agree with the gist of what you say. Indeed, that’s why greater concentration of ownership is mentioned as a ‘market solution’ in the post. This is also partly the explanation of why other countries have not fully followed the Anglo example. The system of strong bank control in Germany and, more or less implicit, state oversight in many other European and Asian economies have prevented the same things happening there.

    However, merely noting the trend in Anglo countries is the starting point of an analysis, not the end. Why has this happened? Dispersed ownership has been with us for a long time now, so something else has happened. It is not helpful to simply say that managers have become more greedy and more powerful, because without knowing what happened it is hard to see what the optimal response should be, if indeed any response is warranted at all. My offered explanation was increased power due to IT innovations allowing top management to get rid of the internal competition (middle management). That also gives a possible market response: the re-introduction of middle management, perchance as agents directly appointed by shareholders.
    The literature does give other explanations, which lead to different proposals, but the disappearance of middle management is a front runner.

  18. Ingolf says:

    Very good point, Melaleuca. Your comment reminded me of a brief piece I saved on Toyota management pay vs GM.

    June 22 2007 (Bloomberg) — Toyota Motor Corp., the world’s biggest automaker by market value, will increase the total amount of executives’ bonuses by 33 percent for the year ended in March after the company posted record earnings.

    The automaker will pay a total of 970.5 million yen ($7.8 million) in bonuses to its top 32 executives, including President Katsuaki Watanabe, for the previous fiscal year, it said at its shareholders’ meeting.

    [ . . . ]

    Toyota’s 32 top executives and auditors received 1.5 billion yen [$12.06 million] in salaries in the 12 months ended March. Nissan paid its top nine executives, including Chief Executive Officer Carlos Ghosn, 2.52 billion yen in salaries.

    In comparison, General Motors Corp. Chief Executive Officer Rick Wagoner’s total compensation for last year was $10.2 million, the company said in a U.S. regulatory filing in April.

    Paul, maybe I’m being too simplistic but I don’t see any real mystery in why this has happened. Dispersed ownership has, as you say, been with us for a long time but management pay levels were in the past probably constrained by the sort of social factors mentioned by Melaleuca. In recent decades, the notion that “greed is good” and that pay should be linked to performance overwhelmed the cultural constraints. The greatest bull market the world’s ever seen didn’t do any harm either; it made shareholders and even workers less inclined to be stroppy.

    In this manic and star struck environment, management, in effective collusion with their boards, were free to set their own pace. I don’t think “looting” is at all too strong a word (and bear in mind I come at these things from a small “l” liberal perspective). The fact that it was in most cases “legal” doesn’t mean it wasn’t a form of theft.

    Now, finally, with the end of the boom this unhappy trend is beginning to reverse. I’d imagine the backlash has a very long way to run.

  19. Ingolf,

    for me, “In recent decades, the notion that greed is good and that pay should be linked to performance overwhelmed the cultural constraints. ”

    is not a good enough explanation. For one, I dont buy the notion that people were less greedy in previous decades. Its a nice idea to think people were somehow more fuzzy and nice in decades and centuries gone by, but bogus nonetheless. On any objective front, we are now less greedy as societies then we were, say, 40 years ago. The level of transfers to the poor we keep voting for dwarfs the levels seen in the 1960s. Crime is down, volunteer work probably just as high.

    So if were just as greedy previously, what made up the mythical ‘social constraints’ that prevented CEOs from giving themselves the millions they undoubtedly already wanted to give themselves? One needs a story for what constituted the culture within organisations and why that has changed. Disappearing middle management fits the bill on both counts: their disappearance means internal culture becomes more orietned towards adultation of the top, and it strengthens the bargaining power.

    Why does it matter whether you have an easy hand-waving moral explanation or a hard-nosed economic one? The hand-waving moral explanation gets you into the impossible position of calling for some kind of return to moral rectitude in the hop that that will magically solve things. Worse, relying on moralising might make you actually believe you can run the economy without allowing for greed and hence wreck it. The hard-nosed economic explanation gets you into a discussion of actual regulatory actions one can take and into discussions about how you can change the operation of companies.

  20. JC says:


    for me, In recent decades, the notion that greed is good and that pay should be linked to performance overwhelmed the cultural constraints.

    is not a good enough explanation. For one, I dont buy the notion that people were less greedy in previous decades.

