Welcome to the next depression

Richard Posner isn't afraid to use the "D" word. He says we're in a depression -- as defined by a steep decline in output, a widespread sense of crisis, costly remediation efforts, and long-term impacts.

In A Failure of Capitalism: The Crisis of '08 and the Descent into Depression (Harvard University Press), Posner persuasively argues that this meltdown wasn't caused by rotten financiers or grasping investors. Instead, the depression was caused by a systemic flaw -- everybody acted rationally and that caused an economic bubble that, like bubbles do, popped.

I won't go into the details; you really should read the book - even if it gets a little long as the same basic argument gets recycled through each element of Posner's thesis. But there is one section worth calling out for corporate consideration: it deals with why companies tend to get caught out when bubbles pop and this portion of it adds some fuel to the debate over executive compensation.

Riding a bubble can be rational even though you know it’s a bubble. For you can’t know when it will burst, and until it does it is expanding and that means that values are rising rapidly, so that if you climb off the bubble you will have foregone a large profit opportunity. As Citigroup’s then CEO put it in July 2007, “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” (He didn’t know it, but the music had stopped.)

The tendency of corporate management to cling to a bubble and hope for the best – or, equivalently, the tendency to maximize short-run profits – is strengthened if, as on Wall Street during the boom, executive compensation is both very generous and truncated on the downside. For then every day that you stay in you make a lot of money, and you know that when the bubble bursts you’ll be okay because you negotiated a generous severance package with your board of directors. Limited liability is a factor, too; neither an executive heavily invested in his company’s stock nor any other shareholder will be personally liable for the company’s losses should it go broke.

And how do executives get such a sweet deal? Well, the board will have hired a compensation consultant who will have advised generosity in fixing the compensation of senior management and as part of that largess will have recommended that senior executives receive a fat severance package (a “golden parachute”) if they are terminated. The consultant will have told the board this because if the board is generous to senior management, senior management may out of gratitude hire the consultant to do other consulting for the firm. And the board will have listened to the consultant’s recommendation because the board will have been predisposed to be generous with senior executives’ salaries. Most members of a corporation’s board of directors will be senior executives themselves. And because a firm’s chief executive officer has a say in whether board members are reelected to the board, the higher a board member thinks CEO compensation should be, the more boards he will be invited to join.

The more generous an executive’s compensation and the more insulated his compensation package is from any adversity that may befall his company, the greater will be his incentive to maximize profits in the short run – especially in a bubble, where the short run is highly profitable but the long run a looming disaster.