The Agent-Principal Conundrum
Also published by United Press International (UPI), Brussels Morning
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Before it is too late, Europe should reign in executive pay and cap it. Otherwise, it is headed towards a period of massive strikes and a decline in the profitability of its industries.
In terms of Purchasing Power Standards (PPS), Europe is still way more equitable than the USA, for instance. Copious social transfers redistribute resources from the rich to the poorer, thus dramatically reducing the dreaded Gini coefficient all over the European Union.
But across the continent, income inequality has been on the rise as has inflation, a regressive tax on the poor.
Such convergent adverse conditions always lead to increased labor unionization, labor unrest, and a realignment of the interests of stakeholders in private business: shareholders (capital), labor, and management.
Recently, the United Auto Workers (UAW) won their battle against Detroit’s Big Three auto-manufacturers which also own European production assets and automotive brands.
Wage negotiations are an intricate dance. As the economist Richard Lester observed, they do not reflect only hard, cold data such as productivity figures or profits. There is a “range of indeterminacy” within which wages fall.
The reason for this uncertainty is an information asymmetry. Workers don’t have access to the big picture or even to other workers’s output and income info.
Workers are also often interchangeable and dispensable. Many of them do not have the financial cushion to survive a strike or litigation against the workplace.
Only when employees band together – unionize - does their aggregate power right the scales, to some extent. A Gallup survey of millions of workers in multiple industries over several decades found that unionized workers earn 10-20% more than their brethren who are not members of a labor union.
Moreover: the extra pay does not affect economic growth, only bloated executive pay and bottom line profitability. But even so, wages make a mere 5-15% of the cost of any given product.
Wages are one example of the conflict between rapacious executives and all other business stakeholders.
In the catechism of capitalism, shares represent the part-ownership of an economic enterprise, usually a firm. The value of shares is determined by the replacement value of the assets of the firm, including intangibles such as goodwill. The price of the share is determined by transactions among arm's length buyers and sellers in an efficient and liquid market. The price reflects expectations regarding the future value of the firm and the stock's future stream of income - i.e., dividends.
Alas, none of these oft-recited dogmas bears any resemblance to reality. Shares rarely represent ownership. The float - the number of shares available to the public - is frequently marginal. Shareholders meet once a year to vent and disperse. Boards of directors are appointed by management - as are auditors. Shareholders are not represented in any decision making process - small or big.
The dismal truth is that shares reify the expectation to find future buyers at a higher price and thus incur capital gains. In the Ponzi scheme known as the stock exchange, this expectation is proportional to liquidity - new suckers - and volatility. Thus, the price of any given stock reflects merely the consensus as to how easy it would be to offload one's holdings and at what price.
Another myth has to do with the role of managers. They are supposed to generate higher returns to shareholders by increasing the value of the firm's assets and, therefore, of the firm. If they fail to do so, goes the moral tale, they are booted out mercilessly. This is one manifestation of the "Principal-Agent Problem". It is defined thus by the Oxford Dictionary of Economics:
"The problem of how a person A can motivate person B to act for A's benefit rather than following (his) self-interest."
The obvious answer is that A can never motivate B not to follow B's self-interest - never mind what the incentives are. That economists pretend otherwise - in "optimal contracting theory" - just serves to demonstrate how divorced economics is from human psychology and, thus, from reality.
Managers will always rob blind the companies they run. They will always manipulate boards to collude in their shenanigans. They will always bribe auditors to bend the rules. In other words, they will always act in their self-interest. In their defense, they can say that the damage from such actions to each shareholder is minuscule while the benefits to the manager are enormous. In other words, this is the rational, self-interested, thing to do.
But why do shareholders cooperate with such corporate brigandage? In an important Chicago Law Review article titled "Managerial Power and Rent Extraction in the Design of Executive Compensation", the authors demonstrate how the typical stock option granted to managers as part of their remuneration rewards mediocrity rather than encourages excellence.
But everything falls into place if we realize that shareholders and managers are allied against the firm - not pitted against each other. The paramount interest of both shareholders and managers is to increase the value of the stock - regardless of the true value of the firm. Both are concerned with the performance of the share - rather than the performance of the firm. Both are preoccupied with boosting the share's price - rather than the company's business.
Hence the inflationary executive pay packets. Shareholders hire stock manipulators - euphemistically known as "managers" - to generate expectations regarding the future prices of their shares. These snake oil salesmen and snake charmers - corporate executives - are allowed by shareholders to loot the company providing they generate consistent capital gains to their masters by provoking persistent interest and excitement around the business. Shareholders, in other words, do not behave as owners of the firm - they behave as free-riders.
The Principal-Agent Problem arises in other social interactions and is equally misunderstood there. Consider taxpayers and their government. Contrary to conservative lore, the former want the government to tax them providing they share in the spoils. They tolerate corruption in high places, cronyism, nepotism, inaptitude and worse on condition that the government and the legislature redistribute the wealth they confiscate. Such redistribution often comes in the form of pork barrel projects and benefits to the middle-class.
This is why the tax burden and the government's share of GDP have been soaring inexorably with the consent of the citizenry. People adore government spending precisely because it is inefficient and distorts the proper allocation of economic resources. The vast majority of people are rent-seekers. Witness the mass demonstrations that erupt whenever governments try to slash expenditures, privatize, and eliminate their gaping deficits. This is one reason the IMF with its austerity measures is universally unpopular.
Employers and employees, producers and consumers all reify the Principal-Agent Problem. Economists would do well to discard their models and go back to basics. They could start by asking:
Why do shareholders acquiesce with executive malfeasance as long as share prices are rising?
Why do citizens protest against a smaller government - even though it means lower taxes?
Could it mean that the interests of shareholders and managers are identical? Does it imply that people prefer tax-and-spend governments and pork barrel politics to the Thatcherite alternative?
Nothing happens by accident or by coercion. Shareholders aided and abetted the current crop of corporate executives enthusiastically. They knew well what was happening. They may not have been aware of the exact nature and extent of the rot, but they witnessed approvingly the public relations antics, insider trading, stock option resetting , unwinding, and unloading, share price manipulation, opaque transactions, and outlandish pay packages. Investors remained mum throughout the corruption of corporate America. It is time for the hangover.
The Good Enough Firm
Conventional economics is based on wildly unrealistic assumptions regarding human nature and, by extension, the conduct of human institutions. One of them is that firms – led by agents and egged-on by principals – seek to maximize both profits and productivity. This is nonsense. Firms seek to optimize – not maximize – profits by choosing the path of least resistance. As far as productivity: it depends on how fierce the competition is. Absent competition, there is no incentive to increase it. Firms invariably settle on being good enough, until they are rattled by an external shock.
One way to remedy all these pathologies is, therefore, to introduce competition, both from within the European Union and from without. Perhaps 18-century economists were not so wrong after all.
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