The Financial Crisis and a Flaw in Corporate Capitalism

The current financial crisis and the events that preceded it do not reveal a new problem in capitalism. They do, however, highlight problems that have been obvious to careful observers for many years, and in some cases for centuries. One central problem underscored by the present crisis is the disconnect between the financial interests of senior company managers and the owners of the companies they work for.

For practical reasons, day-to-day control over publicly traded corporations is placed in the hands of company managers rather than the shareholders who own the company. Managers have wide latitude on how to organize production, allocate investment funds, and select and market the products the company sells. Writing in late 18th century, Adam Smith pointed out the weakness of this arrangement: “… being the managers rather of other people’s money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery [partnership] frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master’s honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.” A crucial problem is that the interests of the company’s managers are not the same as those of people who own the firm.

A solution to this problem is for owners to establish a compensation schedule that aligns managers’ interests with those of shareholders. Whether this is possible remains an open question, though recent experience should give one pause. Defenders of American capitalism claim that the generous stock options, bonus pay arrangements, and rich deferred compensation schemes that have been become common in recent decades achieve their intended goal: Managers’ incentives are closely aligned with shareholders’.

As a labor economist, I am skeptical of this claim. The compensation arrangements that helped pave the way to the current crisis offer plenty of evidence to justify my skepticism. The senior company managers of Bear Stearns, AIG, and Lehman Brothers did not perform their jobs in a way that would suggest they had exclusive concern for the long-term interests of company shareholders. This is true even though most of the managers were shareholders in their companies. Their compensation schedules gave them rich rewards for short-term financial results but failed to impose heavy penalties for the long-term harm their actions might inflict on shareholders — and on the wider economy.

The current controversy over the bonus pay of AIG managers highlights one aspect of the problem. Some of these managers contributed importantly to one of the most spectacular business failures in history. Without the credit extended by the U.S. government, their employer would already be bankrupt. Even with a huge infusion of federal credit, the shares of long-term investors in AIG are worth a tiny fraction of their value two or three years ago. It is hard to see how a sensibly written compensation schedule would give failing managers rich bonus payments after it is plain their decisions contributed to the destruction of their company.

The more general problem is that senior managers have huge power to determine the terms of their own compensation agreement, including the payoff schedule that links their compensation to the success or failure of the business. Often the compensation agreement contains crucial provisions that do not seem intended to link the interests of the manager to those of shareholders. For example, stock options become more valuable to a manager when there is a general rise in stock prices, even if the stock price of the manager’s firm has lagged the price increase of other companies in the same industry. The manager’s performance may have been sub-par, but the general rise in the stock market nonetheless provides him rich rewards.

An unresolved issue of corporate capitalism is how company shareholders can negotiate compensation terms with senior managers so that the interests of the managers are the same as those of shareholders. Analysts such as Lucan Bebchuk have documented how senior managers often negotiate with themselves over the terms of their compensation. The interests of shareholders are only weakly represented in these negotiations. Unfortunately, a badly designed compensation agreement can provide rich payouts to managers who not only fail advance shareholders’ interests but actually harm the long-term prospects of the firm.

Financial crises occur for many reasons. Investors can become over-optimistic and bid up the prices of assets above the level that is sustainable based on economic fundamentals. As asset prices decline to a sustainable level, investors who purchased inflated assets with borrowed funds face ruin. In the current crisis, many of the decisions about asset purchases and extensions of credit were made by senior managers who had financial interests that differed substantially from the long-term interests of the shareholders for whom they supposedly worked. As experience shows, this misalignment of incentives can contribute to terrible decision-making and economy-wide ruin.