Friday, April 04, 2008

Creating an Elastic Wage

In my last post I argued that wages should be more elastic.

The employee stock option is the most popular mechanism for trying to make wages elastic.

Stock options have one fatal flaw. The flaw is that stocks fall precipitously during economic down turns. Stock options magnify the effects of a bust.

An employee who opts for stock options will find the options worthless if they are laid off during a market down turn. For that matter, owning a large pile of stock options makes an employee a larger target for being laid off.

Lets say the board of directors is under pressure to support the price of the company stock during a down turn. In selecting employees for the lay off, they are likely to realize that laying off the employees with a portfolio of stock options would have a direct effect on the stock price.

If the layoff committee is looking at two employees. One has 20,000 stock options that are currently below the strike price and another has none. Laying off the employee with options would retire those options and have an immediate and direct affect on the price of the stock. The employee with options flies out the door.

Employee stock options are the absolute worst way to make wages elastic.

Options, of course, are a derivative. What they do is magnify the peaks and troughs of a cycle. Investors should only use options for stabilizing their portfolio against peaks and troughs. Compensating employees with derivatives will simply have adverse affects on the workforce.

During peaks, you run the risk of encouraging people to live beyond their means. Imagine an employee who takes on a larger mortgage and more consumer debt based on the current value of their options. Such an employee is making the classic blunder of buying options on margin. The blunder is made worse because they employee really doesn't have a fixed sale date or even sale price in mind.

Stock options magnify the ill effects of bad times.

A better solution to making wages elastic would be to simply pay the employee in stock. The company would need to record such stock on the expense side of their ledger (like wages). Paying an employee in stock would create a situation where expenses rise and fall with the market.

Employees tend to have great insider knowledge. If you had a situation where employee stock payments went into a holding account that the employee could sell at leisure, you would probably find the employee selling stock quickly when the company is overvalued, and holding long when the stock is undervalue.

Payment in stock is not intended as an investment mechanism. It is intended to create an elastic component to earnings. There should not be an expectation that employees build up large portfolios of stock in the process.

An employee might have a deal where they are paid, as part of their salary, 100 shares of the stock a quarter. This money would go into an account. They could then sell the stock as needed.

The basic goal is to have a one way transaction. You are not encouraging employees to spend their day trading stock.

As we are dealing with small scale sales, there would not need to be onerous scrutiny of the stock sales.

Yes, employees might use insider knowledge on their small scale sales. For example, imagine an employee being paid 300 shares in stock. They know sales were fantastic that quarter and decides to hold through earnings. Lets say there was a dollar pop in the price after earnings. Well, the employee makes an extra $300.

Such an action is not abusive. The employee simply gets an extra share in the capital gains of the company. Hurray for the employee!

Conversely, the employee who knows that things aren't well and sells shares instantly (before earnings) gives the market a signal that the quarter earnings were weak.

A one way transaction with small quantities of stock does not create an abusive environment.

The evils of insider trading happen when people become manipulative or conspiratorial in their trading. Such evils usually involve large blocks of stock or options. If you have a situation where employees earn (and then sell) stock on a schedule cycle, then you create disincentives for manipulative actions. An employee with a monster pile of options to sell has more incentive to feed the market misinformation than one that one that receives a pile of stock each quarter. Employees with timed stock receipts have an incentive for fair play because they don't want the disinformation given this quarter to affect their future sales.

In conclusion, Paying employees in stock is a better way to make wages elastic than the granting of stock options. Options are a derative that magnifies peaks and valleys. They only really have benefit for investors who are balancing their portfolio. One-way timed payments of a stock allow employees some ability to exploit their insider knowledge of the markets without creating a climate of manipulation and abuse.

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