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OPINION

The free riders

The free riders
March 13, 2014
The free riders

Meanwhile, in the wider world, executive pay in particular and, more generally, the disparity between the pay and wealth of the richest and the poorest are hot topics. You only have to tot up the column inches devoted to these issues - plus the plethora of investigations and initiatives to help solve them - to know this.

So should shareholders take these things seriously or continue to treat the ritual of corporate governance, which controls executive pay without restraining it, as an inconvenience to be accepted for fear of encouraging something worse by their indifference? Alternatively, if the statistical correlation between restrained executive rewards and good share price performance were compelling or the causal link between the two were established, then shareholders would suddenly become experts in pay restraint and devoted followers of the cause.

Quite likely you can spot that my framing the issue by the use of questions provides its own answer - no one knows whether there is a clear link between bosses' pay and companies' performance or the rewards to the rich and a country's performance, so no one knows how best to proceed.

Economic theory says there is a link between the distribution of rewards and performance and it is framed by a trade-off between equality and efficiency. Here, 'efficiency' is synonymous with 'effective performance'. In other words, the more that a country wants economic efficiency, the more it will tolerate a disparity of pay and wealth; the more it wants equality, the more it will tolerate economic inefficiency (ie, less wealth creation).

However, this idea does not work so well in practice. Take the changing disparity of wealth among nations. Two of the great economic success stories of the past 30 years have been Norway and China. Theory tells us that in order to achieve the startling growth in per capita output that these two have managed in that span would necessitate growing disparity of wealth. China conforms to this notion. In 1981, its income distribution was on a par with Sweden's; today it is level with that of the far-less-equal US, while Sweden's income disparity has stayed pretty much where it started.

Meanwhile, Norway turns the notion on its head. In the 1970s, income was distributed even less equally than in the US, but 40 years on, it is distributed more evenly than anywhere else in the rich world. The only other rich nation that has experienced a similar scale of decline in income disparity in that period (although from a much less equal starting point) is France, whose sclerotic economic performance does at least match practice with theory.

Of course, it's easy to see the exceptional circumstances that would make China conform to the theory and Norway resist it. But when exceptions proliferate - as they seem to here - a theory becomes redundant. Or, at least, it should do, but the equality efficiency trade-off remains dominant, presumably because not enough people have the confidence to challenge it (shareholders in companies, voters in democracies).

As to why not, we can use another idea from academia to explain this - the free-rider problem. Put it this way: everyone knows that most company bosses/investment bankers/private-equity managers (name your bête noire here) are self-serving when they say that they give good value for money, deserve their rewards, only get the 'going rate', and so on. But the trouble is that 'most' does not mean 'all'. Most bosses/bankers/etc are interchangeable. Sack one, bring in a new one and - in the long run - results won't improve even if there is an awful lot of change along the way that masks the lack of progress. But a very few - the ones who are truly six-sigma above the mean - are brilliant and deserve everything that they get. The difficulty is, it's pretty well impossible to know in advance which ones will be dazzling and which will be dozy.

Undeterred by prior probabilities, those who make the selections assume they are picking a brilliant candidate and offer him or her commensurate rewards. Partly they are motivated by the fear of missing the truly outstanding one (made all the more real by the inability to separate brilliance from competence). Partly they are motivated by their own incentive to maintain the illusion that bosses/bankers/etc are worth mega rewards. As a result, lots of capable yet ordinary candidates free-ride on the brilliance of the few.

These thoughts might make it easier for shareholders to stomach formal restraints on executive pay. Granted, such measures will constrain wealth creation in the long run. But that's maybe 30 years away. Before that, formal pay restraints could save a bit of money for shareholders at the company level and - more importantly - bring a bit more economic equality at the national level, which might even generate its own worthwhile incentives. Anyway, not necessarily to be scoffed at.