Taking Stock / Hole in One

On the eve of the presidential elections in the United States, Barack Obama spoke at length about the need to rein in pay on Wall Street. During his first months in office, he continued his aggressive line against high executive pay, backed by the state of the economy. Wall Street was in meltdown and Washington's decision to rescue companies that had been led by men earning sky-high salaries, at a cost to taxpayers of hundreds of billions of dollars, proved that even in the U.S., capitalism only works when times are good. When the crisis comes, the taxpayer is called to the flag to pay for the managers' mistakes.

Last month, the moment of truth arrived. Executive salaries on Wall Street in 2009 were published, and the public outcry arose anew. Obama, for his part, changed his tune to a more conciliatory one. Asked about banker salaries, this time he said they were highly skilled people, and besides, there are baseball players who earn more.

Comparing salaries of top executives at publicly traded companies to rock stars and sports superstars has become quite the rage. When you compare a star golfer's pay to that of a banker, it's easier to ask - why so hostile to the banker while handling the golfer's take with equanimity? Talent costs money, right? In one case you pay for the talent of kicking a ball or hitting a hole in one, in the other you pay for the talent to run a finance organization with thousands of employees. Right?

Not right. There's a big difference. Comparing executive pay with that of celebrities is pure manipulation that serves the piggishness of the former.

The pay of stars, in sports or otherwise, is a direct and accurate result of the free market paying for skill, for the ability to generate money or ratings.

A bad sports star doesn't make a fortune. A bad sports star doesn't get a contract based on his social contacts.

The pay of all too many bankers is a direct and accurate result of a market failure in which managers can perform poorly or even destroy value and still make a fortune.

Comparing the salaries of cultural superstars and bankers is one of the many lies sold to the public so executives can continue raking it in and get thanked for their leadership, too.

Here are a few more of the lies pushed down the public's throat.

* "High executive pay is a direct result of the free market and the capitalist way."

That is the greatest of meta-bluffs. It incorporates all the garbage about executive pay into one stale cliche.

I believe in the free market, in competition, and in meritocracy. I have been advocating these values in my writing for 20 years. I want to live in a society that esteems talent and grants full freedom and opportunity to talented people.

But a growing part of the pay lavished on the top people today in the Israeli economy (and elsewhere) is unmerited. It doesn't measure market freedom. It measures the free market's failures.

To be accurate, it reflects the points at which the price of the manager fails to express the real market for talent.

The highest salaries in Israel are paid in sectors controlled by cartels and monopolies, where competition is nonexistent. The main skill evinced by the people controlling these companies is to preserve the anticompetitive structure of their industries.

Take the banks. We're told bankers deserve their high pay because they're talented, and that's what you have to pay to get talented people. Yet behold! When you analyze Israel's banking system over years, you find some interesting stuff. For instance, not one of these luminaries managed to increase his bank's market share by any significant measure. The banks are a cartel that divided up the market. Some of them have no "management" at all because the unions won't let the managers do anything. The CEO of one bank told me a year ago that the bank is run by the union and that he has no freedom of action. That didn't stop him from accepting pay amounting to tens of millions of shekels a year.

? "The base salary of executives derives from market prices. Bonuses are linked to performance."

Balderdash. The base salary of executives in many sectors is affected by pay inflation at other companies, where market failures determine pay levels. As for bonuses, these get paid regardless of the state of the market and are easily manipulated.

Many managers accept bonuses during the good times but don't return the money when profit at their companies vanishes.

* Rewarding executives with stock options links their value creation for shareholders to their pay."

Sounds good. Should be true but often isn't: History shows that companies have turned the entire stock-options mechanism into a joke.

First of all, when any market is rising whether because the economy is strong or interest rates are low, stock options turn managers into multi-millionaires whether they're good managers or not. Second, when the market is falling, corporate boards tend to "adjust" the terms of the stock options. In short, stock options often pay off no matter what happens.

* "The company is privately owned. Yes, its shares are traded on the stock market, but it has controlling shareholders that pay the bonuses."

No. If it's listed on the stock exchange, the company is not privately owned. And whereas 15 years ago, sky-high executive pay was a rarity for the gossip columns, today it's become a macroeconomic and national issue. More than half the pension savings in Israel are in the free market, in shares and bonds of listed companies. Executive pay is eating at these pensions. Mrs. Cohen of Hadera is paying their salaries.

Even a privately owned company not listed for trade can be public, economically speaking, if it's part of a cartel or monopoly. Then its managers take their pay from the monopolistic income they make, at the public's expense.

* "The salaries were approved by the board of directors and controlling shareholders."

Experience proves that controlling shareholders often have alien interests when lavishing high pay that has nothing to do with value creation. If anything, experience shows that companies with controlling shareholders who do have a long-term vision tend to pay their executives less.

As for the board, usually directors serve as rubber stamps. Israel's economy is small and crowded and the directors are covering their behinds. Serial directors don't want to be marked as troublemakers or they won't get hired to other boards.

Management professor Henry Mintzberg summed up the truth behind sky-high executive pay in the United States nicely. Some of his words apply to Israel, too.

While managers are described as leaders , in practice they're gambling in a fixed game.

1. They're gambling with other people's money: that of their shareholders and workers, who could lose their jobs.

2. They get their money not only when they win, but when they only seem to be winning: when the stock rises, or when their bonuses kick in based on accounting criteria.

3. They get money even when they lose the game. It's called a "golden parachute."

4. Some get bonuses even before the game begins; for instance, when agreeing to a merger that may or may not work out. (Most don't.)

5. Some managers get bonuses just for agreeing to stay at the table.

Mintzberg concludes that not only do executive salaries detract from profit, they can ruin companies and create an anti-management culture.

The underlying assumption in most bonus plans is that the company's health is represented by financial parameters or its share price. But companies are far more complicated. Their true health is reflected by what accountants call goodwill: the quality of their brands, their reputation, the depth of their management culture and the managers' and workers' commitment to the company.

More importantly, the wrong assumption that management performance can be gauged by financial parameters ruins management. Focusing on financial parameters becomes a convenient ploy for detached managers who don't understand their business and don't have true management depth.

Impatient managers can abuse financial parameters, ruining the company's goodwill by cutting costs and customer service and replacing talented but expensive workers with cheap ones.

What about the argument that you have to pay top dollar for talent because otherwise you won't get the best?

That can be true, but in some cases it's not. As Mintzberg explains: "I believe that if you do pay bonuses, you get the wrong person in that chair. At the worst, you get a self-centered narcissist. At the best, you get someone who is willing to be singled out from everyone else by virtue of the compensation plan."

Mintzberg is convinced that excellent people can be brought into management without high bonuses because the best people are looking for things other than money: position, the pleasure of managing a big company, or the opportunity to wield influence.

The last two years have brutally exposed the market failures in Israel and the world, as well as the need for intervention. In tiny, cartelistic Israel, where the government is deeply involved in many aspects of the economy and everybody knows everybody else, many places are vulnerable to market failures concerning executive pay. The legislator, the regulator and the public should think about how to fix these market failures.