Taking Stock / The Comeuppance of the Puppet Masters

Until now, managers got away with pretending they deserve their remuneration. But as the true meaning of bottom-crawling interest rates filters through, angry people will smash the machine.

Along with the financial statements for the year 2011, investors also received the usual information on executive pay at Israel's publicly listed companies.

Under Israeli law, the companies must divulge the wage cost of their five top earners. But in their newly aware state, the public isn't particularly interested in who earns the most; the social-justice protests have inspired much tougher questions.

Avishay Braverman tells half the truth: Directors are marionettes.
Tomer Appelbaum

One might have assumed otherwise, but the protests had no effect on executive pay, it turns out. No increase in restraint was evident; no norms changed. The boards of directors did not crack down. "Directors are marionettes," snorted Avishay Braverman, Knesset member, professor of economics and former director at many of the biggest companies in Israel, in conversation with TheMarker three weeks ago.

We already knew that. What is new is that, following the protests, a politician like Braverman feels it pays for him to stand up and tell the simple truth. In fact, everybody who swims in the waters of the Israeli business scene knows that the directors and managers of many of Israel's biggest companies are a closed club sharing out the public's money among themselves.

Why didn't Braverman shout out the truth - that he was a mere marionette - years ago when he was sitting on the boards of big companies? Presumably because he didn't want to get kicked out of the club, which controls hundreds of billions of shekels worth of the public's assets, which picks politicians, and which even controls academic institutions through their boards of trustees. Belatedly, Braverman did what any public servant should do: He told the truth. But he only went halfway. He didn't out the members of the club and expose their actual influence over politics, academia and the press.

The members of that club, like their peers in similar clubs around the world, have tremendous financial clout and influence over the media. They can easily sell the public the idea that there is a tie between their sky-high salaries and the lofty principles of capitalism, free market, entrepreneurship and talent. The rub is that it isn't necessarily so; all too often the correlation is feeble, and in some cases it's the reverse. This is all the more true for Israel, where many of the highest-paid people at Israel's publicly traded companies work for monopolies, pyramidal business groups, oligopolies and the like - companies where the management talent doesn't have much impact on results over time.

Here is a fresh example. The managers of the mobile operators, and the companies that own the mobile operators, have boasted some of the highest salaries in the land for the last seven years. Most of them also received various awards for the wonders of their management skills. The local press described them in terms that would have put Steve Jobs to shame. And indeed, during those years the mobile operators presented gigantic profits and dividends too. One might almost have thought their managers really did have something to boast about.

But two years ago, the mobile operators and their managers encountered an obstacle: a new communications minister. Moshe Kahlon wanted to see competition develop in Israel's communications industry, an effort in which he received firm, massive backing from this newspaper. Kahlon rammed through a series of regulatory changes, among other things giving cellular users greater freedom to switch providers.

A quick Google search will bring up any number of articles in newspapers owned by big business interests arguing desperately that Kahlon's reforms would prove useless in their attempts to truly change the industry. Which is arrant nonsense, of course. The cost of cellular communications has plunged in the last year and should be falling further as new players enter the game. Heavy cellular users could well see their bills shrink 50% in less than three years from the advent of the reforms.

Where are the geniuses?

What happened to the geniuses running the mobile operators, or who bought these cellular service providers? It seems they aren't that smart after all. It seems that in fact they're an irresponsible bunch, with no clue how to handle the challenges of management once their clients actually have a choice. What is certain is that the share prices of the mobile operators have collapsed, losing 50% to 70% of their value, and that two of the three business pyramids controlling them are in danger of collapse or major debt defaults; that will prove once and for all exactly how good the talent is at management.

The managers of the cellular companies have been replaced. The gang that helped itself to salaries worth tens of millions of shekels over the last five years didn't stay around to explain how it prepared for the era of competition, why it enabled the controlling shareholders to siphon off all the companies' cash, and to what degree the profits it racked up during the good years were because of talent and to what degree they were due to squeezing consumers who had no choices.

Happily for some of the superstars on the salary list, the probability of effective, fast-moving reforms throughout the economy - the sort of thing that slammed into the cellular industry - isn't that high. They can continue selling the public the ridiculous story that their sky-high pay has to do with the free market, capitalism and talent.

Happily for the members of the mile-high-salary club, the cutting criticism they hear about their pay is from people who don't believe in the free market, competition or meritocratic economics. Therefore the debate over their pay gets reduced to shouting about "capitalism" versus "socialism." If there had been a pure economic discussion about their salaries over time from a purely capitalist point of view, their true faces would have been revealed: They aren't being rewarded for talent but for being able to massage the regulator, buy directors and pull the wool over the eyes of institutional investors who invest our money in the tycoons' shares and bonds.

This isn't a uniquely Israeli thing. During the last 20 years, hundreds of thousands of managers throughout the world, most notably in the United States, have been helping themselves to sky-high salaries at the expense of investors, consumers and taxpayers, under the guise of "capitalism" and "free market" - yet their success can better be ascribed to low interest rates, short-term remuneration mechanisms, financial acrobatics, uncompetitive markets and insane risks.

Over the last couple of decades, executive pay has changed from "incentive" into an economic problem in and of itself. The structure of the global capital markets has evolved into a mechanism chiefly designed to legally, elegantly, legitimately and impressively channel a huge proportion of the people's pension savings and global gross domestic product into the pockets of a select few.

Especially troubling is that the watchdogs and professionals in academia, the press and the politicians, have become part of this mechanism. They have turned their touted independence into a sick joke.

What's likely to burst this balloon isn't protest movements, whether global or Israeli, but a much more prosaic process: the collapse of interest rates. After 20 years of receding interest rates everywhere, we have reached a new era in which real interest rates - the nominal interest rate minus the inflation rate - are at zero or below.

What that means is that the financial industry is hiding from investors the fact that the probability of achieving any meaningful profits on their investments is also roughly zero. Academia isn't taking up the informational slack either.

The day hundreds of millions of investors around the world grasp the true meaning of "zero real interest rates" - and low returns on their investments over a long period of time - they may demand that their leaders and regulators change the distribution of the economic crisis pie. They may demand that the machine handing out profits to the 1%, not by virtue of any special talent but just because they're members of the club, be destroyed.