Why Executive Compensation Matters

Some folks I know think the drive to limit executive compensation as a condition of getting access to any bailout funds is a kind of red herring designed to distract attention from other important issues. I disagree for the reasons Brian Beutler discusses. To roughly summarize, in order to bail out banks that would go under absent a bailout, we need to also provide access to bailout funds to banks that wouldn’t go under without a bailout. To only bail the very least responsible banks out would create a terrible perverse incentives problem. But on the other hand, to bail out banks that don’t need bailing out would be a horrible waste of money.

Hence the need for executive compensation provisions. If we limited executive pay for bailed out institutions — say by forcing executives to work on government pay scale — then firms’ managers would have a strong incentive to avoid taking taxpayer money unless it was genuinely necessary. Banks that would mere prefer to get bailed out because it would enhance their profits won’t do it if taking the bailout means a big cut in executive pay. But institutions that would actually collapse absent a bailout will take the deal because they have no choice. In my view, of the major proposed conditions on a bailout, namely

  • Executive compensation controls.
  • Equity stake for the taxpayer.
  • Second stimulus.
  • Forced mortgage renegotion

none are red herrings, all are essential. Recall that Paulson appears to have pulled the number $700 billion out of his ass. In practice, once we start handing out the cash, the total tab will be limited only by the limits of business’ desire to take the money. Under the circumstances, it’s absolutely vital to ensure that there are strong incentives to avoid taking the money when it’s not strictly necessary and to get off the dole as soon as possible.