    No but you didn’t have the ease with which people can move around from center to center if the money is good. People think of nothing these days to move jobs from one continent to another. The globalized nature of the US industry to choose what they think are the best executives moved this along. This has been going on for the past 20 years and accelerated in the past decade.

    Searches for CEO’s of top firms are global these days and the package is in easy to understand currency- US dollars.

  21. Ingolf,

    the observation on mobility goes the wrong way for you, because by implication you are suggesting people were not pait their marginal product previously but now that they move around, they do. This not only goes against the observations on the different CEO pay trajectories in different countries, but more importantly would mean that you should not want to curtail these CEO wages because there is no market imperfection underlying them: they are just paid their actual worth. Then, if you curtail them in one place, all the good ones go elsewhere and you are just hurting yourself. Indeed, if mobility is truly the smoking gun, then the call for moral rectitude is going to be resoundly ignored and laughed at.

    In my story (well, not only mine, its a standard story), mobility would mainly increase CEO pay diversity (because you have more observations on their performance there is les averaging towards the mean) whilst the whole level of pay of CEOs gets increased due to the increased assymmetry of information between owners and CEOs due to the loss of middle management.

  22. JC says:


    Shareholders as a whole don’t really give a shit about CEO pay when the firm is doing well. In fact it seems to me that it’s the outsiders who do.

    The average shareholder looks at the AGM resolutions/votes and throws them in the can like i do. The only time CEO comp becomes an issue to shareholders is when the firm is crapping out.

    Shareholders are very much concerned not the see anything rocking the boat when the firm is doing well for fear of interfering at the wrong time and fortunes change. The last thing a shareholder wants to see is the CEO or senior people leaving when the firm is doing well. Check out the stock price when a good CEO leaves a firm and you will see it slide. CEO’s are very important to the future of the firm or at least they are perceived to be by shareholders.

    The only person agititating against CEO at AGMs is Steve Mayne with his 50 dollar investment that allows him entry to the AGM and make an ass of himself. I went to one AGM where he was shouted down by the other shareholders for making a complete clown of himself. However you never read about that.

  23. JC,

    sure, shareholders dont want to rock the boat because they have asymmetric information. Other people who know far more than they do about the company are running them and the individual investor doesnt have enough of an incentive to find out what is really happening. The question is why they are now willing to put up with a whole lot more ‘not rocking the boat’ than before. I find it improbable that the CEOs were somehow grossly underpaid before, or that we’ve gone into moral decline. I want an explanation that makes economic sense.

  24. JC says:

    I find it improbable that the CEOs were somehow grossly underpaid before, or that weve gone into moral decline. I want an explanation that makes economic sense.

    Because the entire world is bidding up for good ceo’s or who they think will be good ceo’s. That’s one of the facets of globalization.

    In the old days dickhead incompetents would sit at their jobs for decades with poor results and none could do anything about it as there wasn’t much to choose from. it was mostly a school tie thing.

    Roll the tape back 25 years and take a look at the BHP executives staff and the board. They went to the same kindergarten, the same schools and uni. They were so inbred you couldn’t tell them apart as they all looked the same.

    Take a look now. The board is international and the senior heads came of Sth Afr., the US, Sth Amerm, australia , the UK and Europe. Which system would you prefer? The inbreeds or the international grouping with really great credentials?

  25. JC says:


    The firm has had a return on equity of 25% for the past of the 6 years the CEO has been on the job. He currently earns $6 million. He just received an offer to run a firm in the US for $10 million with a $10 million golden para. He says he’ll stay if you match the offer. Although the rest of the lower execs are good, you don’t think (as the chairman) they will be able to match the present guy’s abilities. You engage a search firm and they tell you that the going replacement rate for a second string guy is the same as the offer on the table for the current CEO. What would you advise the board to do? Honest question as these are the sorts of problems that come up.

  26. JC says:

    Sorry, I meant Paul.

  27. JC,

    oh, I am not suggesting anyone makes suboptimal choices here given the constraints. However, I am not sure I believe your description of the CEOs of the 60s and 70s as all being from the same school. Social mobility wasnt much different then from now. It was also the age of the engineers, i.e. more CEOs will have been experts at what their firm did rather than experts at people manipulation. You are effectively saying the latter guys are far more productive than the former. You also seem to pick the stories where CEOs appear they might actually be productive. I am sure Ingolf can give you a whole drawer full of stories of what he would call looting. Are you prepared to say that is also a big part of the current situation or is nearly all productivity in your book?

  28. Ingolf says:

    Geez, Paul, this conversation would be much more enjoyable if you responded to what I write instead of what you read.

