Wednesday, February 25, 2009

Change They Don't (Want Us To) Believe In

I was surprised to see these two articles by reputed and brilliant professors in "my" University of Chicago Booth School of Business. One argues against capping CEO / executive pay in taxpayer bailed out companies, and the other against the government spending as part of the Obama fiscal stimulus plan.

The first by Steven Kaplan appearing in a Feb. 17 Op-Ed in The Chicago Tribune warns that "Restricting bank executives' pay would stall recovery." He acknowledges that high and flawed financial incentives were at the root of high risk-taking and illusory profits that brought down these banks, and that the massive taxpayer bailout justifies "some" government say in executive compensation. But he then asserts, "Even though $500,000 is a lot of money, banking executives have a different salary market. They would find the compensation low, and that is likely to create four problems:

  • Banks would avoid accepting government assistance unless the situation is grave. Only the worst firms would accept government help.
  • Many executives would leave the "bailed-out" banks for jobs that pay more, and the best employees would leave the troubled firms at exactly the wrong time.
  • It would be difficult to hire new executives because the best ones would choose other opportunities.
  • Stronger firms that have accepted federal money would give it back to avoid the restrictions.

All these factors would slow the recovery of the financial system."

I find these arguments to be deeply flawed. To his first and fourth points, most banks seeking and continuing to receive government help, even the so-called stronger ones, have little discretion in the matter. They know full well that their failure to do so will expose them to a ruinous bank run or its equivalent with depositors. Their leeway can be further curtailed by imposing regulatory capital requirements that forces them to seek timely government help. Further, the push towards better governance and heightened awareness of potential conflicts of interest will make vigilant bank boards compel their management to do the right thing.

Mr. Kaplan's second and third points are anchored on a "greed is best" premise that the most suitable executives for bank turnaround are lured by outsized financial awards alone. But it is this brand of managers and the existing compensation structure that substantially contributed to the crises in the first place. They stood to make enormous fortunes by fudging numbers, taking massive gambles with other people's money and limiting themselves to short-term "on my watch" perspectives. Instead, we need managers who want to establish their legacy of building or rescuing great institutions. A lack of outsized compensation structure is more likely to attract these types of managers, encourage sounder decisions and reduce their temptation to gamble. Just compare the CEO salaries and the fortunes of Japanese and US automakers. Or consider if hiking the annual pay to a billion dollars will really get us a much better US President.

So I largely disagree with Mr. Kaplan though there is ambiguity in the stimulus amendment limiting top executive pay as reported in a Feb. 14 CNN story. That can lead to some loopholes and confusion even if the measure is directionally correct.

The other article is a Jan. 21 Op-Ed in the Wall Street Journal by Alberto Alesina of Harvard and Luigi Zingales of Chicago Booth. They repeat the Republican refrain of stimulating the economy by cutting taxes, homing in on the complete elimination of capital gain taxes in 2009, and to the exclusion of government spending. Here's a quick counter to their main contentions:

a) Regardless of it starting as a financial / credit crisis, the US economy obviously now fits their description of a "bad equilibrium." That's where layoffs and job loss fears lower consumer demand that makes firms cut back that causes more layoffs that... They concede government spending can change this "bad" equilibrium into a "good" one, yet they still oppose it.

b) Their proposed solution of tax cuts (eliminating all capital gains for investments "begun" during 2009, etc.) is an extension of the Bush efforts for the past eight years. Where did that get us? Plus they want to make all capital expenditures and R&D investments tax deductible. Wouldn't that mean losing a lot of government revenue on the bulk of such expenditures that the companies would have incurred anyway, incentive or no incentive?

They see their role here "... to courageously propose the right economic policy, even when it is unpopular." I wouldn't call it particularly courageous for business academics to write in support of the finance industry and business interests that directly or indirectly sustain them. My friend RS wryly alluded to this equation as one hand washing the other.

To be fair RS thinks highly of Luigi Zingales and his writings in general, and considers this particular WSJ Op-Ed by him to be an anomaly.

Other writings by the Chicago business professors are more insightful and objective, including those relating to the current state of the economy. For example here's a good commentary in the Feb. 12 New York Times by Doug Diamond, Anil Kashyap and Raghuram Rajan on the Geithner Plan. They express reservations about elements of the plan, in particular the public-private partnership to buy up toxic assets, though they don't come up with an alternative. That's why I find Paul Krugman (alas, not of Chicago) to be better. In his Feb. 22 Op-Ed in the New York Times (among other writings) he makes a clear and cogent case for the temporary nationalization of banks. I'd like anyone opposing his proposals including the Chicago crowd to address his arguments head on.

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