Are Ceos Overpaid Argumentative Essay

The compensation of American executives—CEOs and their “C-suite” colleagues—has long been a matter of controversy, especially recently, as the wages of average workers have stagnated and economic inequality has moved to the center of the national debate. Just about every spring, the season of corporate proxy votes, we see the rankings of the highest-paid CEOs, topped by men (they’re all men until number 21) like David Cote of Honeywell, who in 2013 took home $16 million in salary and bonus, and another $9 million in stock options.

Rarely, however, does the press coverage go beyond the moral symbolism of a new Gilded Age. Coverage of CEO pay usually fails to show that the scale of CEO pay packages—and the way CEOs are paid—comes at a cost. At the most basic level, the company is choosing to pay executives instead of doing other things—distributing revenues to shareholders, raising wages for workers, or reinvesting in the business. But the greater cost may be the risky behavior that very high pay encourages CEOs to engage in, especially when pay is tied to short-term corporate performance. CEO pay also plays a major role in the broader trend toward radical inequality—a trend that, evidence has shown, precipitates financial instability in turn.

CEO pay has been controversial in the United States for more than a century—for as long as corporate management has been a profession separate from ownership. In economic booms, CEO pay skyrockets and, after the inevitable bust, it attracts attention—as the million-dollar paychecks of executives such as W.R. Grace of Bethlehem Steel and Charles Mitchell of National City Bank drew notice in the 1930s. But the most recent debate focuses on the staggering, uninterrupted rise in CEO pay over the past three decades, following a long period of moderation in both executive pay and in overall economic inequality. Between 1940 and 1970, average CEO pay remained below $1 million (in 2000 dollars). According to the Economic Policy Institute (EPI), from 1978 to 2013, CEO pay at American firms rose a stunning 937 percent, compared with a mere 10.2 percent growth in worker compensation over the same period, all adjusted for inflation. In 2013, the average CEO pay at the top 350 U.S. companies was $15.2 million.

Given the polarization and stalemate of current politics, one might expect CEO pay to be one of those issues, like tax loopholes, that the public occasionally gets upset about but the political system, which demonstrably tilts toward the interests of the wealthy, ignores or can’t resolve. But in fact, the cause of restraining CEO pay has had remarkable political success—measured by legislation passed and regulations enacted—since the 1930s, when CEO pay first became a contentious public issue.

The problem isn’t that the political system doesn’t want to deal with excessive CEO pay. There have been any number of formal efforts to rein in executive pay, involving a host of direct regulation and tax changes. But most of the specific efforts to reduce executive pay—through major policies such as a limit on the tax deductibility of high salaries, as well as more modest accounting and disclosure legislation—have fallen short. That’s because the story of skyrocketing executive pay is a story about our conception of the corporation and its responsibilities. And until we rethink our deepest assumptions about the corporation, we won’t be able to master the challenge of excessive CEO pay, or the inequality it generates. Is the CEO simply the agent of the company’s shareholders? Is the corporation’s only obligation to return short-term gains to shareholders? Or can we begin to think of the corporation in terms of the interests of all those who have a stake in its success—its customers, its community, and all of its employees? If we take the latter view, the challenge of CEO pay will become clearer and more manageable.

Decades of Modest Pay

It’s strange to imagine, but the position of corporate CEO is a relatively new one in the history of American business, and CEO pay has been controversial for most of that time. According to Harwell Wells of Temple University’s law school, who has written one of the only historical accounts of the CEO pay debate, before the “great merger movement” of the early twentieth century, all but a few companies were small and were run by managers who owned a sizeable portion of the business. At the beginning of the twentieth century, the face of industry was morphing from thousands of small manufacturing firms into fewer large corporations. As owners of these companies opted out of day-to-day management, employee-executives gradually took over their roles, and “management” became a profession. It didn’t take long for CEO pay to begin to climb—and for the American people to object.

There is very little information available about CEO pay prior to 1935, when the 1934 Securities Exchange Act implemented Form 10-K, the annual report companies are required to file with the Securities and Exchange Commission (SEC). One of the only surveys available tells us that, prior to World War I, the average salary of an executive at a large corporation was $9,958, or $220,000 in 2010 dollars, which would be paltry for most of today’s mid-management, let alone today’s high-level executives.