    You’ve somehow managed to draw the conclusion I was offering was a “hand waving moral explanation” as opposed to one of your hard nosed economic one[s] and then gone off on an extended riff based on that assumption. I guess it was the mention of the word greed.

    What I said was that pay levels were in the past probably constrained by the sort of social factors mentioned by Melaleuca. In recent decades, the notion that greed is good and that pay should be linked to performance overwhelmed the cultural constraints. This wasn’t a moralistic judgment, simply a reference to the fact that a shift in perceptions occurred in the 1980s and onwards. It came to be more and more accepted that greed, properly harnessed, could bring about beneficial change. Allied to this shift was a growing consensus that good would also come from linking executive pay to performance. You may disagree with this analysis, of course, but you should respond to it in kind rather than misreading it and then imposing your own prejudices. (I assume, by the way, we can at least agree that cultural factors actually have some bearing on behaviour.)

    I then added The greatest bull market the worlds ever seen didnt do any harm either; it made shareholders and even workers less inclined to be stroppy., a fairly obvious statement that JC clearly agrees with. This wasn’t a moralistic judgment either, just an attempt to further sketch in the outlines of the environment in which so many insanities were able to take root and, for a time, prosper.

    By the way, no argument at all about greed always being a factor. As I said in another thread where JC had raised the topic, I also agree with you on greed. Citing it as a contributing factor is simply a truism. Besides, for the moment theres more reason to worry about its wobbly twin, fear.

    As to what to do about it all, that’s a tough question. In pragmatic terms, much of it will probably be taken care of (for now) by the backlash in attitudes that’s already well underway. Indeed, it may all end up running too far the other way, as usually happens when markets badly overshoot. Longer term, I suspect(amongst other measures) the structural imbalance of concentrated power vs dispersed power I mentioned earlier will eventually have to be addressed.

    By the way, it was JC making the argument about mobility, not me. I think there must be at least some validity in that notion, but I’m not at all sure how much.

  29. Hi Ingolf,

    I am afraid we are not converging. I still disagree with your insistence that greed is part of the explanation for rising CEO pay. If you agree greed has been a constant companion, how can it explain the rise?

    The bull market story also sounds suspect: if people become less stroppy about other people’s pay, why has this occurred at the top of the payscale, rather than at the bottom of the payscale? Simply mentioning the trend in the market and claiming a one-sided shift in attitude doesnt strike me as an explanation at all.

    The same really goes for the statement “It came to be more and more accepted that greed, properly harnessed, could bring about beneficial change. Allied to this shift was a growing consensus that good would also come from linking executive pay to performance.”
    In what way would the outcome of a market negotiation depend on a general concensus in society that greed can be harnassed for good or that performance should be linked with pay? Surely the laws of demand and supply held just as well in times when it was not a concensus opinion that good could come from greed? And are you suggesting that before there was a concensus that performance would be linked to pay, that individuals were happy to be grossly underpaid? That would only work if there was a strong social norm within companies for which shareholders were willing to forego profit too. All that needs an explanation of its own.

  30. JC says:

    I would also say the search and compensation consultancies they own has caused the “problem”.

    Annually boards buy up the research of the international consultancies that most times are aligned with the search firms. Boards use these stats to get an idea where the senior execs line up with the peers around the world in equal industries …..size etc….

    These consultancies can earn up 30% of total comp through a successful placement. 30% of $5 million isn’t as good as 30% on $10 million.

  31. Ingolf says:

    Paul, it seems to me you’re still arguing with a straw man largely of your own construction.

    I’m not insisting that greed is a part of the explanation. As I thought I’d made clear, “greed’ is pretty much always there, sometimes latent, often in full swing. What can change from time to time is the degree to which societal and/or institutional constraints impede its free operation. Melaleuca made this point well.

    As I see it, two primary factors unleashed the extreme relative growth in top level pay. The first is the change in attitudes I outlined in my last comment. Acquisitiveness in all its forms little by little became far more acceptable, not only because of a widespread belief the pie was growing (and so we all might get our slice) but also because the idea of “high achievers” being grandly rewarded in this life became firmly embedded. Just look at sports stars, for example.

