Finance and the Good Society
By Robert J. ShillerPRINCETON UNIVERSITY PRESS
Copyright © 2012 Princeton University Press
All rights reserved.
ISBN: 978-0-691-15809-9
Contents
Preface to the Paperback Edition...........................................viiPreface....................................................................xiiiIntroduction: Finance, Stewardship, and Our Goals..........................1Part One Roles and Responsibilities.......................................1. Chief Executive Officers................................................192. Investment Managers.....................................................273. Bankers.................................................................374. Investment Bankers......................................................455. Mortgage Lenders and Securitizers.......................................506. Traders and Market Makers...............................................577. Insurers................................................................648. Market Designers and Financial Engineers................................699. Derivatives Providers...................................................7510. Lawyers and Financial Advisers.........................................8111. Lobbyists..............................................................8712. Regulators.............................................................9413. Accountants and Auditors...............................................10014. Educators..............................................................10315. Public Goods Financiers................................................10716. Policy Makers in Charge of Stabilizing the Economy.....................11117. Trustees and Nonprofit Managers........................................11918. Philanthropists........................................................124Part Two Finance and Its Discontents......................................19. Finance, Mathematics, and Beauty.......................................13120. Categorizing People: Financiers versus Artists and Other Idealists.....13521. An Impulse for Risk Taking.............................................13922. An Impulse for Conventionality and Familiarity.........................14323. Debt and Leverage......................................................15124. Some Unfortunate Incentives to Sleaziness Inherent in Finance..........15925. The Significance of Financial Speculation..............................16826. Speculative Bubbles and Their Costs to Society.........................17827. Inequality and Injustice...............................................18728. Problems with Philanthropy.............................................19729. The Dispersal of Ownership of Capital..................................20930. The Great Illusion, Then and Now.......................................219Epilogue: Finance, Power, and Human Values.................................231Notes......................................................................241References.................................................................257Index......................................................................273
Excerpt
CHAPTER 1
Chief Executive Officers
The CEO of a company is in a very specialposition, because he or she stands for anidea—the core idea behind the company's activities, a way of thinking thatdefines the work of all the company's employees, and a culture that includesits corporate values, connecting the company to the larger society.
The CEO is responsible for the formulation of short-run goals that promotethat very idea. The CEO embodies the purpose of the company. This responsibilityhas to be put, to a significant extent, into the hands of an individualand not a committee of equals, just as the writing of a novel usually has to beput into the hands of one individual. Human society has natural tendenciesthat can coordinate the activities of teams of people in performing routinetasks; teams seem to form naturally, but they are also vulnerable to conflictand to being sidetracked by the individual goals of their members. We stillneed the prefrontal cortex of one individual—however it may work—coordinatingthe activities of large groups of people. Large groups of peoplecannot be strategic or purposeful if they are leaderless.
A Succession of CEOs
That said, the corporation has a fundamental problem: it has to deal with asuccession of CEOs. Companies, with luck, may live for centuries. CEOs,subject to human mortality, cannot.
The essence of a corporation is its longevity. Successful corporations haveno termination date, no shelf life, no inherent limits on how long they canoperate. The succession of CEOs of a corporation is like a succession of kingsof an empire, each one of whom takes up the fl ag from a fallen predecessorand reinterprets and further develops the cause. Except CEOs cannot relax toenjoy the lives of kings: they have to work especially hard.
A CEO typically serves for only a few years, during which time she or hehas to set goals for a company that is much longer lived than the CEO'sown tenure. Thus there has to be an effective reward system that focuses theCEO on the long term. And this is a problem that lends itself to financialsolutions.
CEOs have egos and personal interests that do not necessarily coincidewith the long-term interests of the firm. Companies must find ways to keeptheir leaders focused on their jobs, attending to the boring and often unappreciatedtasks that take up much of their time. A corporation needs a leaderwho will do an inspired job of keeping everything running over the long term,anticipating trends and shifts and providing a vision for the company, whileputting his own needs and wants second.
The ego of a CEO is most naturally satisfied if he or she is the founding CEOof a company, for being first in any succession carries with it the greatest egogratification. The founding CEO of a company is of special importance. If thecompany endures, the founding CEO may well become a legendary figure tolater generations. Years or even centuries later, the founding CEO may beremembered by employees as an almost mythic figure.
Anthropologists have noted a human universal called a creation myth—astory that everyone in a given society knows, one that describes their origins.Such a myth is typically humanized by the identity of a major leader. A foundingCEO is part of the creation myth for a company. The founding CEO knowsthis and instinctively pursues such legendary status, living out a new versionof that same ancient story. But that is only the first CEO.
Behind the succession of CEOs lies a financial structure, which indeedmakes each CEO's employment possible. The CEO of a modern corporationis technically just an employee, serving at the discretion of the board of directors.He or she is defined by a financial contract, with terms relating compensationto the performance of the company and its stock. The CEO depends ona certain financial structure, a financial invention, for motivation.
Even though the CEO is usually not the founding CEO, he or she is stillexpected to be a visionary. The modern corporation must be reinvented againand again, in response to new information and new market demands.
