The role of executive compensation in our financial crisis might seem an unlikely subject to spark a minor civil war between the editors and columnists of the New York Times. But that’s exactly what seems to be happening.
You’ll recall that a week ago, Paul Krugman wrote a column arguing that the incentives contained in banker compensation packages had decisively contributed to the financial crisis. He went on to say that if we didn’t reform those incentives, we were headed for another crash.
“Indeed, you can make the case that reforming bankers’ compensation is the single best thing we can do to prevent another financial crisis a few years down the road,” Krugman argued.
Yesterday, the influential business New York Times writer Joe Nocera took a swipe at that argument, describing the compensation issue as a “sideshow compared to strengthening capital requirements.” Nocera went on to explain that the focus on compensation by European politicans was a self-serving ploy intended to evade more serious reforms.
We don’t normally focus on such things. It’s far better, in most cases, to write about the underlying issue than the personalities who are analysing it. But in this case we’ll make an exception because we’ve written so extensively about the issue–and because we find the backlash against Krugman’s piece so fascinating. It is as if the editors of the business pages were trying to distance themselves very publicly from the op-ed page.
The Sunday Business section today runs a column by Mark Hulbert that runs through many of the points we’ve made against Krugman’s executive compensation theory of the crisis. Briefly those are:
- The executive compensation theory makes sense in the abstract. The incentives for bankers were potentially dangerous. They stood to make a lot more than they would lose if their bets on the market went bad. This could encourage bankers to engage in overly risky activity.
- But compensation wasn’t the only thing controlling bank behaviour. Those bad incentives were balanced out by others–managerial supervision, concern for reputation, and big holdings of stock of their companies. A pair of economists who have studied the issue “found that the C.E.O.’s of these banks lost more than $30 million, on average, of their investments in their own banks in 2007 and 2008, and that the executives who headed Bear Stearns and Lehman at the onset of the crisis lost close to $1 billion each,” Hulbert writes.
- Banks didn’t load up on risky assets. They bought assets they thought were safe. Better designed compensation packages would not have helped head off the crisis because it wasn’t primarily caused by bad incentives. It was caused by bad information. The bankers thought they were buying low risk securities that turned out to be much riskier. No compensation incentive would have helped them avoid this risk.
[Ohio University Fischer School of Business professor Rene Stultz] “points out that in 2006, a collateralized-debt obligation with a triple-A rating didn’t look like a huge risk. “On the contrary, it looked like an extremely low-risk asset,” he says. “Yet, banks incurred extremely large losses on such C.D.O.’s.”
Regulations that would have encouraged executives to take on less risk, he adds, might have made matters worse because executives “might well have chosen to invest even more in AAA-rated C.D.O.’s and other asset-backed securities.”
Hulbert’s concluding paragraphs seem written almost directly in response to Krugman:
In short, then, we may want to change executive pay practices for a variety of social, political and moral reasons. And it’s plausible that compensation does generally affect risk-taking behaviour. But so far, the evidence doesn’t show a specific link between that pay and the recent debacle.
So we may be fooling ourselves if we think that compensation reforms, by themselves, will prevent another crisis.
We’re glad the business editors have more sense than the op-ed page’s economist. And even happier that they are willing to make their disagreement so public.
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