As Congress rushes to enact the Treasury's $700 billion bailout plan this week, Obama, McCain, and politicians of both parties are insisting that the bailout include restrictions on executive pay at the firms whose mortgage backed securities will be bought by the government. Some of the executives' pay packages are indeed outrageous, but trying to impose pay limits is, it seems to me, one of the worst ideas yet proposed.
Hank Paulson has argued that firms might refuse to participate in the bailout if restrictions on pay were a condition of involvement. Perhaps this is true, although I suspect that shareholder pressure would force even the most reluctant firms to join the bailout party. But restrictions are likely to have two other effects, both of them bad. First, firms who wish to attract high quality executives will attempt to evade the restrictions. If the restrictions are onerous, these evasions may well be abetted by sympathetic courts. This is exactly what has happened after Congress imposed restrictions on executive compensation in bankruptcy in 2005.
The second possibility is that the restrictions will work, and that firms that participate in the bailout would be unable to attract top quality executives, who could earn far more in other, comparable positions. An effort by Ben & Jerry's to implement its social vision in the 1990s by limiting executive compensation to seven times the salary of its lowest paid employee is a sobering illustration of this problem. When the time came to replace Ben Cohen, Ben & Jerry's was unable to attract an acceptable executive, and it had to loosen the compensation restriction.
The urge to punish these executives is completely understandable. But discouraging high quality executives from entering the financial services industry at a time when they're sorely needed is an awfully high price to pay for the temporary illusion that justice is being done.