Convinced that an executive salary would never inspire managers to feel the same stake in their company that owners inherently have, American Tobacco and U.S. Steel were among the first companies, in the 1910s, to institute “performance pay” in the form of bonuses for senior executives, who received a percentage of annual profits in addition to their base salary. By 1928, a survey of 100 industrial companies showed that 64 percent of executives received a bonus, typically in the form of cash linked to the firm’s annual profits. The same survey found that for those executives, bonuses constituted 42 percent of average total compensation. Incidentally, while it’s impossible to do any real comparison with the available data, there does seem to be a noticeable jump in pay after bonuses were introduced. The 1928 survey of industrial firms reports that the median annual compensation for executives was $69,728, or $892,000 in 2010 dollars—four times the pre-World War I numbers.

How the Explosion in CEO Pay Happened

The most comprehensive historical analysis of CEO pay numbers, by Carola Frydman and Raven Saks Molloy, indicates that average pay remained below $1 million (in 2000 dollars) from 1936 to the mid-1970s—despite the fact that there was a lot of company growth during that time span. It even fell in the 1940s: sharply during World War II, and more gradually in the later part of the decade, which, according to Frydman and Saks Molloy, was “the last notable decrease in the past 70 years.” From the early 1950s to the mid-1970s, the inflation-adjusted value of executive pay increased very gradually, averaging less than 1 percent growth a year. Growth in pay picked up speed starting in the mid-1970s and continued until the recent financial crisis, with the most significant increase happening in the 1990s, when annual growth rates topped 10 percent. According to EPI, between 1978 and 2012, CEO pay rose about 875 percent.

Starting in 1930, a handful of shareholder lawsuits put the issue of executive pay on the front pages, culminating in Congress’s “Pecora hearings” on the securities industry. The hearings revealed that Charles E. Mitchell of National City Bank (now Citibank), who was blamed for fueling the speculation that led to the Crash of 1929, took home more than $1 million a year leading up to the crash, a revelation that inflamed shareholders and the American public and prompted the federal government to begin to institute reforms, starting in the early 1930s with the Securities Act and the Securities Exchange Act.

The New Deal response to the Pecora revelations centered on disclosure, which was already a major component of the nascent structure of corporate reform and Wall Street regulation. As previously noted, the 10-K form on which we find chief executive salaries to this day was created in the Securities Exchange Act of 1934. Soon after, in 1938, the SEC required shareholder proxies to report compensation of the corporation’s top three executives. Since the New Deal, the SEC has, among other regulations, instituted a variety of disclosure rules, including a 2009 rule requiring some companies to disclose what they pay for compensation consulting. And it has recently proposed a strong disclosure rule—mandated by the Wall Street Reform and Consumer Protection Act of 2010, better known as the Dodd-Frank bill—on the CEO-worker pay gap.

Another avenue to target executive pay has been through the tax code. Tax provisions specifically addressing executive pay date back to 1950, when restricted stock grants were given preferential treatment. And overall changes to tax rates have likely had a significant effect on executive pay. Thomas Piketty has suggested that a major cause of the sharp rise in inequality beginning in the late 1980s was the tax reform of 1986, which reduced individual rates and closed corporate loopholes, making it more lucrative for executives to take money as salary than to leave it in the company.

But it wasn’t until the beginning of the 1990s that the current effort to use the tax code to target executive compensation directly took hold. Compensation expert Graef Crystal’s 1991 book, In Search of Excess: The Overcompensation of American Executives, became a best-seller, but more important was a single reader: then-presidential candidate Bill Clinton. CEO pay became a core issue of Clinton’s 1992 campaign, during which he pledged to eliminate corporate tax deductions for executive pay in excess of $1 million a year. In the 1993 budget legislation, this policy became part of the U.S. tax code, known as Section 162(m). But it came with a few qualifiers. The most significant was the exception for executive pay based on specific corporate performance goals, called “performance pay.”

The IRS offered a technical definition for performance pay but, to corporations’ collective glee, allowed a lot of room for interpretation, so companies quickly began moving executive pay from salaries to mainly stock options and restricted stock grants. If you look at a standard proxy statement, you’ll notice that most companies say outright what sections of their executive compensation packages are designed to avoid being taxed.

After In Search of Excess and Section 162(m), CEO pay continued to skyrocket, now at an even faster pace. Using the performance-pay loophole, during the longest sustained run-up in stock prices since the 1920s, the spike was driven by short-term measures of earnings or stock performance.

The Value of a CEO

Aside from the occasional anomaly, where pay clearly doesn’t align with performance (as in, for example, the case of JPMorgan Chase’s Jamie Dimon, who recently announced 10,000 potential layoffs by the end of 2014 despite his $20 million in pay last year), one might ask what is so wrong with high CEO pay. Especially when it’s linked to profits or stock performance, haven’t executives earned this compensation?

Indeed, that is what the economic theory of marginal productivity—which holds that any worker is paid based on what he or she adds to the firm’s income—would suggest. Harvard economist N. Gregory Mankiw has argued that “the most natural explanation of high CEO pay is that the value of a good CEO is extraordinarily high.”

But this is the most tautological of economic ideas. The theory requires very strict assumptions that are found nowhere in the real world, and it cannot be put to the test, because it is impossible to measure the performance of a CEO in terms of his or her marginal contribution to a firm, particularly when success is the function of an entire team. And when “pay for performance” is based on the company’s stock price, it is really “pay for luck,” because more of the share price performance that CEOs are paid for is driven by broader macroeconomic factors, particularly economic upswings, than anything the executives did. But when the economy declines, and the share price goes down with it, executives are usually not penalized. Marginal productivity theory seems to move in only one direction.

The foundation of “pay for performance” is “agency theory” or “shareholder primacy.” The intellectual godfather of shareholder primacy is Milton Friedman, who wrote in 1970 that “a corporate executive is an employee of the owners of the business [i.e., the shareholders]. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible,” without breaking the law or cheating people. At a time when CEO pay was less than 40 times what the typical worker earned (the multiple is now more than 350), Michael C. Jensen and William H. Meckling codified Friedman’s argument with their seminal 1976 article, “Theory of the Firm.” The purpose of corporate governance, they argued, is about finding ways to align the incentives of shareholders (whom they referred to as “principals”) and executives (“agents” of the shareholder-owners). This theory has enraptured economics departments and business and law schools for decades and profoundly shaped how corporate officers, shareholders, taxpayers, policy-makers, and even most Americans think about the roles and responsibilities of corporations.

Though shareholder primacy has never been challenged in a serious way, a bit of heresy did happen at the 2013 annual meeting of the Allied Social Science Associations, where mostly neoclassical economists converge to present their research, graduate students scramble for tenure-track jobs, and what should be debatable ideas like marginal productivity theory are taken as pillars of research. That year, a French financial economist named Jean-Charles Rochet gave the keynote address, in which he skewered the very foundation of pay for performance. Cornell Law School professor Lynn Stout calls it the “shareholder value myth”—the idea that corporations exist for shareholders and no one else. Rochet told the conference: “Everyone knows that corporations are not just cash machines for their shareholders, but that they also provide goods and services for their consumers, as well as jobs and incomes for their employees. Everyone, that is, except most economists.”

Rochet was, if anything, being too kind. While economists are certainly to blame for presenting an ideology as a natural law, shareholder primacy has also infiltrated the consciousness of most politicians and journalists and has been transmitted in our classrooms, to the extent that today, most of the American public has come to take this myth for granted.

The idea that there are other corporate stakeholders besides shareholders—the stakeholder framework—is not a new one. But it’s gained traction recently as a result of Rochet’s speech, Stout’s 2012 book, The Shareholder Value Myth, and the emergence of new corporate forms like benefit corporations, which promise to be accountable and transparent about their impact on the environment and surrounding communities, and often aspire to a “double bottom line” of private and public value. A high-profile union-recognition battle at a Volkswagen plant in Chattanooga earlier this year, in which the company not only didn’t challenge the union but actually invited the vote, brought new attention to the German corporate model, based on “works councils” that include labor in decision-making, and a much broader vision of the corporation’s obligations.

At the heart of almost every effort to curb CEO pay have been the assumptions of marginal productivity and shareholder primacy. There is no silver bullet to slow the growth of CEO pay. It requires all the tools in our toolbox—the tax code, disclosure and accounting rules, and so forth. But none of those will be fully effective without rethinking the very purpose of the corporation, a question that is too often outside the scope of debate.

The True Costs of High CEO Pay

Before we go any further, we should consider how CEO pay is determined. In theory—and this is what corporations would like us to believe—compensation packages for CEOs are determined by independent boards of directors, by compensation committees made up of members of the board, and sometimes by compensation consultants, who make pay recommendations based on their analysis of the market.

But Lucian Bebchuk and Jesse Fried, in their 2004 book Pay Without Performance, argued that this procedure is a comforting fiction. They wrote that skyrocketing executive pay is the blatant result of CEOs’ power over decisions within U.S. firms, including compensation. Being on a corporate board is a great gig. It offers personal and professional connections, prestige, company perks, and, of course, money. In 2013, the average compensation for a board member at an S&P 500 company—usually a part-time position—was $251,000. It only stands to reason that board members don’t want to rock the CEO’s boat. While directors are elected by shareholders, the key is to be nominated to a directorship, because nominees to directorships are almost never voted down. Bebchuk and Fried showed that CEOs typically have considerable influence over the nominating process and can exert their power to block or put forward nominations, so directors have a sense that they were brought in by the CEO. Beyond elections, CEOs can use their control over the company’s resources to legally (and sometimes illegally) bribe board members with company perks, such as air travel, as well as monetary payment.

Usually the CEO pay debate pivots on the public’s distaste for extreme inequality. While Thomas Piketty has recently provided us an impressive historical account of how capital accumulation increases inequality, Joseph Stiglitz, in his 2012 book The Price of Inequality, and former Labor Secretary Robert Reich’s recent documentary Inequality for All have moved the conversation by broadening our grasp of how economic inequality, including between CEOs and the typical worker, harms our society. What we haven’t talked about enough is how the assumptions and incentives driving CEO pay, which primarily encourage executives to raise the price of the company’s stock, can damage the economy by encouraging companies to take on excessive risk, rewarding fraudulent behavior and curtailing real investment and innovation.

A successful business leader or entrepreneur needs to be willing to evaluate and take risks. Starting a business, moving into new markets, and developing new products all come with great risks—of losing profits, shutting down departments, even closing a company’s doors. One of the main arguments for high CEO pay is that it compensates executives for being exceptionally calculating risk-takers. Yet there is plenty of evidence that shows us that when CEOs are paid with stock—either options or grants—it can enable executives to become very wealthy very quickly without bearing much risk at all. This creates the financial motivation for CEOs to make shortsighted and very high-risk decisions in order to boost their company’s stock prices, which will ultimately line their own pockets. The effects of this behavior, particularly with CEOs in the financial industry, can be measured in higher share-price volatility (meaning large swings in share prices) and in bank failures, such as those of 2008 and 2009, which had profound consequences for the broader financial and economic system.

More troubling about the ways in which CEOs are paid is that incentives can easily move from risky behavior toward outright fraud, including misrepresenting the company’s finances and illegal stock-options backdating. The backdating of stock options became a scandal in the late 2000s. By retroactively changing the date when a stock option was granted, typically to an earlier date when the share price was lower, companies can change the baseline by which performance was measured, making it look better than it was, in order to pump up executive pay. At its peak, this was not a rare practice: A study led by Bebchuk showed that between the mid-1990s and mid-2000s, 12 percent of the firms in the sample backdated options for their CEO, boosting total compensation by around 20 percent. Many studies demonstrate that firms found committing fraud have greater stock option-based compensation, suggesting that the greater the incentive for CEOs to maximize the company’s stock price, the greater the incentive the CEO has to engage in fraudulent activities to accomplish this objective.

