Barack Obama?s decision to cap top executive pay at $500,000 a year in all institutions on federal government support will mean significant pay cuts for top managers in almost all major US banks. The salaries of bankers will now be closer to that of public servants?the top US public servant, the president, receives some $400,000 a year. Fair enough one could say, since both are now funded by taxpayers? money.
But it isn?t that simple?banking after all is, and should be, very different from public service. Public service is not for profit whereas banking is for profit. Bankers need to take risk and be sufficiently rewarded for that risk. If bankers end up like bureaucrats?and India?s PSU banks are a good example?then the economy will inevitably lack dynamism and will probably end up fostering crony capitalism with the full collusion of politicians. Using this logic, it?s best if banks are left in the private sector and left to determine their own pay?surely private shareholders should be able to exercise discipline on over-indulgent executives.
The current crisis scenario makes things more complicated. Banks continue to make massive losses, hold toxic assets and remain reluctant to perform their most vital function?lending. Almost every expert agrees that banks need financial support from the government?differences remain on what form this should take: whether recapitalisation, buying up of toxic assets, insuring against losses, creating a bad bank or even full nationalisation. But if the taxpayers are going to pay, in whichever form, they will want to enforce some discipline on the people they bail out. Nationalisation will mean taking over ownership and management of banks, which isn?t the best idea given the dangers of public sector banking. Creating a bad bank would mean that the taxpayers take on all the bad assets and leave private banks to reap profits with no liabilities. In between the extremes, putting a temporary cap on top executives pay seems a reasonable middle path, enough to satisfy the taxpayer (who remember is also a voter) and to keep banks away from full nationalisation.
There is another good reason to target executive pay. One of the reasons cited for the origins of this crisis is the skewed compensation and incentive structure that was given to bankers. Since much of the total compensation package came in the form of bonuses?which were a function of the company?s short-term (quarterly or at most annual) profits?there was a clear incentive to undertake excessive risk (and leverage) to maximise short-term gain. Where that brought the global economy is a story already told many times over. Moving forward, and beyond this temporary government enforced cap, the banking industry, preferably without the help of government, has to rework the design of pay/compensation to align with better incentives, which encourage solid long-term performance more than fragile short term gain.
There may be a temptation on the part of some analysts to view President Obama?s move as a fundamental shift in US political economy away from a free-market model, which values wealth creation over a state-controlled, more egalitarian system. This is unlikely to be the case.
The US voter had consistently supported the deregulation and liberalisation of markets which began under President Reagan in the 1980s?policies which created much dynamism, entrepreneurship and wealth but which also exacerbated inequality. According to statistics from the US Congressional Budget Office, inequality rose sharply in the 25 year period between 1979 and 2004. Households in the lowest 20% of the population were making just 2% more (adjusted for inflation) in 2004 than 25 years earlier. The next 20% were making 11% more. The middle 20% were making 15% more. The next 20% were making 23% more and the top 20% were making 63% more over the same period. Still, the US political economy through this period (and indeed through its history) has been much more tolerant of inequality than say Europe . Americans accept greater inequality for the greater opportunity it offers. Europe, in its preference for greater equality has always lagged the US in dynamism. Wealth, in the US, has rarely been scorned upon, not even through the boom years which saw top executives earn a staggering 364 times the amount earned by the average worker.
But, while admiring of wealth, the US is a country which also places deep faith in ?fairness? and ?merit? which are equally important characteristics of a properly functioning free market democracy?and the staggering bonuses paid to failing Wall Street executives or the massive severance pay granted to under-performing and exiting top honchos violated this sacred bit of the American social contract.
If bankers were not going to obey the first rule of the free market, that people are rewarded for success not failure?the recent reports of over $18 billion being paid out by various banks in bonuses for a crisis hit 2008 are evidence of bankers? disregard for free market principles?then someone had to remind them in no uncertain terms about the basics of the system they have thrived in until now. In your columnist?s view, therefore, Obama is simply reaffirming the principles of the free-market that has brought the US much prosperity over the years.
dhiraj.nayyar@expressindia.com