Mitchell’s Musings 7-31-2017: If-Then

28 Jul 2017 1:06 PM | Daniel Mitchell (Administrator)

Mitchell’s Musings 7-31-2017: If-Then


Daniel J.B. Mitchell


Human resource practitioners have long had experience with compensation systems based on some version of “pay-for-performance” rather than just measured time worked. Simple piece rates and sales on commission are examples of arrangements that have been used with varying degrees of extensiveness for decades. And the problems that arise from the simple and appealing concept of pay-for-performance are well known. Piece rates by themselves emphasize quantity over quality and can lead to shoddy products unless some other controls are implemented. Individuals on commission may end up misrepresenting what they are selling, ultimately causing harm to their employer once lawsuits and public approbation arise.


A recent review article in the Journal of Economic Perspectives focuses on the pitfalls of “financialization” in corporative governance.[1] By “financialization,” the author refers to the practice of rewarding top executives by some measure of the firm’s share price or profitability. For example, if you give executives stock options in the firm and the share price rises (for whatever reason, but maybe because of their smart managerial decisions), the executives reap a reward. One theme in the article is that such financial approaches to pay-for-performance by executives have drawbacks in actual practice. Given the long history of reward systems and their pitfalls for ordinary employees, perhaps this conclusion regarding executive rewards should not be surprising. Maybe more surprising is that the literature cited in the article is mainly focused on high-level corporate governance, but the longstanding human resource experience is not referenced. Sometimes history outside one’s immediate focus has something to teach.


In any case, I was struck by one excerpt from the article: (page 32)


The important real-world issues around corporate governance do not fit neatly into most common economic frameworks and models. The history of corporate governance includes a parade of scandals and crises that have caused significant harm. Although each episode has its unique elements, after each scandal or crisis, the narratives of most key individuals tend to minimize their own culpability or the possibility that they could have done more to prevent the problem. Common claims from executives, boards of directors, auditors, rating agencies, politicians, and regulators include “we just didn’t know,” “we couldn’t have predicted,” or “it was just a few bad apples.” A recent report commissioned by the board of directors of Wells Fargo Bank regarding the scandal in which bank employees misled customers and fraudulently opened accounts for years referred to executives and the board as having a “disinclination... to see the problem as systemic” despite numerous flags and opportunities to act.[2]


Economists, as well, may react to corporate scandals and crises with their own version of “we just didn’t know,” as their models had ruled out certain possibilities. They may interpret events as benign, arising from exogenous forces out of anybody’s control, or try to fit the observations into alternative models. However, many economic models still ignore highly relevant issues of incentives, governance conflicts, enforcement, and accountability. Economists may presume that observed reality is unchangeable or efficient under one set of frictions, while leaving out other frictions and ways to address them through changes in governance practices or policy.


The article then goes on to elaborate on the deficiencies in economic models that seem to have played a role in the move to financialization of corporate governance. But implicitly there is another question that can be raised. What is the reward (and penalty) system for economists whose ideas help lead to practices that have real world consequences? In broader terms, financialization affected not only firm governance, but also the development of instruments that were abused and ultimately produced such negative externalities as the Great Recession.


In the end, almost all reward systems have an If-Then component. If you produce more widgets, then your total pay from piece rates will be higher. If you sell more stuff, then you will earn more in sales commissions. Are you a lawyer on contingent fees? If you win your case, then you will share in the settlement and the bigger the settlement, the more you will receive. If you are a top manager whose good decisions cause the firm to be more profitable or cause its stock price to rise, then you will be rewarded.


Indeed, even if you are not covered by an ostensible pay-for-performance system – i.e., you are paid a straight hourly wage or annual salary – there is a crude IF-Then element in the overall employment relationship. If your performance is not viewed as satisfactory by some kind of review process, then you can be fired. Of course, all of these systems are employer-specific. If there is some kind of external effect on society – increased inequality, a financial crisis that tanks the larger economy – the compensation system does not directly penalize you. And, for that matter, if you make decisions that benefit the larger society, the same is true, i.e., there is no direct reward.


The externality issue is not something that is likely to be addressed when it applies to top executives. Firms will tend to be focused on their own narrow performance. But what about economists whose ideas have potential effects beyond the usual academic reward system of tenure, having papers appear in prestigious journals, etc.? The usual “fix” for (inevitably) defective reward systems is some kind of regulation. Thou shalt not do X. Thou shalt do Y. What about in academia?


Recently, there has been a spotlight on the so-called “Goldwater Rule” for professionals in the psychological and psychiatric fields that essentially is aimed at stopping the public diagnoses of political figures. The origins of the rule go back to the Johnson-vs.-Goldwater presidential election of 1964. Its re-emergence as a professional constraint was triggered by the Trump phenomenon.[3] The Goldwater Rule is an example of a negative thou-shalt-not regulation. In economics, particularly empirical economics, an example of a positive thou-shalt rule is the requirement by many journals that data sets that are the basis of an article be made available to other researchers.


It’s not at all clear that the problem of economic concepts spilling over into public and private policy and into society – with consequences – are well covered by academic reward systems or any professional regulations. Particularly when it comes to negative societal effects, it’s not even clear what some equivalent of the Goldwater Rule would be. Just saying you shouldn’t espouse theories that end up tanking the economy would be meaningless. If it were obvious ex ante that a theory would have that effect, it probably wouldn’t have been espoused.


We do have positive systems of recognition in economics including a Nobel Prize that focus on what seem to be positive contributions. In the spirit of If-Then, if it appears after-the-fact that there were negative impacts, some professional “recognition” might also be needed. By now, most in the profession would accept the verdict that the idea in the late 19th century (by long dead economists) that the business cycle had something to do with sunspots was wrong. But there would be more controversy as we approached more recent events such as the Great Recession. No one likes to admit error or take blame, so a Hall of Shame is not likely to be established. Maybe the best that can be done is to encourage more review articles that highlight economic concepts that didn’t work out or led to bad results.

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Footnotes:

[1] Anat R. Admati, “A Skeptical View of Financialized Corporate Governance,” Journal of Economic Perspectives, Vol. 31, Number 3, Summer 2017, pp. 131–150. Available at: http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.31.3.131.

[2] Note that here, the author is citing a contemporary example involving ordinary employees, again without noting the longstanding literature regarding reward systems at that level.

[3] https://www.theguardian.com/science/head-quarters/2017/jul/28/the-goldwater-rule-why-commenting-on-mental-health-from-a-distance-is-unhelpful.


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