Finance and the Good Society

Robert J. Shiller

• Editorial: Princeton University Press
• Año: 2013
• ISBN:
  9781400846177
• Categoría: Business
• Categoría: Finance

Nobel Prize-winning economist explains why we need to reclaim finance for the common good The reputation of the financial industry could hardly be worse than it is today in the painful aftermath of the 2008 financial crisis. New York Times best-selling economist Robert Shiller is no apologist for the sins of finance—he is probably the only person to have predicted both the stock market bubble of 2000 and the real estate bubble that led up to the subprime mortgage meltdown. But in this important and timely book, Shiller argues that, rather than condemning finance, we need to reclaim it for the common good. He makes a powerful case for recognizing that finance, far from being a parasite on society, is one of the most powerful tools we have for solving our common problems and increasing the general well-being. We need more financial innovation—not less—and finance should play a larger role in helping society achieve its goals.Challenging the public and its leaders to rethink finance and its role in society, Shiller argues that finance should be defined not merely as the manipulation of money or the management of risk but as the stewardship of society's assets. He explains how people in financial careers—from CEO, investment manager, and banker to insurer, lawyer, and regulator—can and do manage, protect, and increase these assets. He describes how finance has historically contributed to the good of society through inventions such as insurance, mortgages, savings accounts, and pensions, and argues that we need to envision new ways to rechannel financial creativity to benefit society as a whole.Ultimately, Shiller shows how society can once again harness the power of finance for the greater good.

Part One

Roles and Responsibilities

An old saying holds that while the problem with socialism is socialism, the problem with capitalism is capitalists. Some of the headlines of the past decade—from the exploits of the executives of Enron and Satyam to those of the likes of Bernard Madoff—would seem to confirm that the problem with financial capitalism is indeed financial capitalists. But achievement of the good society is dependent on a healthy and robust financial sector—including the people who occupy the roles that enable the financial system to run, and thus help the economy to run. If finance is the science of goal architecture, those who work in the field are the architects who structure these goals and manage the risks of small businesses, families, school systems, cities, corporations, and all the other vital institutions throughout society. If finance, properly understood in the good society, is the stewardship of society’s assets, it is these same people who are entrusted with the management and cultivation of those assets.

In this part of the book we review a full array of roles played by financial professionals, from CEOs through accountants and philanthropists. The idea is not to biopsy these roles for their flaws. Rather it is to get to the heart of their value; to understand their functions; to better appreciate how factors such as rewards, reputation effects, and codes of conduct promote best professional practices; and also to predict how these roles are likely to change in the future. And it is also to try to understand why so much of the public does not seem to appreciate the value of these roles, and why there is so often hostility toward those who fill them. For all the talk of critics and apologists alike about Wall Street, a clear, succinct account of the various roles and relationships that actually make it work has not existed until now. But any discussion of the future of finance and its connection to the goals of the good society presumes an understanding of these roles, so we begin here.

Chapter 1

Chief Executive Officers

The CEO of a company is in a very special position, because he or she stands for an idea—the core idea behind the company’s activities, a way of thinking that defines the work of all the company’s employees, and a culture that includes its corporate values, connecting the company to the larger society.

The CEO is responsible for the formulation of short-run goals that promote that very idea. The CEO embodies the purpose of the company. This responsibility has to be put, to a significant extent, into the hands of an individual and not a committee of equals, just as the writing of a novel usually has to be put into the hands of one individual. Human society has natural tendencies that can coordinate the activities of teams of people in performing routine tasks; teams seem to form naturally, but they are also vulnerable to conflict and to being sidetracked by the individual goals of their members. We still need the prefrontal cortex of one individual—however it may work—coordinating the activities of large groups of people. Large groups of people cannot be strategic or purposeful if they are leaderless.

A Succession of CEOs

That said, the corporation has a fundamental problem: it has to deal with a succession of CEOs. Companies, with luck, may live for centuries. CEOs, subject to human mortality, cannot.

The essence of a corporation is its longevity. Successful corporations have no termination date, no shelf life, no inherent limits on how long they can operate. The succession of CEOs of a corporation is like a succession of kings of an empire, each one of whom takes up the flag from a fallen predecessor and reinterprets and further develops the cause. Except CEOs cannot relax to enjoy the lives of kings: they have to work especially hard.