Success in reinventing the company is reflected in financial prices. Whenthe CEO is successful, the price of shares in the company goes up. When theCEO fails, the price falls. A CEO avidly watches the company's share price—itis like a continual report card on his or her activities, issued minute by minute.It is the reward signal for the cognitive center of the company, and there is ananalogy to the reward system for the decision-making apparatus in the humanbrain, a point to which we shall return later in this book. In the corporation,as in the brain, the reward system is imperfect but essential.
The financial arrangement for the typical CEO is carefully human engineered,designed to incentivize that person to stay in the position long enoughand prominently enough that his or her relationship to others as their leaderbecomes firmly established in everyone's minds.
The dispensation to CEOs of stock or options on the company's own sharesis a method of aligning the CEO's incentives with those of the company. Anoption to buy a share in the company at a specified price is valuable only ifthe actual market price is higher, and so granting options to the CEO createsan incentive to take actions that will boost the firm's share price.
A share of stock does not have a termination date, as does the CEO's tenure.Assuming that the stock market price of a share in the company is a goodindication of its true long-term value, then the change in the stock price is ameasure of the CEO's contribution to the long-term value of the company.The stock price signals a reward only if there is good news. It responds toactual news, and it does not encourage gloating over past successes. The CEOis thereby incentivized to be the bearer, to attentive investors, of good newsabout the company's long-run potential—news about the long run, but newsthat is delivered today, right now—and thus to plan for the indefinite future,not just his or her own tenure.
Incentivizing by stock options can be a lot better than awarding bonusesto the CEO for achieving high profits: profits-based bonuses might encouragethe CEO to merely milk the company in the short run, neglecting longer-termproblems and leaving a disastrous situation for his or her successor. Withstock-price-related incentives, on the other hand, the CEO is encouraged tosteer the company toward opportunities that could improve its long-term value.
Setting the Level of the Reward
The salaries and bonuses of CEOs are the subject of many news accounts,owing to their extraordinarily high levels, especially in recent decades andespecially in the United States. The anger and resentment over executivecompensation account for much of the public hostility toward financial capitalismin general.
But sometimes a high level of compensation for a CEO is readily understandable.Consider the example of a man who was the very successful CEO ofCorporation A, who has turned the company around, taking it from the brinkof failure to success. Along the way he handled numerous unpleasant tasks likefiring key people, waging policy battles against entrenched forces within thecompany, and shutting down operations—and he did so in such a politicallydeft way that those who remained in place were not resentful, and indeed weremotivated to take the company to new levels. He was paid handsomely for hiswork, and he now presides over a well-managed, successful company. He maybe thinking about retiring early and enjoying some of his fortune.
Now suppose the board of directors of Corporation B feels it needs to takethose same drastic actions. It is entirely plausible that they would ask our CEOto quit his present job and become their new CEO. They could ask someonewith no such experience to do what he did, but that other person would nothave the same personality, the same judgment. They want him.
It is entirely possible that our CEO will respond that he has had enough ofthis unpleasant business and in fact has more money than he could ever spend.No, he doesn't want to go through all that again.
So it is plausible in turn that the board of Corporation B would offer a reallyattractive package to lure the CEO—a package that might, say, offer optionson the company's stock potentially worth $30–50 million if he is successful.That amount is not enormous relative to the earnings of a large company. Adiligent board exercising its fiduciary responsibility in presiding over a companywith billions in revenue might consider a highly qualified, proven CEOworth all of this.
Running, or turning around, a business all over again, after one has alreadydone it, may not seem all that glorious in and of itself the second or even thirdtime around—yet it is precisely those who have done such an important jobbefore who have the best credentials to do it again. CEOs, even those of Fortune500 companies, are not usually particularly beloved or famous, with onlya few exceptions. Thus high compensation is the best way to attract qualifiedcandidates to such jobs.
It is often observed that in decades past, when CEO salaries were muchlower, companies still found people who were willing to do the job. As presidentof American Motors from 1954 to 1962, George Romney, Mitt Romney's father,turned down huge bonuses. In 1978 Lee Iacocca offered to serve as the CEOof Chrysler, to save it from bankruptcy, for a salary of only one dollar. Theseare fine examples, but they do not mean that companies can always cheaplyhire the CEOs they want. Romney and Iacocca were rare exceptions: each hada strong public moral persona, and for them such symbolic gestures may havebeen especially important. Romney later became governor of Michigan, andIacocca later wrote three best-selling books about his business philosophy. Atone time or another both showed signs of running for president.
Moreover, the growth in high salaries that we have seen in recent decadesmight in part be explained as the result of improvements in our capitalistsystem, as the system comes to recognize the importance of qualified leadersand refuses to be bound by arbitrary pay conventions.
This is why the Squam Lake Group (a nonpartisan, nonaffiliated group offifteen academics who offer counsel on financial regulation, of which I am amember) advised in its 2009 report that the government should not regulatethe level of CEO compensation. Some CEOs are, and always will be, worth agreat deal to their firms. On the other hand, the group did believe that regulationof the structure of CEO compensation is called for.
