Does Executive Comp Cause Big Recessions?

Posted by: Michael Mandel on August 03

A new academic paper makes a credible argument that stock option contracts for executives can cause excessively large swings in the economy. The paper, which I think is destined to become a classic, has a great title: “Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts. ”

John Donaldson, Natalia Gershun and Marc Giannoni( of the Columbia Business School, Pace University, and Columbia Business School) examine stock options, and point out that:

With such a compensation contract, a given increase in the firm’s output generated by an additional unit of physical investment results in a more than proportional increase in the manager’s income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager’s expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result.

Arbitrarily large!

This is not a good thing. What it means is that managerial confidence, rather than consumer confidence, has now become a central driving force for economic fluctuations.


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Reader Comments

Ajay

August 3, 2009 06:20 PM

And can you think of a better example of managerial overconfidence than Obama and his acolytes in govt today? Unfortunately, people are sufficiently stupid that they try to remedy managerial overconfidence with more managerial overconfidence, just different managers. ;) I don't know that you can blame managers alone for this recession though, as investor and consumer overconfidence had equally large roles to play in the housing price bubble and stock market overvaluation. As for the underlying issue of options as compensation, they seem a fantastically stupid way of incentivizing managers, as Peter Drucker pointed out decades ago. What you want to do is cut all employees in on a proportionate share of profits over time, meaning the years after they leave too, so that actual performance is measured and they can't just bang out a quick profit surge and leave a shell to the newcomers, like the financial firms may have tried to do recently but failed.

Squeezebox

August 4, 2009 11:51 AM

Excessive compensation of executives seems to be a leakage from our economy. Execs don't spend very much of their pay and they like to hide it in Swiss Bank accounts. They go to ridiculous lengths to hide from taxation and they don't invest in the economy that earned the money for them in the first place. Also, very few of the executives are as brilliant as they all claim to be. Most are mediocre and should be replaced at a much lower price. How about you pay a flat salary and the board approves bonuses based on actual results? Oh year, that's right, the board is golf buddies with the executive!

beezer

August 4, 2009 05:19 PM

Why not have salaries/bonuses capped at a certain percentage of revenues?

And why not have this percentage shared amongst employees in a well understood manner?

Not everyone will have a great year, every year. But someone will. A regular distribution of sharing makes sense to me, top to bottom.

CompEng

August 4, 2009 05:35 PM

Arbitrarily large is a little hard to swallow: I think the effect can be quantified to something more reasonable :) Other than that, I basically agree with what Ajay said.

Everyone is always going to be capable of screwing up their little part of the market: you can't eliminate stupid mistakes. They key is to keep the risk and ownership distributed. You can and should point out common mistakes to make them less common, but you can't really eliminate them.

Mahmud Abbas

August 9, 2009 12:17 PM

Ajay is totally wrong. he comes from a third world country hence he does not know anything about the American democratic system. stop commenting and go back to snake charming

TARUN MUKHERJEE

September 10, 2009 12:19 PM

This is such a though-provoking article. Ajay is entitled to his opinion and has the intellectual right to express it. One may not agree with Ajay's opinion. However, the way Mahmud Abbas expresses his disagreement
(via personal attack) is uncalled for and demonstrates his narrow-mindedness. There is no place for such outbursts in an intellectual debate. He should simply put forth his discussion stating why he disagrees with Ajay, instead of engaging in name-calling.

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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