After the Bell: Executive remuneration and unintended consequences

What is the world’s most unintended, unintended consequence? We hear all the time about “unintended consequences” and, you know, I kinda love them. The contrarian in me can’t help being amused by how strange and odd the world is. Of course, some unintended consequences are just horrible – actually, many are. But it’s really curious how often they occur.

Some of the world’s most unintended consequences were prohibition in the United States, and later the ‘war on drugs’ in the 1970s. Both led to huge rises in organised crime, enormous losses to tax revenue, and, ultimately, an increase in usage. The seventies is sometimes regarded as the druggie decade. But actually the real drug decade is now. In the US, death from overdoses per 100,000 people in 1970 was 3.8. In 2020, it was 28.3 – about 100,000 people a year. I am not making this up. It’s beyond shocking.

Perhaps the most awful unintended consequence was the Great Leap Forward in China, intended as an attempt to rapidly transform China from an agrarian society into socialism through rapid industrialisation and collectivisation. The result was widespread famine and around 30 million people dying from starvation. 

One of the most classic unintended consequences was something called the “cobra effect” in colonial India. The British colonial government in India decided to offer a reward for dead cobras to try to reduce the cobra population in Delhi. The result was a massive increase in cobras, because, of course, people started breeding them to get the bounty. And so it goes. 

In finance, there have been two notable unintended consequences. The first in the US was the Repeal of the Glass-Steagall Act in 1999 which separated commercial and investment banking. The deregulation led to catastrophic consequences in the 2008 financial crisis after excessive risk-taking led to a global banking collapse, although it’s possible excessive risk-taking could have happened anyway. 

But the other notable financial unintended consequence was the requirement to publish CEO remuneration, which was intended to constrain pay levels and reduce inequality within companies. The effect was entirely the opposite, as boards started using the disclosed ratios as targets rather than as a warning. 

Comprehensive disclosure of executive pay was introduced in the US in 1992 (and SA shortly afterwards) and at that point, the ratio between CEO salary and median salary was about 60 to 1. It’s now about 200 to 1. Once again – not making this up.

There is a wonderful name for this in the research called the ‘Lake Wobegon Effect’, which argues that because no firm wants to admit to having a CEO who is below average, no firm allows its CEO’s pay package to lag the industry average. The name comes from public radio host Garrison Keillor’s mythical home town of Lake Wobegon, Minnesota, where all the children are above average. 

So this is all a lead-up to SA’s Companies Amendment Act, one of the many passed in a rush before the election, with the obvious intention of trying to win votes. There is a lot to the act, but one aspect is the requirement for all public companies and SOEs to develop and publish a remuneration report stating all directors’ remuneration; what the highest and the lowest paid employee gets, and what the top 5% and lowest 5% get. 

This is very different from how it’s handled internationally, where the common ratio is total CEO remuneration compared to median pay. Why did SA legislators go for this highest-paid/lowest-paid system? To be honest, I haven’t seen an explanation directly on that point, but I can guess; I think this is an activist-styled demand intended to embarrass companies rather than actually trying to fix anything. Why else go for top vs bottom, as opposed to something more sensible like the Palma ratio, which compares the bottom 40% of earners with the top-paid 10%?

There is no requirement in the legislation that demands companies operate within certain bounds, and you can understand why: if they did, companies would immediately outsource their lowest paid workers. See unintended consequences above. My colleague Ray Mahlaka has already criticised this legislation for not including outsourced workers.

But more pertinently, what does a very big gap, or a very small gap, actually tell us? We already know that this gap is huge, and it’s huge because SA has this enormous unemployment rate negatively affecting competition at the bottom of the pyramid, and a huge skills shortage at the top of the pyramid, affecting competition at the top of the pyramid. 

Obviously, as a priority, we all want to get the gap down, so I suppose there is some utility in measuring it. So this is a step forward in that respect. But if the proponents of the legislation think publication alone is going to help here, I think they have another think coming. The dynamics of the labour market are much more complicated than that. 

In some senses, it is actually dangerous because it falls into that terrible South African habit of pretending to do something by righteously and venomously shouting about it in lieu of actually doing something concrete about it.  Actually doing something about it would be to concentrate on improving SA’s skills base, which would improve productivity and make employees worth more and they would be paid more and the gap would close. 

SA’s low level of productivity is very much part of the problem here, and it’s rather astounding considering how much is spent on skills training and education in general.  

Finally, it’s worth asking why the mere publication of inequality stats is proving such a weak tool in fixing the problem all over the world. There are lots of reasons, of course, including that there are no real consequences for large disparities, and probably rightly so, because, as a friend pointed out, we don’t have a standardised normative agreement about what is acceptable and what is not. 

It’s also that markets can be a bit potty – and because executive pay is often constituted in share options, CEOs can find themselves earning gobs, or not, for no other reason other than that the market got a bee in its bonnet about something. 

Just to take one recent example: shares of Seattle-based Starbucks surged 25% on Wednesday, the most ever, and added $21.4-billion to the company’s value after it announced it had hired Chipotle Mexican Grills’ CEO Brian Niccol. 

Niccol could – and probably will – argue that next to this increase, the $110-million payday of his predecessor was kinda cheap. Trying to fit enforceable ratio rules into this scenario would be tricky, to say the least. 

For the moment, these ratios are more useful as indications of outliers than as tools for generic social change. Sadly, imho. BM