Whether you call President Barack Obama's proposed $500,000 pay cap for top executives of firms receiving federal bailout funds good or bad, there is no denying that in a market-based economy, it's downright ugly. However, it may well be necessary.
Why is capping executive pay good? The most common answer is that the top executives in failing firms requiring a federal bailout have placed personal greed above the interests of all the firm's other stakeholders (e.g., stockholders, employees, customers and creditors). In economic terms, this situation suggests that there has been a market failure requiring government intervention. Capping the pay of top executives is one possible way to address this market failure. Because top executives have final control over the activities of their firms, it is often argued that they should also accept the final responsibility for the financial crises facing their firms. Indeed, many argue that the principle of moral fairness requires this.
Why is capping executive pay bad? Many argue that the best way to handle the current financial crisis is through the normal mechanism of the free marketplace rather than a government-imposed pay cap. They believe that government intervention can cause a failure that will hurt society more than the market failure it is trying to correct. In economic terms, the argument is that the most efficient use of a society's resources will be achieved by supply and demand.
A second argument is that these firms will lose some of the best talent. Because other firms are not receiving federal bailout funds, many believe that capping the salary of the top executives in bailed-out companies will create an exodus of some of the people who are best suited to revive the failing firms.
A third argument against a pay cap is that it unfairly singles out one group responsible for the crisis and ignores the fact that other groups share culpability (e.g., greedy home buyers and politicians not fulfilling their regulatory oversight responsibilities). Of course, these latter groups of people are not the ones receiving the financial bailout.
So much for the good and the bad. Why is capping executive pay ugly? There are at least three reasons.
First, the 2008 financial crisis has harmed millions of people. Capping executive pay is largely symbolic and will unlikely be of any economic help to most of these people.
Second, discussions supporting a pay cap often portray senior executives as heartless villains who only care about their wealth. My experience in dealing with hundreds of senior executives over the years is just the opposite. Most senior executives work tirelessly for their firms and truly care about all of their firms' stakeholders.
Third, the issue can turn quickly from capping CEOs' pay to eliminating bonuses for midlevel executives who only control their small portion of activities within a firm. These bonuses, in most firms, are essentially the equivalent of sales commissions to employees who receive a relatively low fixed salary. Furthermore, except for the midlevel executives in the departments that caused the firm's problem in the first place (such as the mortgage departments of many of the failing banks), penalizing those individuals who are successfully doing their jobs related to other activities of the firm would likely cause a widespread morale problem within the firm. This, in turn, would likely result in an exodus of highly productive people out of the firm and the industry, leading to further problems for the firms being bailed out.
History suggests that wage and price controls are a mixed bag in a free society. Nevertheless, President Obama's decision to cap the pay of top executives is understandable. Even if such a move is largely a matter of form rather than substance, one should not underestimate the psychological benefits of symbolism. The general public is clearly calling for such a move, and the president had to respond.
In the end, it will take a lot more than symbolism to pull the United States and the rest of the world out of the current economic crisis. Let's hope the economic stimulus package will be the appropriate fix to get the U.S. and world economies on the path to recovery.
Lawrence A. Gordon is the Ernst & Young alumni professor of managerial accounting and information assurance at the University of Maryland's Smith School of Business. His e-mail is firstname.lastname@example.org.