Within the firing line of public vitriol, particularly since the 2008 financial crisis, is the issue of executive remuneration, the rewards and incentives paid to executives and directors of large corporations in return for their productivity. Specifically, of course, we mean remuneration that is deemed to be excessively high in relation to the resulting output that these rewarded executives create. Needless to say the level of remuneration in the financial services sector – the proximate cause of the seemingly endless depression we are enduring currently – has been singled out for its apparent injustice. Why should executives, motivated by their greed and lust for riches, get to walk off with pots of gold when they are responsible for so much entrepreneurial failure while the rest of us are left to suffer job losses, redundancies and unemployment? Indeed there is even the accusation that executive remuneration is the primary cause of the financial crisis, fuelling the fire of so-called “irrational exuberance”.

There are many typical free-market responses to this sort of criticism – that high levels of remuneration are simply a function of supply and demand; that talented bosses would just go elsewhere if a firm did not offer competitive remuneration, and so on. Indeed, many of the same responses are made to criticisms of egregiously low pay in developing countries and the call is always to leave things alone and let “the market” determine the figures. While this is all true, it is only so in a genuine free market and not in the heavily managed and distorted economy with which we are cursed today. It is only by analysing and understanding the influences on wage rates in the economy as it actually exists that we can propose any solution, should one be needed. To simply dismiss the problem leaves it vulnerable to alternative (and false) explanations that lead to the danger of equally false solutions. Indeed, one of these current incorrect analyses is that there is a natural (rather than a deliberately engineered) tendency for the rich to get richer while the poor get poorer, with all economic development fundamentally being a struggle of rich against poor. As libertarians and “Austrian” economists we must examine the root causes of social phenomena and not assume that everything is alright simply because the proximate social relations appear to be voluntary. Let us, therefore, proceed with this task.

Theoretically, executive remuneration is no different from the remuneration of every other type of employee – all workers, from bosses to bin men, earn their marginal revenue product. Bonus payments, an aspect of executive remuneration that seems to particularly grate in the public mind, can even save a firm money in a given year. A firm might agree to pay an executive a £1m bonus if and only if he achieves £1m or more worth of productivity; if he delivers £0-£999K worth then he gets nothing; if he delivers £2m worth then the firm is paying only £1m for double that amount in net income. In both cases the firm receives a level of productivity without having to make a corresponding pay out. However, this idyllic description is not the situation in the economy where the government distorts price signals, causing the delivery of false income during the boom years only to have it all come crashing down at the bust. The basic problem with executive pay lies in understanding the influence of government credit expansion on the economy, and particularly on the financial services sector.

The starting point of the business cycle, as understood by “Austrians”, is the expansion of credit and the lowering of the rate of interest. Not only does this falsely incentivise all firms to enter longer term investment projects but, crucially, this new money enters through the financial system. It is, therefore, the firms most closely connected to the source of new money – large banking and investment operations – that will experience the largest distortionary gains first. Hence, remuneration in these firms will rise fastest and strongest, in line with the false profits made from all of the doomed loans and investments that they happily make in blissful ignorance. Everything at this point looks fine, executive remuneration for apparently successful operations going without mainstream criticism. Yet, once the taps are turned off and the flow of new money dries up, the bust sets in and it is exactly those same firms that benefitted the most in the boom – those closest to the source of new money and ploughed it into unsustainable assets – that have the most to lose. Indeed it is no exaggeration to say that the entire financial system would have collapsed in 2008 had central banks not intervened to prop up asset prices and hence keep financial firms nominally solvent. Executive pay, therefore, is not a cause but merely a symptom of a deeper, underlying problem that is caused by governments and central banks. Anticipation of higher profits does not appear because executives are paid more; rather, it is the false anticipation of future profits caused by the distortions of credit expansion that leads to rising executive pay.