    As this shift became more pronounced, anyone in a position to capitalise on their position or skills (most aren’t, of course, hence the relative change) felt more and more free to do so. Not so much by any conscious decision, I don’t think, more through a process of slow osmosis. Since the period we’ve been living through was one of quite extraordinary all round excess, the rewards for the winners in this battle were beyond anyone’s imagination of only a generation ago. If, as I think JC believes, CEOs had simply been the beneficiaries of supply and demand forces (however much some of us might think they’ve been of the hot house variety!), this would have been largely unobjectionable. I don’t think that’s the case, or more accurately only in part.

    Which brings me to what I see as the second principle factor, which I mentioned first up: . . . . its a classic case of concentrated power vs dispersed power and is a more egregious case than usual only because, rather than having to lobby for favours, top management gradually gained control of the treasury themselves. As the boom times rolled on, any resistance to disproportionate CEO pay was gradually overwhelmed: shareholder power, as we both agree, was far too dispersed to be an effective counter; performance based pay became an accepted commonplace and was, as often as not, tied to factors (like the share price) over which management had only marginal influence but which brought huge rewards as the market rose; corporate stars were lionized and the inconceivable became the new commonplace. As I said right at the start, I don’t think most CEOs (or their boards) would have seen what they were collectively doing as unfair, much less as a form of looting. It all became self-validating so long as the boom went on.

    Nevertheless, this small group in effect possessed the keys to the kingdom, had in fact done so for a long time. What changed, I think, was that as the new gilded age rolled on they came to feel they had the right, indeed the obligation (Goddamn it!), to put them to full use. And, unsurprisingly, they did.

  32. Patrick says:

    I actually wonder a bit about all that Ingolf. How much is what you describe just a function of scale?

    I’m sure that the last gilded age featured a bit of appropriation of the kingdom – indeed wasn’t that one of its hallmarks? Perhaps the difference was at least in part about how much bigger the kingdom had become. This may also help explain Paul’s reluctance to believe that shareholders (and boards) would willingly forego profit in order to pay CEOs exorbitantly – when the company’s profit is a couple of billion or more, a few tens of millions doesn’t seem so much after all.

    Whilst I certainly think your analysis of the power imbalances has merits and is part of the answer, I just wonder how substantial a part it really is.

    Another thing I’m very sceptical about is the influence of consumption inflation. Although I know that some people like to argue about it, indisputably ‘ordinary people’ are now unimaginably better off than their forerunners of even the last gilded age. And the improvements are extremely substantial – health, education, longevity, access, etc. I wonder how many beautiful cars makes you as much better off than someone with one than one makes you better off than someone with none? How big a yacht might achieve the same effect? How many mansions make you as better off than someone with a small single-fronter as five extra years of good health makes you better off than someone without them?

    Call it compensation for the diminishing marginal utility of money if you like.

  33. Ingolf,

    we seem to be at loggerheads over what counts as an explanation. Where I agree with you is the basic observation that CEOs managed to get control of the ‘treasury’ of the firm and have gradually been able to overpower internal and external barriers. The question is how this happened. Call me an old-fashioned Marxist, but if we agree that the underlying motives of the actors havent changed (greed springs eternal) then the reduction in barriers to CEO greed must have come through shifts in the underlying economic structure which is where I search for explanations. The shifts in attitudes within and outside the organisations then came as a result of the shift in economic reality, not its cause. You seem to say (and forgive me if this is a misinterpretation) that the CEOs always were in control anyway (i.e. no shift in economic ‘understructure’) but that shifting societal attitudes previously constrained them in their greed, and that the shacckles have been coming off (i.e. the morality was the barrier). Hence you see the shifts in attitudes as the first mover which for me simply begs the questions I asked earlier: how at the local level can ‘societal attitudes’ counter the laws of demand and supply to the extent necessary in this case? And where then did this shift in morality, which did not occur to the same degree elsewhere, come from?

  34. NPOV says:

    “This may also help explain Pauls reluctance to believe that shareholders (and boards) would willingly forego profit in order to pay CEOs exorbitantly…”

    But it’s not just profit that’s foregone – it’s the opportunity to pay the rest of the staff more. You talk about “what’s a few 10s of million in extra CEO pay if the company’s profit is in the billions”, but if such a company employs 10000 workers, those millions could have just as well been divided up as pay raises for the 9999 workers under the CEO. It would be nice to think that “market forces” should be enough to encourage companies to pay their workers better, but realistically very few workers are going to leave their job for an extra thousand dollars a year they might get working elsewhere. The upshot of which means that in many (if not most) cases a board will see more benefit in paying the CEO an extra million rather than modest pay rises across the board, even though there’s good reasons to suppose that we would *all* be better off if corporations consistently agreed to moderate CEO pay increases and redirect the money to other workers.

