Golden Sponge Cake with Creamy Filling and Moral Hazard

One argument for high executive compensation is that there is a high degree of risk that comes with the job. In theory, great success is met with great reward, mediocre results produce much lower compensation and anything short of that will cost you your job. This is supposed to align the interests of executives with those of shareholders -- my portfolio loses value and you lose your job -- but where we have risk, it probably makes sense to talk about moral hazard.

Think about the familiar argument against a one-time government program to bail out underwater homeowners. Even if we included a provision saying that the homeowners sign away the right to take advantage of similar programs in the future, you could still argue that the program presented a moral hazard because it set a precedent. To put it in plainer terms, it's a bad example. Other prospective homeowners will look at this and be more likely to buy more house than they can afford or, worse yet, pick up a copy of Rich Dad and start flipping houses.

We can argue about the validity of the argument in this particular case (I have problems with it myself), but we should all be able to agree on at least two points:

1. there are potential problems to shielding people from negative consequences;

2. these problems extend, not just to those shielded but to those who think they may be shielded in the future.

All of this suggests that the numerous and highly publicized examples we've seen of executives getting better compensation than their performance merits might be doing damage even in companies that really are aligning   pay and performance.

And it makes stories like this truly scary:

The latest news from the bankruptcy front at iconic Twinkies maker Hostess Brands: AP is reporting that the Irving, Texas company is planning to ask a bankruptcy judge to grant approval of bonuses totaling up to $1.8 million for its executives. Hostess says the incentive pay is necessary to assure that the 19 managers in charge of the liquidation process remain on board until the wind-down is complete. Hostess wants to make two of those executives eligible for additional financial rewards, depending on how efficiently they carry out the liquidation.

What's so disturbing here is the fact that the horrible condition of Hostess is actually an argument for increasing the potential compensation of the executives who drove it into the ground. They managed the company so badly it supposedly can't survive a change in management.

That's what I call a bad example.