Executive Compensation: The View from General Equilibrium

We study the dynamic general equilibrium of an economy where risk averse shareholders delegate the management of the firm to risk averse managers. The optimal contract has two main components: an incentive component corresponding to a non-tradable equity position and a variable 'salary' component indexed to the aggregate wage bill and to aggregate dividends. Tying a manager's compensation to the performance of her own firm ensures that her interests are aligned with the goals of firm owners and that maximizing the discounted sum of future dividends will be her objective. Linking managers' compensation to overall economic performance is also required to make sure that managers use the appropriate stochastic discount factor to value those future dividends.incentives; optimal contracting; stochastic discount factor

Macroeconomic Frictions: What have we Learned from the Real Business Cycle Research Programm ?

One interpretation of the RBC research program is that it was meant to identify and incorporate into dynamic general equilibrium models those market imperfections which are most relevant for macroeconomic theory and policy. This paper reviews the methodological basis for this interpretation. It then discusses the empirical foundations for some of the many frictions that have found their way into RBC models including efficiency wages, labour contracts, nominal price rigidities, limited market participation, imperfect competition and expectational errors. We find that the 'necessity' of these frictions is better established in some cases than in others. While one is lead to the prediction that the 'next neo-classical synthesis' will be a dynamic stochastic general equilibrium with frictions, it is premature to decide which specific friction will necessarily be taken on board.Business cycle; neo-classical synthesis; market frictions

Decentralizing the Stochastic Growth Model

The objective of this paper is to propose a number of alternative decentralized interpretations of representative agent style stochastic growth economies and to explore their implications for the generality of this model construct. Under our first interpretation, firms exist forever and undertake all multiperiod investment decisions while consumer-worker-investors only own financial claims to the firm's output. This contrasts with the more standard decentralization approach where firms exist on a period-by-period basis and consumer-workerinvestors have direct title to the economy's capital stock. Under our second interpretation shareholders hire a manager who undertakes the firm's investment decisions in conformity with his incentive contract. The time series properties of the shareholder-manager economy are seen to replicate those of the analogous representative agent economy if and only if the manager's contract assumes a specific form. This suggests the time series properties of an economy where incentive contracts such as stock option plans are pervasive will differ from those of more standard real business cycle models.stochastic growth model; business cycles; delegated management

A Note on NNS Models: Introducing Physical Capital; Avoiding Rationing

This note makes two comments on recent NNS models. First, it disputes the way physical capital has been introduced into these models arguing that this leads to the dubious postulate that the cost of adjusting physical capital stock is an order of magnitude lower than the cost of changing prices. Second it warns against a possible logical inconsistency whereby calibrated NNS models are implicitly assuming that some (price-constrained) firms are willing and able to sell their output below cost.New Neo-Classical synthesis; sticky prices; cost-of-adjusting capital; rationing

The Macroeconomics of Delegated Management

We are interested in the macroeconomic implications of the separation of ownership and control. An alternative decentralized interpretation of the stochastic growth model is proposed, one where shareholders hire a self-interested manager who is in charge of the firm’s hiring and investment decisions. Delegation is seen to give rise to a generic conflict of interests between shareholders and managers. This conflict fundamentally results from the different income base of the two types of agents, once aggregate market clearing conditions are taken into account. An optimal contract exists resulting in an observational equivalence between the delegated management economy and the standard representative agent business cycle model. The optimal contract, however, appears to be miles away from standard practice: the manager’s remuneration is tied to the firm’s total income net of investment expenses, abstracting totally from wage costs. In order to align the interest of a manager more conventionally remunerated on the basis of the firm’s operating results to those of stockholder-workers, the manager must be made nearly risk neutral. We show the limited power of convex contracts to accomplish this goal and the necessity, if the manager is too risk averse (log or higher than log), of considerably downplaying the incentive features of his remuneration. The difficulty in reconciling the viewpoints of a manager with powers of delegation and of a representative firm owner casts doubt on the descriptive validity of the macro-dynamics highlighted in the representative agent macroeconomic model.business cycles, delegated management, contracting

The Macroeconomics of Delegated Management

We are interested in the macroeconomic implications of the separation of ownership and control. An alternative decentralized interpretation of the stochastic growth model is proposed, one where shareholders hire a self-interested manager who is in charge of the firm's hiring and investment decisions. Delegation is seen to give rise to a generic conflict of interests between shareholders and managers. This conflict fundamentally results from the different income base of the two types of agents, once aggregate market clearing conditions are taken into account. An optimal contract exists resulting in an observational equivalence between the delegated management economy and the standard representative agent business cycle model. The optimal contract, however, appears to be miles away from standard practice: the manager's remuneration is tied to the firm's total income net of investment expenses, abstracting totally from wage costs. In order to align the interest of a manager more conventionally remunerated on the basis of the firm's operating results to those of stockholder-workers, the manager must be made nearly risk neutral. We show the limited power of convex contracts to accomplish this goal and the necessity, if the manager is too risk averse (log or higher than log), of considerably downplaying the incentive features of his remuneration. The difficulty in reconciling the viewpoints of a manager with powers of delegation and of a representative firm owner casts doubt on the descriptive validity of the macro-dynamics highlighted in the representative agent macroeconomic model.business cycles; delegated management; contracting

Distribution Risk and Equity Returns

In this paper we entertain the hypothesis that observed variations in income shares are the result of changes in the balance of power between workers and capital owners in labor relations. We show that this view implies that income share variations represent a risk factor of ¯rst-order importance for the owners of capital and, consequently, are a crucial determinant of the return to equity. When both risks are calibrated to observations, this distribution risk dominates in importance the usual systematic risk for the pricing of assets. We also show that distribution risks may originate in non-traded idiosyncratic income shocks.Income shares; Distribution risk; equity premium; limited market participation

Distribution Risk and Equity Returns

In this paper we entertain the hypothesis that observed variations in income shares are the result of changes in the balance of power between workers and capital owners in labor relations. We show that this view implies that income share variations represent a risk factor of ¯rst-order importance for the owners of capital and, consequently, are a crucial determinant of the return to equity. When both risks are calibrated to observations, this distribution risk dominates in importance the usual systematic risk for the pricing of assets. We also show that distribution risks may originate in non-traded idiosyncratic income shocks.income shares; distribution risk; equity premium; limited market participation

Junior Must Pay: Pricing the Implicit Put in Privatizing Social Security

Proposals that portion of the Social Security Trust Fund assets be invested in equities entail the possibility that a severe decline in equity prices renders the Fund assets insufficient to provide the currently mandated level of benefits. In this event, existing taxpayers may be compelled to act as insurers of last resort. The cost to taxpayers of such an implicit commitment equals the value of a put option with payoff equal to the benefit's shortfall. We calibrate an OLG model that generates realistic equity premia and value the put. With 20 percent of the Fund assets invested in equities, the highest level currently under serious discussion, we value a put that guarantees the currently mandated level of benefits at one percent of GDP, or a temporary increase in Social Security taxation of at most 25 percent. We value a put that guarantees 90 percent of benefits at merely .03 percent of GDP. In contrast to earlier literature, our results account for the significant changes in the distribution of security returns resulting from Trust Fund purchases. We also explore the inter-generational welfare implications of the guarantee.

Junior is Rich: Bequests as Consumption

We explore the consequences for asset pricing of admitting a bequest motive into an otherwise standard overlapping generations model where agents trade equity and perpetual debt securities. Prices of securities are seen to be approximately 50% higher in an economy with bequests as compared to an otherwise identical one where bequests are absent. Robust estimates of the equity premium are obtained in several cases where the desire to leave bequests is modest relative to the desire for old age consumption.