  35. Ingolf says:

    Agreed, Patrick, the sheer scale of the boom was a major factor; as I said, the inconceivable became the new commonplace. And yes, no doubt plenty of shenanigans also went on in the last gilded age although I think there was one vital difference in that those raking in the big rewards in those days were principals, not the bureaucratic CEO types we’re talking about. More like Gates or Ellison, or Forrest for that matter. Although some will no doubt also find their riches objectionable, that has to be for a very different reason to what we’ve been discussing here.

    Paul, clarifying our differences as you’ve done here is most helpful. I wouldn’t for a moment deny that the relationship between attitudes and the underlying reality is symbiotic; they shift and unfold in a kind of constant dance. Sometimes one appears to be taking the lead, sometimes the other. Still, I don’t agree that the underlying motives of the actors haven’t changed. While we could debate whether the underlying motives were always there, their visible expression radically changed in recent decades. The social conditioning that had held greed and self aggrandisement in check (indeed, made excess of the sort we’ve witnessed quite literally unimaginable) lost its power for a while; other standards took its place and they will in turn be dethroned. In fact, it’s happening right now.

    You ask how at the local level can societal attitudes counter the laws of demand and supply to the extent necessary in this case? Consider, as an example, those 32 top executives at Toyota who last year collectively earned about the same as the CEO of General Motors did on his own (and it’s not as if GM’s been showing a clean pair of heels to Toyota). Are the Japanese uniquely unequipped with the capacity for greed? Unresponsive to those laws of supply and demand? Similarly, from what I’ve read, the pay of European executives has remained in a much more traditional relationship to that of their workers. Societal mores are very powerful, but they’re not set in cement and, in the Anglo world we seemed peculiarly willing to shrug off many of ours. We also (and not coincidentally, I think) took to debt like newly minted addicts.

    In any case, as I noted earlier, the laws of supply and demand weren’t properly at work here. With effective control of the corporate treasury, CEOs and their boards (and consultants) increasingly came to control the demand side from a monetary viewpoint.

  36. JC says:

    Hey Ingolf. gallows humor doing the rounds from wall street buddy.


    CEO Chief Embezzlement Officer.

    CFO Corporate Fraud Officer.

    BULL MARKET A random market movement causing an investor to
    mistake himself for a financial genius.

    BEAR MARKET A 6 to 18 month period when the kids get no
    allowance, the wife gets no jewelry, and the husband gets no sex.

    VALUE INVESTING The art of buying low and selling lower.
    P/E RATIO The percentage of investors wetting their pants
    as the market keeps crashing.

    BROKER What my broker has made me.

    STANDARD & POOR Your life in a nutshell.

    STOCK ANALYST Idiot who just downgraded your stock.

    STOCK SPLIT When your ex-wife and her lawyer split your
    assets equally between themselves.

    FINANCIAL PLANNER A guy whose phone has been disconnected.

    MARKET CORRECTION The day after you buy stocks.

    CASH FLOW The movement your money makes as it disappears
    down the toilet.

    YAHOO What you yell after selling it to some poor sucker
    for $240 per share.

    WINDOWS What you jump out of when youre the sucker who
    bought Yahoo @ $240 per share.

    INSTITUTIONAL INVESTOR Past year investor whos now locked
    up in a nuthouse.

    PROFIT An archaic word no longer in use.

  37. Ingolf says:

    Thanks, JC. Here’s a few samples from another list I saw recently:

    Backtesting: the art of adjusting trading system parameters so as to ensure maximum profit in the past and zero profit in the future.

    Cycle analysis: – a method of analysis that allows losing trades to be organised into regular patterns.

    Fundamental analysis: a method of analysis that provides compelling reasons for why a stock shouldnt fall in price when it does.

    Fundamentally sound: – the condition in which an economy finds itself immediately after a stock market collapse.

    Live feed: – a technology that enables the instant incorporation of bad ticks into a charting program.

    They: – the members of a powerful international conspiracy who target small, private traders in order to make their lives miserable. For instance, they ran the market to my stop and then turned it around.

  38. just sent to me:

    “There are two sides to a balance sheet: the Left & the Right ( Liabilities
    and Assets respectively). On the Left side there is nothing right, and on the right side there is nothing left.”

  39. Pingback: Club Troppo » Has capitalism (neo-liberalism) failed?

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