A CEO typically serves for only a few years, during which time she or he has to set goals for a company that is much longer lived than the CEO’s own tenure. Thus there has to be an effective reward system that focuses the CEO on the long term. And this is a problem that lends itself to financial solutions.

CEOs have egos and personal interests that do not necessarily coincide with the long-term interests of the firm. Companies must find ways to keep their leaders focused on their jobs, attending to the boring and often unappreciated tasks that take up much of their time. A corporation needs a leader who will do an inspired job of keeping everything running over the long term, anticipating trends and shifts and providing a vision for the company, while putting his own needs and wants second.

The ego of a CEO is most naturally satisfied if he or she is the founding CEO of a company, for being first in any succession carries with it the greatest ego gratification. The founding CEO of a company is of special importance. If the company endures, the founding CEO may well become a legendary figure to later generations. Years or even centuries later, the founding CEO may be remembered by employees as an almost mythic figure.

Anthropologists have noted a human universal called a creation myth—a story that everyone in a given society knows, one that describes their origins.¹ Such a myth is typically humanized by the identity of a major leader. A founding CEO is part of the creation myth for a company. The founding CEO knows this and instinctively pursues such legendary status, living out a new version of that same ancient story. But that is only the first CEO.

Behind the succession of CEOs lies a financial structure, which indeed makes each CEO’s employment possible. The CEO of a modern corporation is technically just an employee, serving at the discretion of the board of directors. He or she is defined by a financial contract, with terms relating compensation to the performance of the company and its stock. The CEO depends on a certain financial structure, a financial invention, for motivation.

Even though the CEO is usually not the founding CEO, he or she is still expected to be a visionary. The modern corporation must be reinvented again and again, in response to new information and new market demands.

Success in reinventing the company is reflected in financial prices. When the CEO is successful, the price of shares in the company goes up. When the CEO fails, the price falls. A CEO avidly watches the company’s share price—it is like a continual report card on his or her activities, issued minute by minute. It is the reward signal for the cognitive center of the company, and there is an analogy to the reward system for the decision-making apparatus in the human brain, a point to which we shall return later in this book. In the corporation, as in the brain, the reward system is imperfect but essential.

The financial arrangement for the typical CEO is carefully human engineered, designed to incentivize that person to stay in the position long enough and prominently enough that his or her relationship to others as their leader becomes firmly established in everyone’s minds.

The dispensation to CEOs of stock or options on the company’s own shares is a method of aligning the CEO’s incentives with those of the company. An option to buy a share in the company at a specified price is valuable only if the actual market price is higher, and so granting options to the CEO creates an incentive to take actions that will boost the firm’s share price.

A share of stock does not have a termination date, as does the CEO’s tenure. Assuming that the stock market price of a share in the company is a good indication of its true long-term value, then the change in the stock price is a measure of the CEO’s contribution to the long-term value of the company. The stock price signals a reward only if there is good news. It responds to actual news, and it does not encourage gloating over past successes. The CEO is thereby incentivized to be the bearer, to attentive investors, of good news about the company’s long-run potential—news about the long run, but news that is delivered today, right now—and thus to plan for the indefinite future, not just his or her own tenure.

Incentivizing by stock options can be a lot better than awarding bonuses to the CEO for achieving high profits: profits-based bonuses might encourage the CEO to merely milk the company in the short run, neglecting longer-term problems and leaving a disastrous situation for his or her successor. With stock-price-related incentives, on the other hand, the CEO is encouraged to steer the company toward opportunities that could improve its long-term value.

Setting the Level of the Reward

The salaries and bonuses of CEOs are the subject of many news accounts, owing to their extraordinarily high levels, especially in recent decades and especially in the United States. The anger and resentment over executive compensation account for much of the public hostility toward financial capitalism in general.

But sometimes a high level of compensation for a CEO is readily understandable. Consider the example of a man who was the very successful CEO of Corporation A, who has turned the company around, taking it from the brink of failure to success. Along the way he handled numerous unpleasant tasks like firing key people, waging policy battles against entrenched forces within the company, and shutting down operations—and he did so in such a politically deft way that those who remained in place were not resentful, and indeed were motivated to take the company to new levels. He was paid handsomely for his work, and he now presides over a well-managed, successful company. He may be thinking about retiring early and enjoying some of his fortune.