Moral Hazard and Deferred Compensation
There is a reason for the government to intervene in the process of determiningexecutive salaries: to mitigate a specific moral hazard that seems to haveplayed a substantial role in causing the financial crisis that began in 2007—atleast for big and so-called systemically important firms. This moral hazardarises because the CEOs and other top officers of such key firms have incentivesto take extraordinary risks. They believe that their companies are too bigto be allowed to fail. Because the failure of their companies would be simplytoo disruptive to the economy as a whole, they reason that the governmentwill not allow that to happen.
Given such a mindset, the CEO may not very much care about the risk ofprecipitating an international financial crisis. He may on the other hand bevery interested in taking a gamble that gives him a 50% chance of achievinga huge increase in the stock price and so reaping a windfall on his stockoptions—even if that same gamble has a 50% chance of wiping out the companyand taking much of the global economy with it. In the one case, he endsup rich. In the other, well, his options are worth nothing—but they might havebeen worth nothing for sure if he had not taken the gamble.
Moreover, a CEO with a stock-option-based compensation scheme has anincentive to manipulate the flow of information out of the company and todoctor financial reports—to delay the release of unfavorable information untilafter he has received his compensation. And such practices do not conflictwith the efficient markets theory—the theory, to be discussed in various placeslater in this book, that market prices efficiently and quickly incorporate allpublic information about a company. The CEO is a company insider andknows things that are being deliberately kept secret from the market.
Therefore, the Squam Lake Group recommended that government requirethat systemically important firms defer a substantial part of their CEOs' compensationfor an extended period, say, five years.
The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act inthe United States contains terms that resemble the Squam Lake Group's recommendation.Notably, the act includes provisions that require a CEO to giveback "erroneously awarded compensation" that was the result of "materialnoncompliance of the issuer with any financial reporting requirement underthe securities laws." Yet the Squam Lake proposal is more far-reaching, inthat it would deprive the CEO of the rest of the compensation if ever therewere a bailout or failure of the company.
Cronyism in the Boardroom
Of course there are different circumstances under which a CEO might receivean especially high salary. It could be fraud. It could be that the board of directorsvotes in favor of a high salary out of a sense of professional courtesy orclass sympathy. There may even be individual expectations of being repaidin kind later on.
Lucian Bebchuk and Jesse Fried, both professors at Harvard Law School,have argued in their 2006 book Pay without Performance that the growth of topexecutive salaries has largely been the result of a breakdown in the arms-lengthbargaining process between boards of directors and the top executives theyhire. When the "bargaining" is among close friends, it may have only theappearance of being fair: "Directors have had various economic incentives tosupport, or at least go along with, arrangements favorable to the company'stop executives. Various social and psychological factors—collegiality, teamspirit, a natural desire to avoid conflict within the board team, and sometimesfriendship and loyalty—have also pulled board members in that direction."
Thus it is ultimately psychological tendencies that underlie the problem ofcronyism in the boardroom. There has been public awareness of this problem,and reforms strengthening director independence have already been introducedby lawmakers. But the problem persists.
The issue, Bebchuk and Fried argue, is not with financial capitalism, butwith certain details of its implementation. To reduce the problem of boardfavoritism, they propose reform of the election of board members, measuresto make it easier to replace a board, and procedures to give shareholders thepower to initiate changes in corporate charters.
The rise over the second half of the twentieth century of venture capitalfirms—which specialize in providing funding to unproven startup companiesthat have a high probability of failure, hoping to profit from the few thatsucceed—has helped deal with such problems, at least for startup or early-stagefirms. They have replaced many of the angel investors—independentlywealthy individuals who have supported startup firms in the past, investorswho are not investment professionals and who, through inexperience, arevulnerable to error.
Venture capital firms have learned some things about CEO talent andcompensation over the years. They have learned that the talent and dedicationof the CEO and top executives make an enormous difference to the success ofthe firm, but that these talented people—at the stage in their lives when theyare most hungry and most energetic—are not necessarily expensive to hire.Venture capital firms do make sure that the top executives in the firms theyfund will participate substantially in the possible success of their companies;the firms have learned how to structure contracts, typically including stockoptions, that motivate executives well and protect them against the high riskof failure. A venture capital firm almost always demands a seat on the boardof directors—a vantage point from which it will stop in its tracks any non-arms-lengthdeals excessively rewarding CEOs. Venture capital firms also aremore likely than angel investors to replace the founder with an outside CEOwhen things go badly. Unfortunately, venture capital firms typically sell theirshares and exit the business as firms in which they have invested succeed andgrow larger.
Institutional investors—portfolio managers, to be discussed later—cansometimes enforce similar limits on executive overcompensation. Yet there isstill a need to improve their methods and organization to help them do a betterjob of this.
(Continues...)
(Continues...)Excerpted from Finance and the Good Society by Robert J. Shiller. Copyright © 2012 by Princeton University Press. Excerpted by permission of PRINCETON UNIVERSITY PRESS.
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