Boardroom pay stokes passions. Having lost the 2017 election by less than pundits (including me) had predicted, Jeremy Corbyn felt emboldened to attack a “broken economic system” and call for an end to “greed-is-good” capitalism. Though the market economy is in fact resilient rather than broken, its defenders are forever being accused of advocating avarice. It’s a potent criticism but a false one, and its hollowness is currently being demonstrated by shareholder resistance to excessive executive rewards.
Foxtons, the estate agency, is facing strong criticism from investors over a decision to give its chief executive, Nic Budden, a bonus of almost £1 million for 2020. This was a year in which the company received £4.4 million in furlough payments and £2.5 million in business rates relief. The bonus, comprising £389,300 in cash and £589,000 in shares, is on top of Mr Budden’s salary, taking his total compensation to £1.6 million, compared with £1.25 million the previous year.
Advisers to the shareholders are urging them to vote down the remuneration package, and I totally agree with them. I hope shareholders do this more often; there’s a good reason why supporters of the market economy should encourage this type of shareholder activism, and it has nothing to do with the politics of envy.
First, let me give a personal digression on the merits of the market. One of the hazards for anyone who spends time, as I once did, in Labour politics is that constituency activists continually hunt for heresy. I found it tough to counter the accusation that I was not a socialist at all but merely a liberal, because it was true. On grounds of efficiency and liberty, I favour a market economy rather than a collectivised one. I want a bigger state and more extensive welfare spending than my Conservative colleagues such as Daniel Finkelstein and Matthew Parris, but I don’t want to nationalise profitable companies or supplant the price mechanism in order to get there.
Among the insights of economic liberals such as Friedrich Hayek is the futility of seeking to determine what is a “fair wage”. We don’t have the knowledge to ensure that a particular wage will attract enough workers to produce enough goods or provide enough services to meet consumer demand. A complex economy requires a phenomenal amount of information to be transmitted about wants, needs and preferences. This information is generated constantly by shifts in relative prices. Some degree of income inequality is needed in an efficient economy, not just to provide incentives but to yield information. It’s a signal that acquiring or improving particular skills will be worthwhile in the labour market.
There are problems, however, at either end of the income distribution. Monopsony wage determination (in which a few large companies are able to set wages in the marketplace below market clearing levels) amply justify a minimum wage. And in executive pay, we come up against problems like Mr Budden’s compensation package, which seems quite arbitrary.
What’s happening here is a type of principal-agent problem. The chief executive of a quoted company is the agent of the owners. Normally in a publicly quoted company the shareholders are many and not coordinated. Rather than being set in the marketplace, extravagant executive pay is set in the boardroom; it’s the directors who in practice the chief executive is answerable to. The owners, being variegated, don’t normally have the power to rein back these pay awards.
Well, that’s what’s now happening at Foxtons, and rightly so. Let’s hope there’s a lot more of it in British business. The owners (that is, the shareholders) are forcing the agents to justify a big pay rise apparently independent of the company’s performance and when it has benefited from public funds. Nor is Foxtons a one-off. There is a problem of executive pay that ought not to be left to Mr Corbyn to remark upon. It’s not only the size of pay awards but the structure of them that’s at issue.
One very common way of aligning the interests of agent and principal in a quoted company is to provide executive compensation in the form of stock options. Both the chief executive and the owners benefit from rises in the share price. It sounds a neat solution but it isn’t, even in principle. A minor criticism is that the chief executive may well take poor corporate decisions that are nonetheless consistent with a rising share price. For years before the pandemic, many big companies engaged in share buybacks, which drove their share price higher. It turned out to be a disastrous decision when the shock of the pandemic struck, and the companies had very little cash left with which to pay furloughed employees.
The still bigger problem is that, if a chief executive has a lot of their compensation and wealth tied to the share price of one company, that’s risky. The rational thing (I’ve always done this when I’ve owned shares in my employer) is to sell as much as you’re able to when a vesting date arrives, and put the proceeds in a diversified fund. And because it’s risky, the chief executive will typically require a bigger pay package than they would if compensation were purely in cash.
There’s a way of managing this problem that is if anything worse than the problem itself. One final issue with stock options is that, in numerous cases of corporate failure, the executive turns out to be cushioned by generous redundancy terms. This is not only perceived as unfair by workers who lose their livelihoods, but actually encourages the top management to pursue greater business risks than they otherwise might. The rewards are stacked towards the chief executive and the directors, and the risks are borne disproportionately by employees (and, in the case of banks in the crash of 2007-09, by the taxpayers).
Though my own preferences in policy are for more welfare spending and a bigger state than my Conservative friends and colleagues, support for the market economy is a crucial message in these polarised ideological times. My plea to those who recognise the need to defend markets is to take seriously the problems in wage setting for the low-paid and the high-paid.
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