Fed Up!

The economic meltdown was caused by the underestimation and mispricing of risk. The small town broker,  the average family, and the Wall Street banker were all responsible for taking on too much risk. The government has correctly diagnosed the ailment – in part. While the Fed and Treasury both point to the excessive risk taking, they only seem to place the blame on Wall Street.

As The Financial Times reports, the Federal Reserve has unveiled new rules aimed at limiting and controlling executive pay at all institutions under its purview. This follows sharp controls from the Treasury for executive pay at institutions who still have bailout money.

The Fed defends the proposed rules by claiming they will reduce the excessive risk taking that caused the meltdown. Chairman Ben Bernanke, stated that “…compensation plans that encourage, even inadvertently, excessive risk-taking can pose a threat to safety and soundness.” The argument implies that economic downturn was the direct result of risk taking that was driven by high-pay packages for greedy executives.

This perspective is downright foolish. It is unquestionable that mismanagement and so-called ‘fat cat’ bankers played a role in causing the economic mess. However, they are no more culpable than ‘covetous’ housewives who took out a home-equity loan to buy the flat-screen TV or new Mercedes or the ‘greedy’ loan originator who turned a blind eye to the proper documentation in order to make a quick sale. The fact of the matter is all of America is to blame. Most Americans – individuals and companies – did not make smart investment decision.

The Fed’s new pay policy is simply an attempt to make it appear like the government is doing something productive. In reality, it is simply to appease voters who, egged-on by the finger-pointing Obama, are looking for a scapegoat. It is politically and logistically easier to go after a few, big-target banks, than a million or so credit card owners.

Unfortunately government meddling in executive pay will not make things better. It is the wrong medicine for the correct diagnosis. Such a narrow shot at poor risk-management completely misses the fundamental problem. It obscures the fact that the underlying issues are not and will not be addressed. Even more concerning is the fact that it nestles the government far too deep into the private sector.

Not only will the plan fail to address systemic problems, but it will most likely fail to solve the problem at companies. In fact, it is more likely to exacerbate problems. CBS News reports, that talent is already being driven from top firms. Furthermore, individual executives will find ways around the system. They will find alternative ways of compensation or establish unconventional institutions that do not fall under the purview of the Fed. This will move the main banking industry out of the regulatory eye of Bernanke. At the end of the day the risk will still be incorrectly accounted for and nothing will have changed.

Bernanke is correct that excessive risk is to blame. But let’s step back and stop pointing fingers. Smarter policy that is not punitive and spiteful needs to be designed. Flashy regulations that scapegoat a few individuals while absolving the rest of America from responsibility are counterproductive and will only lead to the next bubble and burst. This is particularly true if our government is simultaneously diminishing risk by bailing-out companies. Any market distortions will misprice risk – why doesn’t the Fed understand this?

The Union Between Failure and Inflexibility

As GM heads towards a government deadline, it is scrambling to restructure and avoid bankruptcy. In the process, bondholders are getting the short end of the stick, being cast as the bad guys. The big winners are, of course, the unions which may receive, according to the latest plan up to 20% of the new GM. (See MSNBC report http://www.msnbc.msn.com/id/30938307).

This is a most unfair solution for the failing auto giant. The United Auto Workers (UAW) and the bondholders share an equal claim to GM’s assets. However, our leftist, pro-union government is demonizing the bondholders and unfairly assisting the union. (See a great editorial by the average American bondholder in the Wall Street Journal http://online.wsj.com/article/SB124338330278956585.html#mod=djemEditorialPage).

If anything, the situation should be reversed. The UAW has way too much power and control in the auto industry. The worst possible solution is to give the unions even greater control over the failing industry. While not the sole cause of the auto industry’s failures, the unions have profoundly contributed to its current state. Unions, in general, contribute to rigidity in an industry. They prevent jobs from being phased out when no longer necessary. This ultimately undermines research and development and technological growth, causing unionized companies to lag behind those without unions. While it is impossible to know what GM would look like today without unions, it is clear that it would have had greater flexibility to change its business model, modes of production, and more. Instead, the stiffness of the system has forced GM and other auto companies to continue a model that should have been discarded long ago.

In non-unionized industries, companies are rewarded – or fail – based on their innovations and specialized superiority. Competition encourages them to reinvent and routinely redesign themselves. If they fall behind, everyone – management, workers, suppliers, retailers – lose out. However in the rigid system of the auto industry, as consumer demand shifts the auto companies are unable to appropriately shift the business. Workers cannot be let go and plants cannot be shut down. This prevents the company from developing new products and methods that could be more efficiently performed with workers or factories with different abilities. Instead, the company must continue an outdated business model and sell an inferior product.

And so for all their contribution to the downfall of the industry, the unions are being rewarded. Once again they are unjustly being a given a piece of the pie that they do not deserve. If our government wants to save the auto industry, it better think long and hard about the role of the union. The answer is not to reward those who made the system too inflexible to succeed, but to create a new, more competitive company that excludes the rigid structures and players that previously dominated. This approach may save the auto industry- giving the UAW undue ownership will not.