Posted by: erichosemann | October 25, 2009

Where’s the Pay Czar for the Pay Czar’s Pay?

The whole idea of a federal “pay czar” is absurd, and it is grounded in the confused populist notion that executive salaries are arbitrary sums used to placate and enrich executives at the expense of a company’s stock holders and customers.

A company’s profit is the difference between its total revenue and total cost.  Included in the total cost figure are the salaries of managers and wages of employees.  Profit is maximized when the company produces the quantity of output at which the marginal cost to produce an additional unit of output equals the marginal revenue gained from selling an additional unit of output.  Salaries for executives are a part of marginal cost.  They are essentially the price the firm must pay to procure profit.

Investment banks are financial intermediaries that match debtors to creditors.  For example, if a company needs $100 million to fund an expansion of its facilities, it can enlist the aid of an investment bank.  The investment bank will arrange for the sale of bonds totaling $100 million.  The investment bank doesn’t have the $100 million.  It must round up individuals and institutions willing to buy bonds—say at $1000 a piece—in quantities equal to that $100 million.  In effect, it is the bond purchasers and not the investment bank that hold rights to the debt.  The company must pay a premium—something akin to interest—to bond holders over the life of the bond, and once the bond reaches maturity, it must pay back the principle to all bondholders.  In a way, investment banks are to capital what your grocery store is to green beans.  The grocery store lines up producers of green beans to sell to consumers.  The investment banker lines up producers of capital (you, me, pension funds, hedge funds, etc., etc.) to sell to consumers of capital—corporations.

Investment banks provide a service.  The output they produce could be measured in the ease with which they gather capital for their customers.  Investment bank executives contribute to the process of capital generation.  They manage the departments and divisions that generate capital for specific industries and companies within those industries.  What reading I have done on the topic suggests that the availability of capital depends on investor willingness to buy bonds, which in turn depends on investor perception of the viability of an industry or particular company.  The investment banker is part mathematician, part psychologist.  He must understand the risk involved in arranging the sale of bonds for a specific company, as that risk is manifested in the financial viability of the company, and he must know where to look for investors willing to buy those bonds.  He must expend resources searching out these investors and providing them with the information they need to make their purchase.

What I’ve just outlined is just the tippy-tip of the tip of the iceberg.  We live in a $14 trillion economy—or at least the hollowed out hulk of one.  The number of man-hours required to generate the capital that makes such an economy not only operate on a daily basis but plan for the future must be enormous.  The number of calculations generated by each team of investment bankers as they arrange for capital transfer from those who have it to those who want it would make my eyeballs pop out.  What I’m trying to build here is the idea that calculating the marginal cost of an investment banker’s talent is much more complicated than adding up the number of days on the job and dividing by his division’s profits.  It is a proprietary process that involves the decision makers at an investment bank, the people on intimate terms with what the bank does, the amount of capital it rounds up and the complex network between investment bankers and investors.  My earlier analogy of the investment bank to a grocer sounds primitive, and at first I was going to admit that I used it only to simplify the idea of what it is that an investment bank actually does.  But that does the grocer an injustice.  The grocer’s job may be every bit as complex as an investment banker’s.  Think about it.  He must arrange purchase agreements with producers of green beans, fresh, frozen and canned.  Think about the number of different brands of green beans available.  Each bag, can or pound of green beans has its own marginal cost and marginal revenue associated with its production and sale.  Those numbers change continuously.  The number of green bean producers changes from year to year, as does the output from each harvest.  The grocer must decide how much shelf space to devote to green beans based upon how much revenue he believes the sale of each type of green bean will generate.  Multiply this process by the hundreds of different products the grocer sells, and you get a sense of the magnitude and complexity of his job.  There is much more to the process, but you may be starting to see my point.  Doing business of any kind, whether it is selling green beans or generating capital, requires the coordination of vast amounts of information.  Grocers and investment bankers don’t have a handle on every bit of that information, but they do know a great deal of it, and their compensation reflects the fact that, on the margin, their expertise generates a lot of revenue.

And yet…and yet we have a pay czar.  We have a guy who will use relatively primitive, political calculations to manage the pay of investment bank executives.  I am willing to grant that the Obama administration and its functionaries have the same goal most investment bankers have—growth.  But determination of levels of executive pay by members of the Obama administration implies that they possess as much or more of the vast amount of information required to generate capital than the actual people who generated that capital on a daily basis.  And there is no evidence—none—that they do.  The executives whose pay they are slashing have that information, not President Obama, and not Ken Feinberg, the pay czar.

But more to the point: if an executive’s pay represents the increase in marginal revenue he generates per additional unit of product sold, what rate of marginal revenue is Ken Feinberg targeting as he makes his recommendations?  At what rate does he think the investment banking industry, and by extension, the entire U.S. economy, should grow?  And why does he have a right to determine what that rate is?

Let’s assume Ken Feinberg makes everything okay, and his caps on executive pay work out.  Where is the pay czar for the pay czar’s pay?  What’s wrong with assuming that we taxpayers could have had pay czar services at a much cheaper rate?  Or paid a higher rate and gotten someone with more experience who could have turned the down times into boom times at the snap of a finger?  In other words, who’s looking out for us?

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Categories

%d bloggers like this: