A new academic paper makes a credible argument that stock option contracts for executives can cause excessively large swings in the economy. The paper, which I think is destined to become a classic, has a great title: “Some Unpleasant General Equilibrium Implications of Executive Incentive Compensation Contracts. ”
John Donaldson, Natalia Gershun and Marc Giannoni( of the Columbia Business School, Pace University, and Columbia Business School) examine stock options, and point out that:
With such a compensation contract, a given increase in the firm’s output generated by an additional unit of physical investment results in a more than proportional increase in the manager’s income. We find that incentive contracts of this form can easily result in an indeterminate general equilibrium, with business cycles driven by self-fulfilling fluctuations in the manager’s expectations. These expectations are unrelated to fundamentals. Arbitrarily large fluctuations in macroeconomic variables may possibly result.
This is not a good thing. What it means is that managerial confidence, rather than consumer confidence, has now become a central driving force for economic fluctuations.