CEO pay that is ultimately based on the stock price invites another easy trick to show performance: stock buybacks. The problem, according to economist William Lazonick, co-director of the UMass Center for Industrial Competitiveness, is that funds for stock buybacks come at the expense of other priorities. By choosing to buy back publicly held shares, executives can push up the price of the stock without actually investing in the company’s capital, research and development, or workers.

Lazonick’s research provides many examples. For several decades after World War II, IBM had a lifetime employment policy, which was the norm for that era. In the mid-1990s, IBM shifted gears from manufacturing to software and services, and global employment dropped from 374,000 to 220,000. A leader in the U.S. offshoring movement, IBM announced in 2011 a strategic plan for the years until 2015, the main objective of which is to raise their earnings per share from $13.44 to $20 by increasing “operating leverage” (i.e., layoffs) and buybacks. IBM bought back $107 billion of its stock between 2003 and 2012, $13.9 billion in 2013 alone, and $8.2 billion in the first quarter of 2014. All these financial moves have had the effect of boosting “performance pay” for executives without the slightest improvement in the company’s revenues, market share, or profits.

Performance pay, on the model encouraged by the 1993 reform, has been tested. What we’ve learned is that it rewards not performance, but shortsightedness, excessive risk, and even fraud, and that the consequences go well beyond radical inequality to include the kind of crisis that nearly took down the economy in 2008, abrupt layoffs and plant closings to meet shareholder expectations, corners cut on products that risk consumer safety (as seen at General Motors), and desperate attempts to evade the costs of environmental and workplace safety regulation.

From Shareholders to Stakeholders

There is an alternative. If Rochet, Stout, and others are right that a corporation has obligations beyond delivering short-term gains to the shareholders of the moment, then surely that alternative view of the corporation can provide a sounder foundation for thinking about CEO pay. CEOs should be rewarded for productivity and performance, yes, but success should be measured in terms that reflect the interests of all the stakeholders in a corporation, and the corporation’s own health.

The stakeholder corporation is not a new idea. The term stakeholder has been in circulation since the 1960s to characterize the key groups of people that support an organization. R. Edward Freeman brought it into the management world in 1984, when he published Strategic Management. The book proposed that effective management consists of balancing the interests of all the corporation’s stakeholders, including employees, customers, and communities:

Simply put, a stakeholder is any group or individual who can affect, or is affected by, the achievement of a corporation’s purpose. Stakeholders include employees, customers, suppliers, stockholders, banks, environmentalists, government, and other groups who can help or hurt the corporation. The stakeholder concept provides a new way of thinking about strategic management—that is, how a corporation can and should set and implement direction. By paying attention to strategic management, executives can begin to put their corporations back on the road to success.

The concept of the stakeholder corporation has percolated since Freeman’s book, and interest in this model has slowly begun to take root, particularly since the failed United Auto Workers vote at the Volkswagen plant in Chattanooga.

German corporations like VW are far friendlier than their U.S. counterparts to worker rights and “co-determination.” [See “The Church of Labor,” Issue #22.]Works councils, or Betriebsrat, are essentially “shop floor” organizations that represent workers and institute labor law at the local level. The works council is what the Germans proposed in Chattanooga but, after a drawn-out public battle, workers at the plant rejected the idea by voting against unionization, which was opposed by the state’s Republican politicians, but not by the company.

The stakeholder corporation is not only a brilliant model, as the German economic success, especially in manufacturing, shows—it is also the key to the unresolved problem of CEO pay. Shareholder primacy is now so self-evidently flawed that we should be emboldened to think of a range of options—through policy, corporate norms, and culture—for changing CEO pay practices. The irony, as Cornell’s Stout points out, is that broadening the scope of corporate stakeholders would benefit many shareholders as well, because “long-term shareholders fear corporate myopia.”

Imagine what becomes possible when we start to understand that executives and managers are not strictly beholden to shareholders—who hold their shares for an average of four months—and share prices. When executives and directors are free to consider a range of stakeholders—workers, suppliers, creditors, customers, shareholders, and the community in which they’re based—in managing a company, it inherently changes their time horizon from the next quarter to the next decade or quarter-century and beyond, because most of these stakeholders have deeper investments in the company.

