Thursday, January 7, 2010

Private Vs Public bureaucracies

After examining information on salaries and bonuses for 2,505 CEOs in 1,400 publicly held companies from 1974 through 1988, Michael Jensen and Kevin Murphy argued in a 1990 working paper that what is important with executive compensation is not how much is paid, but how it is paid. They wrote,

"In most publicly held companies, the compensation of top executives is virtually independent of performance. On average, corporate America pays its most important leaders like bureaucrats. Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets?"


Let me illustrate this with two parables. Assume Too-big-to-fail (TBTF) Inc, an investment banking firm operating in Greed Street. Its Chief Expropriation Officer (CEO) is paid $10 m a year plus a bonus of 5% of firms profits. His fund manager is paid at 2% of the funds managed and 20% of the profits made. In true spirit of "limited liability" neither get penalized for any losses.

Now consider the case of the typical Mr Public Servant who is responsible for the delivery of civic services for Public Welfare Department of Government of Democratia, headed by Mr Public Manager. His wages are fixed at $10000 a year irrespective of the final outcome. In other words, Mr Public Servant takes home his salary irrespective of the deliverance of his mandated performance outcomes.

In case of TBTF Inc, the principal-agent problems arise at two levels - one, between owners of the funds being managed and the CEO/fund manager; two, between the shareholders/partners of the investment bank and the CEO/fund manager. In case of Public Welfare Department, the problem operates again at two levels - between Mr Public Servant and the citizens whose interests he is appointed to serve, and between him and Mr Public Manager.

It is very obvious that both cases bear striking similarities. In both cases, the performances of private and public managers respectively are not relevant to determination of their compensation. Interestingly, both TBTF Inc and Public Works Department work as classic bureaucracies. But while the latter's actions and omissions evoke immediate indignation and anger, similar indiscretions and lapses of the former gets overlooked, though the actions of both agents have harmed their principals. An example of representativeness bias?

To those who argue that unlike the officials of Public Welfare Department, the CEO and fund manager of TBTF Inc have to deliver performance to retain their places, I have three issues

1. In an extended asset market bubble, as we have seen from the experience of the last two decades, it becomes far too easy to keep rolling out those spectacular profits. There are very few alphas at work, only a case of rising tide lifting all the boats. The beta gets mistaken for alpha!

2. The moral hazard arising from the absence of penalization provisions if losses are made, coupled with the perverse compensation structure (incentive to take any amount of risk and show short-term profits, so as to keep drawing in investments/funds) only exacerbates the principal-agent problem.

3. When the same compensation structure is in place everywhere and the rising tide is lifting all (or atleast the vast majority of them) the boats, the dis-incentive (or deterrent effect) effect arising from any fear of losing the job is diffused away to insignificance, as to be almost irrelevant.

2 comments:

Harish YN said...

Witty illustrations!

Is there any 'tendency' of public bureaucrats getting attracted to private bureacracies in India?

gulzar said...

thanks

Since the attractions of private bureaucracy is almost equal to the benefits of public bureaucracy plus its fat salaries, it is inevitable that the outflow started. The danger is that it could end up becoming an exodus!