Risk/reward incentive skewed in favor of CEOs?

Economics Economics Questions
1

Sorry if this is a really naive question. I heard this argument another week and was wondering how Austrians respond to it.

Basically, the argument said that in the major corporations investing stockholders’ money, the risk/reward ratio is skewed in favor of the CEOs, because the CEOs take a chunk of the profit in case their investment strategy works out, but if it falls through, all the shareholders share the losses equally. (Or at least, “more equally” than in the case of a profit.)

So, even in the cases when a CEO may lose his job if his risky strategy fails, if it wins, he will double his salary. On the other hand, the ratio of risk to reward is much more skewed towards the risk for the stockholders. This leads to the CEOs taking on much more risky projects/investment strategies than they would if there was no such skew.

The person who told me this gave me two examples: first, he said, yes, the whole housing crisis was caused (as the libertarians claim) through the government’s efforts of making housing loans much easier than they should’ve been and skewing the real risks of investing in the loan business. But then, even when the investors knew the risks, they still went ahead with it, because they are much more risk-prone than they would be if they were investing “their own” money.

Second, he gave an example of BP. They made a stupid decision, he said, by rushing to finish something-or-other, and as a result this snafu in the Gulf happened. Now, the losses for the snafu are shared equally by all stockholders, but in case the gamble worked out, the CEOs would take proportionally a greater chunk of the profits than the rest of the stockholders.

This reality, he said, argues for the necessasity of regulations of what sort of things investors can or cannot do.

I am wondering whether the picture he paints is accurate, and even if it is, what the response of a libertarian economist to the argument would be.

Thanks…

2

1st whole paragraph on page 32:

http://books.google.com/books?id=RkbV8iSX_hoC&pg=PA123&lpg=PA123&dq=ceos+future+bonds+naked+economics&source=bl&ots=qiFPyaWSx6&sig=wm1ikOWOkjNWHTJ64lNBzsSNJGY&hl=en&ei=aZZ2TsngJ4LX0QHy2c3bDQ&sa=X&oi=book_result&ct=result&resnum=1&ved=0CB0Q6AEwAA#v=onepage&q=ceos&f=false

Stock options prevent CEOs from taking too much risk.

But then, even when the investors knew the risks, they still went ahead with it, because they are much more risk-prone than they would be if they were investing “their own” money.

If government tells you that whether you win or lose you will get money, wouldn’t you take the risk? The problem is government, not CEOs. While we’re at it, the consumers as well. Consumers need to stop buying from companies that they hate.

This reality, he said, argues for the necessasity of regulations of what sort of things investors can or cannot do.

Regulations are needed to protect investors from CEOs? No, investors just need to know what type of company they’re putting money into. More government regulations means less responsibility on the individual to look out for his interest.

I am wondering whether the picture he paints is accurate

Is he arguing for more government? Then it’s inaccurate :slight_smile:

Actually, I would agree that there must be more regulations… just not by the government. We need free-market voluntary-regulation companies like we would have under AnCap :slight_smile:

3

Whatever a CEO is receiving in terms of pay and/or risk/reward skew (the optionality of which is also translatable into $) is a reflection of the supply/demand for such talent on the market. Just like with bread or bananas the government has no business regulating what the price of a CEO should be. If the share owners believe the CEO is being overpaid, they can either (1) fire him and find someone cheaper, or (2) sell the shares and have nothing more to do with such an unfair predicament. Either way, no affected party above needs (or is asking) the government to “save” anyone from anyone.

4

Perhaps one should compare the structure of a limited liability corporation to a constitutional republic or democracy. What’s the difference, in practical managerial and administrative terms, between a cabinet and a board of directors? Between the head of government and a CEO? Between the constitution and a company’s articles of incorporation? Sure, a director’s job is supposed to be to run a company in terms of the best interests of its shareholders, and a democratically-elected government’s job is supposed to be to run a country in the best interests of its citizens. At least with directors, people know that they’re only expected to be ethical because they’re being paid a fortune for it and people are watching for them to slip up, and not because they’re some sort of moral superhero.

If shareholders can’t really exercise control over the doings of a large/public limited liability corporation, because they are not its owners in theory nor in practice, then how are voters in a democracy supposed to control their government, exactly? You need the government to step in and regulate corporate governance? Who’s going to step in to regulate the government?

This is not going to work. You can’t expect what is effectively a super-corporation to regulate all other corporations impartially and fairly, simply because that’s supposed to be its job on paper. It’s supposed to be the other corporations’ jobs, on paper, not to screw up in the first place.

Maybe it would be better to question artificial legal persons, like government and corporations, in the first place. Why not have the ‘shareholders’ own the assets directly? In other words, abolish the government, and the ‘corporation’ as it presently exists.

That’s not quite the whole story. The credit was granted by banks who would sell that debt obligation extremely quickly to somone whose job it was to package lots of this bad debt into a barely comprehensible, barely legal financial instrument which would look less dubious on the face of it, and then sell it off to some poor sucker. It was glorified money-laundering, and eventually someone is going to be left holding the bag.

It’s a much, much bigger problem than loose corporate governance in a few corporations. Clearly some investment banks are more equal than others.

5

Dangit, James, you beat me to it! Washing dishes today I suddenly compared voters in democracy to shareholders. Which led me to ask “if the US government is to blame for something, are the voters responsible as well? If the people are the bosses of the politicians, shouldn’t we punish the people due to causation?”

It’s disturbing to think that all those Bush voters are liable for the deaths of thousands of people.