The next steps in controlling CEO pay fall into two categories. The first should involve reconsidering and reversing the failed practices that were the result of shareholder primacy. The second would begin to advance the vision of the stakeholder corporation.

The most obvious priority is to close the performance-pay loophole and stop subsidizing pay practices that encourage CEOs to behave like financial speculators. Last year, Democratic Senators Richard Blumenthal and Jack Reed, with Congressman Lloyd Doggett of Texas, introduced the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act, which would cap the deductibility of compensation at $1 million, as Clinton had originally proposed, regardless of the form that compensation takes. The legislation also broadens the range of Section 162(m) by applying it not just to public companies but to all companies that file quarterly reports with the SEC. It would also no longer be limited to CEOs and the three highest-paid executives in a company; it would apply to any employee earning more than $1 million.

UMass’s Lazonick proposes stronger regulation of stock buybacks. The current SEC rule, he argues, “has given top executives license to use buybacks to manipulate the market.” He also suggests that the SEC rescind its current rule and “conduct a Special Study, on the scale of its 1963 study of securities markets that resulted in the creation of NASDAQ, of the possible damage that open-market repurchases have done to the U.S. economy over the past three decades.”

One small and familiar step, endorsed even by shareholder-primacy advocates, would be to move toward more independent boards of directors by reducing the power of the CEO in the nominating committee. Another option, still based on traditional assumptions, would be for companies to pay their executives for performance only after the fact, with performance measured by what Edward D. Hess of the University of Virginia’s Darden Business School and author of the 2000 book Smart Growth calls “authentic earnings.” Hess identifies “non-authentic earnings” as “numbers manufactured creatively by accountants and investment bankers.” Authentic earnings, based solely on real transactions with real customers, provide a broader and more accurate picture of a company’s productive capacity, engagement with new markets, and technological innovation than share price. Hess also challenges the idea that corporate success should expect earnings growth to be continuous and linear. Successful companies might not always be growing. It would be complex, but not impossible, to structure tax incentives for CEO pay based on the measures Hess identifies.

But it’s necessary to go well beyond these steps, which don’t challenge the assumptions that led to the 1993 reform. Yes, we need to reform corporate boards, but let’s do it by following the successful German model and creating a place for workers at the board table. Employee board-level representation is a core part of Germany’s corporate “dual structure”: a management board for day-to-day functions and a supervisory board for more high-level decisions, akin to U.S. boards. Depending on a company’s number of employees, up to half of the supervisory board members are employee representatives rather than shareholders.

And yes, we need to redefine performance pay, but let’s reward companies and CEOs that not only keep executive pay down but increase the well-being of all those connected to the corporation. One smart, still-theoretical proposal would adjust the corporate tax rate based on the ratio of CEO pay to the average pay for workers in the company. At the moment, this is difficult to implement, or even to study, because the data on average pay is invisible or unreliable. In some cases, it should include employees of firms, often offshore, that contract solely with the parent company, and it might have to be adjusted based on industry sector—for example, a firm like Apple, where the average employee might be an engineer, will look much better than a firm like Costco, even though Costco pays very well for its sector. But the reporting provision of Dodd-Frank, if implemented effectively, could provide the data needed to develop a policy that would push against inequality in both directions.

Beyond policy efforts, we need to change our cultural understanding of what corporations are for. It’s highly ironic that one of the most articulate critiques of shareholder primary was delivered by one of its most grandiose beneficiaries: Jack Welch of General Electric. After years as one of the best-paid celebrity CEOs, and after taking a retirement package worth $417 million, including tax-free perks such as club memberships and the use of private aircraft, Welch told the Financial Times in 2009 that the doctrine of shareholder primacy was “the dumbest idea in the world,” and added: “Shareholder value is a result, not a strategy…your main constituencies are your employees, your customers, and your products. Managers and investors should not set share price increases as their overarching goal…. Short-term profits should be allied with an increase in the long-term value of a company.” A few days later, Welch backtracked, but his words make a biting case against the doctrine on which he built his career and reputation.

