Executive Pay

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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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Ethical Banking – the Woes of The Co-operative Bank

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The Co-operative Bank, one of Britain’s smaller financial institutions, has recently gone through several spectacular stages of self-destruction that has left many of its advocates, having trumpeted the fact that the bank initially emerged from the financial crisis of 2008 relatively unscathed, eating hearty slices of humble pie. Earlier this year its planned acquisition of more than six hundred branches from Lloyds Banking Group fell through when it was revealed that the bank was harbouring a large capital shortfall, most of it stemming from bad debts that were incurred as the result of an earlier merger with Britannia Building Society. The resulting rescue attempts by The Co-operative Group – its outright owner – left seventy per cent of the bank in the control of its bondholders, many of whom, such as US hedge funds, are precisely the kind of outfits that this “ethical” institution did not wish to emulate. Then, in November, the bank’s chairman at the time of its crisis, the Reverend Paul Flowers, was filmed allegedly purchasing illegal drugs from an acquaintance days after his appearance before a Treasury Select Committee during which he was unable to answer basic questions about the bank’s operations during his tenure, and had apparently organised drug fuelled orgies with rent boys from his bank email address, in addition to other past indiscretions. To make matters worse it has been alleged that Reverend Flowers’ influence extended to the leadership of the British Labour Party, expanding the Co-op’s in-house crisis into a political one. This succession of events has highlighted not only the hypocrisy of The Co-operative Bank in striving to maintain and promote an ethical stance and status (an aim that it is shared by its parent and the wider Co-operative movement) but also those who have used this institution as a political tool in holding it up as a paragon of virtue in the wake of the havoc and destruction caused by those greedy and unethical city banks. But this raises a very pressing and pertinent question – precisely what is ethical banking?

The Co-operative Bank’s ethical pride appears to centre on its mutual, member-owned status (or at least that of its parent) that allegedly offers an alternative to the shareholder model, and its Ethical Policy that prevents it from extending banking services to arms dealers, polluters, oppressive regimes, animal testers and so on. Having apparently brought itself to the brink of collapse through over-expansion and bad loans on the watch of a junky chairman who didn’t even know the size of the bank’s loan book does not appear to give much credit to this. Nevertheless, as far as the basic ethics of banking are concerned, all of this is pretty irrelevant. Rather we must conclude that banking, as far as it is practised in most of the world today, is inherently unethical. The Co-operative Bank, regardless of its ownership or its lending policy, was still engaged in the fraudulent cartel of fractional reserve banking under the aegis of a central bank and in that overriding respect it was no different from any other financial institution – and it was this fact that is at the foundation of its weakness. It took money from depositors and lent that very same money with which it had been entrusted to borrowers, expanding the supply of money, lowering the rate of interest and diverting resources to otherwise unsustainable capital projects and investments. It is this that marks the grossly unethical conduct of The Co-operative Bank and one cannot claim to be an ethical institution while at the same time engaging in this kind of fraud, the outcome of which can only be to lead the economy on to a destabilised path. Thieving depositors’ money is not made any better simply because it is lent to politically correct, environmentally friendly and do-gooding borrowers (indeed given that Co-operative Bank has apparently extended several million pounds worth of loans on favourable terms to the Labour Party some might say it makes it much worse).

Genuine, ethical banking can only come about only when a deposit institution issues one, single title to each penny that is on deposit. Where a bank extends a loan this must be met either from its own funds, or from fixed term deposits that mature at a date specified to coincide with the repayment of a corresponding loan. Naturally a bank can specify that it will only lend to certain borrowers in order to attract a certain class of saver, but that is only a distraction from a bank’s basic ethical duty – to safeguard the funds of its depositors. Any bank, regardless of the characters and qualities of its borrowers, puts these funds at extreme risk under the fractional reserve system if those same borrowers cannot repay the loans. Whatever went wrong with The Co-operative Bank’s particular peculiarities, one should not allow them to detract from this central fact of the banking system and focus should be diverted to its direction if we are ever to have truly ethical financial institutions.

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