Now suppose the board of directors of Corporation B feels it needs to take those same drastic actions. It is entirely plausible that they would ask our CEO to quit his present job and become their new CEO. They could ask someone with no such experience to do what he did, but that other person would not have the same personality, the same judgment. They want him.

It is entirely possible that our CEO will respond that he has had enough of this unpleasant business and in fact has more money than he could ever spend. No, he doesn’t want to go through all that again.

So it is plausible in turn that the board of Corporation B would offer a really attractive package to lure the CEO—a package that might, say, offer options on the company’s stock potentially worth $30–50 million if he is successful. That amount is not enormous relative to the earnings of a large company. A diligent board exercising its fiduciary responsibility in presiding over a company with billions in revenue might consider a highly qualified, proven CEO worth all of this.

Running, or turning around, a business all over again, after one has already done it, may not seem all that glorious in and of itself the second or even third time around—yet it is precisely those who have done such an important job before who have the best credentials to do it again. CEOs, even those of Fortune 500 companies, are not usually particularly beloved or famous, with only a few exceptions. Thus high compensation is the best way to attract qualified candidates to such jobs.

It is often observed that in decades past, when CEO salaries were much lower, companies still found people who were willing to do the job. As president of American Motors from 1954 to 1962, George Romney, Mitt Romney’s father, turned down huge bonuses.² In 1978 Lee Iacocca offered to serve as the CEO of Chrysler, to save it from bankruptcy, for a salary of only one dollar.³ These are fine examples, but they do not mean that companies can always cheaply hire the CEOs they want. Romney and Iacocca were rare exceptions: each had a strong public moral persona, and for them such symbolic gestures may have been especially important. Romney later became governor of Michigan, and Iacocca later wrote three best-selling books about his business philosophy. At one time or another both showed signs of running for president.⁴

Moreover, the growth in high salaries that we have seen in recent decades might in part be explained as the result of improvements in our capitalist system, as the system comes to recognize the importance of qualified leaders and refuses to be bound by arbitrary pay conventions.

This is why the Squam Lake Group (a nonpartisan, nonaffiliated group of fifteen academics who offer counsel on financial regulation, of which I am a member) advised in its 2009 report that the government should not regulate the level of CEO compensation. Some CEOs are, and always will be, worth a great deal to their firms. On the other hand, the group did believe that regulation of the structure of CEO compensation is called for.⁵

Moral Hazard and Deferred Compensation

There is a reason for the government to intervene in the process of determining executive salaries: to mitigate a specific moral hazard that seems to have played a substantial role in causing the financial crisis that began in 2007—at least for big and so-called systemically important firms. This moral hazard arises because the CEOs and other top officers of such key firms have incentives to take extraordinary risks. They believe that their companies are too big to be allowed to fail. Because the failure of their companies would be simply too disruptive to the economy as a whole, they reason that the government will not allow that to happen.

Given such a mindset, the CEO may not very much care about the risk of precipitating an international financial crisis. He may on the other hand be very interested in taking a gamble that gives him a 50% chance of achieving a huge increase in the stock price and so reaping a windfall on his stock options—even if that same gamble has a 50% chance of wiping out the company and taking much of the global economy with it. In the one case, he ends up rich. In the other, well, his options are worth nothing—but they might have been worth nothing for sure if he had not taken the gamble.

Moreover, a CEO with a stock-option-based compensation scheme has an incentive to manipulate the flow of information out of the company and to doctor financial reports—to delay the release of unfavorable information until after he has received his compensation. And such practices do not conflict with the efficient markets theory—the theory, to be discussed in various places later in this book, that market prices efficiently and quickly incorporate all public information about a company. The CEO is a company insider and knows things that are being deliberately kept secret from the market.

Therefore, the Squam Lake Group recommended that government require that systemically important firms defer a substantial part of their CEOs’ compensation for an extended period, say, five years.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States contains terms that resemble the Squam Lake Group’s recommendation. Notably, the act includes provisions that require a CEO to give back “erroneously awarded compensation” that was the result of “material noncompliance of the issuer with any financial reporting requirement under the securities laws.”⁶ Yet the Squam Lake proposal is more far-reaching, in that it would deprive the CEO of the rest of the compensation if ever there were a bailout or failure of the company.

Cronyism in the Boardroom

Of course there are different circumst...