When even Jack Welch can see that Milton Friedman’s doctrine was no eternal rule, but one economist’s theory with no basis in law, then business schools, economics departments, and financial journalists should be able to do the same. If they can train students, including future CEOs, how to think creatively about the challenges corporations face in building viable businesses that meet their obligations to all their stakeholders, then even if CEOs continue to be well-paid professionals—although not at today’s stratospheric levels—at least they will be paid for helping their companies and communities become better off.

One of Reader’s Digest’s more popular sections is “That’s Outrageous!” When the feature spotlights government pork-barrel projects, absurd zoning restrictions on homeowners, or illogical regulations on small business, libertarians can applaud. Unfortunately the October 2005 issue featured a column that focused on “outrageous” CEO packages, an enduring controversy. The writer, Michael Crowley, displayed precious little knowledge of economics, and at times his complaints were downright contradictory.

The article begins with the anecdote about Stephen Crawford, then the co-president of Morgan Stanley. A few months after accepting this promotion, Crawford quit during a “management shake-up” and “strolled off with a severance package that included two years’ salary and bonus,” which amounted to $32 million. To make sure his readers are sufficiently outraged, Crowley points out that “Crawford pulled in $54,000 per hour!”

Before delving into the conceptual issues, let’s be clear on where that number comes from. It is obviously due to Crawford’s quitting much sooner than anyone (probably including himself) predicted when the contract was originally negotiated. (Had the shakeup occurred six weeks earlier, Crawford would’ve earned over $100,000 per hour, according to this method.) This is certainly a misleading approach, especially when contrasting it with the mean annual earnings of workers (as Crowley does). If one wants to show how much more CEOs get paid—and of course they do get paid far, far more than the average worker—then a fairer comparison would have been mean annual earnings of workers versus mean annual earnings of CEOs. (Later, Crowley follows this more reasonable route and reports that in 2003 “CEOs were paid over 300 times what the average production worker made.”) To pick an example like Crawford rigs the comparison; one could certainly find cases of average Joes who quit or were laid off after only working a very short time, and hence whose “hourly earnings” would appear vastly inflated.

For example, I myself was once sent home after only working about ten minutes as a receptionist in a law firm; I had been sent there by my temp agency, and it turned out I was unfamiliar with the phone system at the firm. Nonetheless, I still got paid for at least one hour (possibly more, I can’t remember) of work. Using Crowley’s approach, he could argue that the case of Robert Murphy shows that some Irish workers are paid six times more per hour than the median temp worker.

Even on its own terms, the calculation is suspect. Crowley isn’t explicit about where the $54,000 per hour figure comes from, but we do know that the total package was $32 million and that Crawford quit “[a]bout 100 days” after starting in the new spot. Well, $32 million divided by 100 is $320,000 per day, which works out to $40,000 per hour if we assume eight hours of work per day. Thus to get the higher figure of $54,000, Crowley must be assuming that, in addition to working only eight hours per day, Crawford only worked five days per week. Now I don’t know too much about being co-president of Morgan Stanley, but even so, I’m quite sure that this job requires more than 40 hours of work per week.

Of course, these minor quibbles about the figure overlook the biggest objection: So what if CEOs earn more money than most other workers? In a free market (and below we deal with the complication that in today’s world there is no truly free market), the price of labor corresponds to its marginal product. That is, competition ensures that workers are paid according to how much additional revenue they bring in to their employer. The fact that some types of labor command thousands of times more market value is no more surprising or outrageous than the fact that some goods in the marketplace (such as a house) have a price hundreds of thousands of times higher than the prices of other goods (such as a pack of gum).

Oddly enough, it is the critics of capitalism who implicitly claim that market value should correspond to ethical worth. No competent economist would argue that Stephen Crawford was a good person because he earned so much money, just as no economist would argue that a television set is ethically superior to a copy of the Holy Bible because of its higher price. No, the only thing economic science can say is that Stephen Crawford’s services were in higher demand than the services of (say) the janitors at Morgan Stanley. So long as the labor contracts are voluntary, there really isn’t an issue of fairness (subject to the complication noted above).

