Bob Diamond, head of Barclay’s investment banking division, earned £21m ($42m) in pay and bonuses last year. His basic salary was about 1% of this. Tim Harford shows how rational expectations theory can be used to explain the process
In the popular reports, Bob Diamond’s recent remuneration has been contrasted with Barclay’s drop in profitability. However, as President of Barclays PLC, and Chief Executive of Investment Banking and Investment Management, which was the most profitable part of the company, Diamond Bob can make a case for being its highest earner, if not the highest among executives in the FTSE 100 this year.
Where’s the logic of it?
Don’t ask me. Rather, take a look at Tim Harford’s analysis in The Logic of Life. The intrepid Undercover Economist is, as ever, elegantly pungent. Particularly relevant is the chapter entitled Why your boss is overpaid
According to expectation theory, It’s partly a matter of the cost of hard-to-obtain information. In business life
…it is hard to pay people as much or as little as they deserve [p89] …
Added to which is the assumption that the human inclination for players within any system is to achieve stated criteria in order to maximize personal reward. This is an inconvenient point for remuneration specialists.
He illustrates how very large leadership rewards can be explained ‘rationally’. He takes the case of Michael Eisner and his $800 million acquired in his thirteen years as CEO of Walt Disney. Was is a good deal for Disney?
According to Harford, the golden carrot might not have been one open to precise calculation, but it might still have been cost-effective, assuming the Company had been unable to find merit in seeking a lower CEO compensation deal.
He outlines the incentivisation arguments for linking the CEO’s pay to share price, and therefore to monster stock-options. The deal he secured did not need even to motivate Eisner directly.
‘ …if Eisner’s pay motivated his underlings to add more than the $ 800 million [of value], then it would have [still] been rational for Disney’s shareholders to pay Eisner …to spend all day with his feet up on his desk watching Tom and Jerry’.
The ingenious Mr Harford goes on to outline how competition, so beloved an element in economic theory, can lead to game-playing directed against internal rivals. So Watching Tom and Jerry, and acting as a figure head, are rational things for a CEO to do.
Harford draws on high-profile intellectual bodyguards to provide him with further sophistications (‘suspicious aspects’ [p106]] of reward schemes. He concludes (more gloomily than elsewhere in his lively book) that there is great encouragement for boards of directors to pay up, as long as they ‘avoid provoking shareholders too severely’ [p108].
[M]ost CEOs are “paid for luck”, skimming hefty bonuses that are due not to their own efforts but to external factors.
It’s a hard life at the top
Meanwhile, Diamond Bob has to suffer whatever discomfort he receives from criticisms of his compensation package, comforted only by the hundred-fold bonus to his basic salary.
Note: See Tim Harford’s website for more about the celebrity journalist and his latest work.
For an earlier analysis of rational expectations and much more beside, see Matthew 25:14-30.