Ian Mulheirn sets out why tackling excessive pay will only work if policy focuses on its cause and not merely on its symptoms.
Tomorrow Vince Cable will deliver a major speech at the SMF on tackling executive pay. Last week was dominated by the three party leaders setting out their plans to rein in corporate excess. Unfortunately the political debate so far has focused on tackling symptoms rather than causes, and the mooted proposals won’t butter many high pay parsnips. Cable has the credibility to set out something more meaningful and effective to tackle this important problem. But the solution, particularly for high pay in financial services, needs to come from a different place to last week’s debate.
Policy prescriptions to date have started with the same assumption: that excessive pay, particularly in financial services, is an affront to the rest of society. This is true. But the emotional reaction leads to three approaches that will ultimately fail to solve the problem. By contrast, understanding absurd remuneration as evidence of market failure leads us to a solution.
The problem with pay restraint
First, let’s look at the solutions that moral outrage suggests. We could, as David Cameron has argued, urge firms to show voluntary pay restraint for top executives in pursuit of a more ‘moral capitalism’. But trying to turn the amoral market place into a bastion of morality won’t work and will probably lead to more questionable corporate behaviour rather than less. How many worthy community projects do big corporates need to sponsor to absolve themselves of their sins on excessive pay? A liberal market economy responds to rules and incentives, not blandishments from supine politicians.
The limited impact of transparency
So what about something less woolly? Real action could take the form of doing something at the point where remuneration decisions are made in companies. Strengthening shareholder oversight and increasing transparency over top pay are the two most commonly suggested remedies this week. But it’s doubtful that these will have much impact and the second could in fact push pay higher. Most institutional investors, even if they did want to act, aren’t short of a bob or two themselves – not the best people to be in charge of pay moderation, you might think. And why anyone thinks that pay transparency will lower CEO wages is just baffling: how many shareholders of aspiring global multinationals want a cut-price Joe in charge?
Taxing high pay
A third approach is to do something after high pay has been awarded, through tax. The problem here is that any meaningful move probably would drive large companies away from the UK, and those that stayed would likely raise the pre-tax awards for their leaders, passing the tax bill on to customers or shareholders.
What’s driving high pay?
Moral outrage is justified but it leaves us tinkering around the edges with ineffectual policies. Instead, we need a better understanding of what’s driving high pay in the first place. That leaves a fourth approach of doing something about the environment that generates such absurd rewards in the first place. In any walk of life there are two ways to make money: you can make value by giving people a product they want, or you can take value, using anything from monopoly power to outright theft. Government’s role in the market economy is to close off the second option.
Economics tells us that in a properly competitive market people’s pay should equal only the value they add – note these are also the conditions of what most would consider to be ‘fair capitalism’. So when we see Goldman Sachs paying employees an average of $367,057 in the past year, that’s powerful circumstantial evidence that the wholesale finance market is not competitive. Either these people are all super-humans or there is rent-seeking going on as the result of weak competition. Indeed, just last year the Office of Fair Trading concluded that the equity underwriting market is “not working well, with little effective competition on underwriting fees”.
In any industry if you pour outsize revenues in one end, they’ll show up in excessive pay at the other. But most sectors are either highly competitive or closely regulated to prevent that happening. In wholesale financial services neither condition applies, and the result is obscene unjustifiable reward for a few. That’s bad for society and bad for capitalism. But there will be no solution to the high pay problem if we keep debating the symptom rather than the cause.