This is not the end of the matter however. For the very same problem – credit expansion – produces an endemic and seemingly endless price inflation, price inflation we are told is the natural consequence of growing economies. Indeed central banks even maintain price inflation targets (the Bank of England’s being 2%) as a result of the false (or perhaps dishonest) impression that price inflation is required for economic growth. The result of this is that anyone who holds cash for an extended period of time can watch the real value of their wealth diminish. This has several important impacts upon the financial services sector. First, companies opt to switch from equity financing to debt financing as it is cheaper, in real terms, to fuel growth through servicing a loan rather than from revenue reserves. Secondly, the need to hold appreciating assets rather than depreciating cash has meant that the average saver – i.e. someone who wishes to put money away for retirement – now has to invest in stocks or bonds rather than simply save cash. Indeed it was once possible to fund one’s retirement simply by hoarding gold coins, the coins appreciating in real value through a gradual price deflation caused by increased productivity. Now, however, everyone has to entrust their hard earned savings to money managers and speculators who, having taken a fat percentage cut, will probably be barely able to keep up with price inflation anyway. Both of these aspects cause a vast swelling of the demand for financial services and, consequently, an increase in executive pay in that sector.

The latter aspect, however – that of investing in order to fund one’s retirement – also has another important consequence. Executives serve their shareholders and are employed to meet the needs of those shareholders by “executing” the purpose for which the shareholders formed the enterprise. They are the delegates, the servants of the shareholders and their scope of activity and their remuneration for the same is bound by that which the shareholders desire. Taking a part ownership of an enterprise as a shareholder, therefore, is an important and active responsibility, one that requires the focus of one’s attention and is not a mere hobby or pastime. It was once the case that most companies and corporations were privately owned by a handful of active investors rather than publically traded on stock exchanges like they are today. Yet, because of the necessity to invest one’s money to keep a pace with inflation, we are now in the position where the majority of beneficial owners of businesses are passive investors, merely entrusting their money to a fund manager who will spread it across a vast array of businesses – probably following an index of shares such as the Dow or S&P 500. The result of this is that there is no one keeping an active eye on executives, or at the very least the capacity for doing so is greatly diminshed. Indeed, the most popular base index for tracker funds in the UK – the FTSE All-Share Index – is comprised of around one thousandcompanies. No single beneficial owner of the companies in that fund can hope to maintain a keen interest in even a significant minority of those organisations. With executives left alone to run the shop entirely, their ends begin to take precedence over the ends of shareholders. The primary preoccupation of the latter is to grow, sustainably, the capital value of the business, investing assets in productive services that meet the needs of consumers. Executives, however, are mere “caretakers” of those assets who can derive a gain from the enterprise only so long as they are in charge. Not only, therefore, will they have the incentive to increase present income as fast as possible at the expense of long term capital growth, but they will attempt to milk the business as much as possible for all they can get during their tenure – the primary method of doing this being through their remuneration packages. This incentive is always present in any business of course, but the lack of shareholder oversight presents an enhanced opportunity for it to be fulfilled. Indeed, most boards – who, nominally regulate the activities of the executive on behalf of the shareholders – are usually made up of other executives in the same or related industries and will, therefore, largely defer to and be empathetic towards the management rather than the shareholders. This is not to imply that executives are only looting businesses for all they can get. There are, of course, many brilliant and competent managers who richly deserve their rewards for growing, sustainably, complex and important operations that serve the needs of consumers. However where all other outcomes are equal and it comes to a basic choice between maximising long term growth on the one hand and increasing present income on the other we can see quite clearly that executives will plump for the latter. Some attempt has been made to rectify the situation by paying bonuses in shares or options and creating longer-term incentive plans – in other words, turning bosses into part-owners – but it does not remove the fundamental problem which is the lack of keen oversight from the beneficial owners.

What we have learned therefore is that excessive executive remuneration, especially in the swollen financial services sector, is not a cause of financial collapse but merely another unhappy consequence of underlying problems – that of government and central bank interference in the economy through meddling with the rate of interest and expanding the volume of credit. If we want to return to executive pay that accurately reflects the creation of long term growth in sustainable businesses then we need to do away entirely with government interference and establish a genuine free market economy.

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