On disclosure: Shame?

Geoffrey Manne —  6 March 2006

Daniel Akst in the NYT has an interesting piece on executive compensation and disclosure (HT: Tyler Cowen). He calls for more shame — more reliance on norms to manage intractable agency problems:

Although more disclosure and pay-for-performance requirements won’t dampen runaway C.E.O. compensation, both are useful for illustrating a larger lesson: that it’s naïve to place too much faith in the power of rules to limit human behavior. Indeed, the problem of C.E.O. compensation suggests that, as in many aspects of modern life, few mechanisms of constraint are as effective as one on which we relied so often in the past. That mechanism was shame.

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HISTORY teaches that there is no ultimate solution to the so-called agency problem, or the tendency of those who merely work in an enterprise to act in their own interest rather than that of the owners. Rules and incentives can help, of course, but they cannot take the place of an honest sense of obligation, duty and loyalty — values that ought to run in all directions in any decent corporate culture.

Akst makes a good point: Just because we call it an agency problem does not mean that it can or should be solved; agency costs are a reality of agency relationships. At some point, of course, it costs more than it’s worth to “solve” agency cost problems (see, e.g., Jensen & Meckling, Coase, Williamson, etc., etc.).

But Akst also wants some relief on the cheap. He wants good values (“an honest sense of obligation, duty and loyalty”) to govern where rules can’t (or shouldn’t) reach. To his credit, he recognizes that disclosure of executive pay will hardly inculcate these norms, but he doesn’t suggest from whence else they should come.

Unfortunately, the relative absence of such norms is likely also an intractable problem (if it is a problem at all) — and one that will only be exacerbated by efforts to staunch the flow of executive compensation.

As Akst points out,

disclosure of a few more million here and there won’t fundamentally change a hiring system that actively recruits the most grasping and hubristic candidates. Consider the incentives: by offering lavish pay and perks that would make royalty blush, corporate directors today are perhaps unwittingly selecting C.E.O.’s for shamelessness and egotism rather than leadership.

In fact, I would argue that the satisfaction of hubris and egotism is a form of “psychic compensation.” Corporate managers are effectively paid more than their pecuniary compensation because they also receive the psychic benefits of their positions.

These benefits are not, it seems to me, dependent on the size of the executive’s salary (although that’s surely a factor). Rather, companies can and do pay executives less than they would otherwise have to because executives receive some compensation in these non-pecuniary forms. The two are substitutes.

The implication should be obvious: If explicit pecuniary compensation is made more costly via “effective” disclosure rules, more of executives’ compensation (assuming a relatively competitive market) will come from non-pecuniary (and non-disclose-able) sources. Meaning, in particular, that those executives with a comparative advantage in deriving utility from the status of their position will tend to gravitate toward managerial positions under a constrained pecuniary compensation regime. So what do these folks look like? Well, perhaps they are the more honest, loyal, other-regarding workers. But more likely they are the antithesis of the scrupulous, noble executive Akst (and others) would like to encourage. Deriving utility not only from cash but also (fundamentally) from power would seem to correlate with more rather than less self interest and self aggrandizement at the cost of a corporation’s shareholders. If so, constraining executive compensation will not only not solve the problem, it will exacerbate it.

Now — I don’t necessarily agree that there is a problem. I’m not certain that shareholders would be better off with milquetoast managers than with these supposed sharks. Perhaps, unwittingly, the SEC’s executive compensation disclosure proposal will help to channel the very most ruthless, innovative and energetic folks into the executive ranks, and perhaps that will serve shareholders well. Perhaps, in other words, this is an agency problem that doesn’t need solving.

Either way, I’m fairly confident that more disclosure of pecuniary compensation will exacerbate the issue, just as many presume it will reduce it.

Geoffrey Manne


President & Founder, International Center for Law & Economics