Poisoning Shareholders
By Tim Worstall : BIO| 01 Aug 2006
"Don't mess with markets" is sound advice for anyone, most especially politicians trying (on those rare occasions) to make the world a better place. "Don't listen to them" is also useful, especially for politicians being told how to make the world a better place. For, as is inevitable, those doing the telling will be pushing actions that will make the world a better place for themselves -- usually by messing with markets.
Armed with our newly created homespun wisdom we can now set out to explain the recent rises in executive compensation in the US. As The Economist tells us:
"In 2004 the ratio of chief executives' compensation to the pay of the average production worker jumped to 431 to one from 301 to one in 2003, according to 'Executive Excess', a recent study of 367 big American firms by the left-leaning Institute for Policy Studies. That is not quite a record: in 2000 the ratio reached 525 to one [...]. In 1990 the ratio was 107 to one and in 1982 a mere 42 to one. This year's numbers seem certain to show the gap widening still further."
Now I am not one to worry much about the distribution of wealth or income in society, apologies, but egalitarianism just isn't one of my motivating drives. There are, as you know from reading other writers in other places, plenty who do indeed worry about such things and this trend is, of course, driving them absolutely nuts. What would be interesting then would be to try and explain why there has been this huge rise in executive pay relative to Joe Six-Pack. A number of ideas come to mind.
It could be that executive pay in the 1980s was depressed in some manner and that we are now returning to a more historical norm. I have to admit though that unless we're about to start talking about the income differences between a Renaissance Prince or Pope and a medieval villein working the fields, I really don't think that idea is much of a starter.
Another idea could be that there has been a mass outbreak of greed, that somehow the moral climate has changed, or perhaps some horrible virus has infected the executive suite which causes them to act in such an inhuman manner. Which would be rather an odd thought for there have been written condemnations of coveting thy neighbor's house or ass for at least 4,000 years showing that greed is not exactly a new phenomenon in humans. Indeed, it's pretty much one of the basic thoughts of the entire classically liberal canon that humans are greedy (and lazy) which is why they respond to incentives.
A third, and I think correct, explanation is offered in Deepak Lal's new book Reviving the Invisible Hand. As a result of the takeover boom of the early 1980s the managements of some of the larger corporations started to look for permission, from both courts and politicians, to protect themselves with poison pill defenses in order to thwart takeover bids. These take a number of forms but the essential outcome is much the same: it makes the hostile takeover of a company by a corporate raider more expensive.
This strikes to the heart of the agency problem. In a modern corporation the shareholders have to hire experts (managers) to do the actual work for them. But how are they to ensure that what is good for the shareholders is exactly the same as what is good for the managers? In fact, as is fairly obvious, whether or not a company gets taken over is exactly when those interests diverge. If there is a hostile takeover, the shareholders get the bidding premium, take their money and go and do something else with it. The managers lose their jobs. A pretty clear divergence of interests there I hope you'll agree?
The managers clearly benefit from the poison pill defenses and the shareholders equally clearly do not. As Lal quotes from a paper by Manne from 2002:
"Every statute, adjudication, or regulation that in any way inhibited the free functioning of the market for corporate control simply raised the cost of ousting inappropriate managers. Dollar for dollar, every increase in these costs could be claimed by incumbent managers, either in greater rewards for themselves or in inefficient management policies. Until the real cost of wastefulness equals the cost of a successful takeover fight, they remain secure behind a legal barrier to their ouster, at least until the whole house of cards collapses."
Another way of putting this is that back in the 1950s and 60s, when there was a fairly unregulated market for corporate control, managers could not pay themselves huge sums in this manner because someone could and would come along and buy the company and throw the bums out. Now that those poison pills form the corporate defenses they can't, or at least only at vastly greater cost. If we accept, as I do, that people will broadly do whatever they can get away with in their own self-interest then there is absolutely no surprise in the finding that executive pay has risen.
All of this now brings us to the question of what we should do about it, if anything. Various trial balloons have been floated, for example that executive pay deals should be approved in a vote by the shareholders, even some are insisting that there should be legal limits on top pay. Which all seems a bit odd, really. The problem has arisen because we've allowed the politicians and the courts to mess around with a market, that for corporate control. Rather than adding another set of regulations, which will undoubtedly have knock on effects in other areas, why not just undo the original interference?
Of course, I look forward to those complaining about what they perceive to be excessive executive compensation beginning a campaign in favor of hostile takeovers. Only by restoring a competitive market for corporate control can such behavior be limited, if that is something that we actually want to limit.
The larger point should also be clear. Changes and alterations to the incentives faced by actors in a marketplace almost always have unexpected and possibly unwanted effects elsewhere. The lesson to both courts and politicians is therefore, obviously, "Don't mess with markets".
Now, can we let Michael Milken work his magic once again?
Tim Worstall is a writer living in Europe.
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