Later in the article, Crowley raises concerns that may trouble even a genuine supporter of the free market. Of course it makes perfect sense that successful corporate executives earn millions of dollars. But what of the strange cases of “corporate leaders actually failing their way to riches”? Crowley gives us some allegedly outrageous examples of this trend:

Viacom CEO Sumner Redstone took home about $28 million in 2004, including a bonus of $16.5 million, even as his company’s stock dropped 11 percent during the fiscal year. Applied Materials CEO Mike Splinter got a tidy $5 million bonus in 2004, despite a stock slide of more than 22 percent. That same year Rick Wagoner, CEO of General Motors, saw GM stock plunge 25 percent, yet he still pocketed a $2.5 million bonus—only slightly less than his award in 2003, when GM stock actually rose. So much for accountability.

As noted, this phenomenon is initially quite puzzling. Why would firms reward incompetent executives? Don’t they want to make money? Yet before dismissing power brokers in the business community as self-destructive and/or incredibly stupid, perhaps we should give them the benefit of the doubt and search for a rational explanation.

The most important point that scoffers like Crowley overlook is that the business world is uncertain. When a company brings in a new executive, it is not at all obvious what steps he or she should take to turn the company around and boost profits. (If it were obvious, the company wouldn’t waste millions of dollars hiring the executive.) Now regardless of the executive’s competence, it is entirely possible that the plan will fail—and the executive knows this as well as anyone else. Because of this, it would be very risky for such an executive to sign a contract in which, say, he or she earned $20 million if the company were profitable, but $50,000 if the company tanks. Rather than sign that contract, the executive (who must be quite skilled to be offered such a job in the first place) could consult or take a less glamorous position and earn, say, $5 million for sure.

This principle—that an executive gets paid handsomely even if the company does poorly—doesn’t seem outrageous when the numbers are lower. For example, when GM stock plunged 25 percent, did Crowley expect the assembly-line workers to give back a quarter of their wages for that year? If not, why not? After all, if the public stops buying GM vehicles, the services of the assembly-line workers aren’t as valuable. The simple answer, of course, is that the assembly-line worker doesn’t want his contract contingent on the overall profitability of the company; he wants to be paid—and to get his pension and other benefits should he retire or quit—whether or not the company’s stock does well. If it’s acceptable for the assembly-line workers, why not for the CEO too?

Greater Influence

Naturally, there is one obvious difference in this respect between assembly-line workers (or janitors and receptionists) and CEOs: Far more so than these other employees, the CEO can greatly influence the profitability of the company. Rather than giving the CEO a well-specified set of instructions to mechanically implement, the people hiring him allow far more discretion. After all, the CEO is brought in to run the company.

Yet this difference shows up quite clearly in the market: CEOs and other executives do get paid according to how well the company does. In addition to a base salary, these executives are often paid in stock options. A stock option (specifically a call) gives its owner the right to purchase shares of stock at a specific price, called the strike price. Therefore, if the actual market price of the stock is lower than the strike price, the option is worthless. But if, through their behavior, executives can boost the company’s stock price above the strike price, the options are valuable in proportion to the difference between the strike and actual prices.

Given his outrage over executives being paid regardless of profitability, one would expect Crowley to be a huge advocate of paying CEOs in nothing but stock options, which perfectly tailor earnings to the success of the company. Yet Crowley complains about the fairness of this too, even with highly successful companies. He cites the case of Yahoo! CEO Terry Semel, who took advantage of $230 million in stock options in 2004:

The average Joe might be more outraged if he understood the sorts of payouts and benefits that corporate brass are getting. Stock grants still provide a windfall for many chief executives, despite new regulations that force companies to account for options as expenses. Yahoo! CEO Terry Semel exercised $230 million in options last year. His company has had strong earnings of late so it’s fair to say that Semel earned his $600,000 salary, plus a hefty award for boosting the stock price. But $230 million? Come on.

Now what exactly is Crowley’s definition of fairness? If Semel is paid a large chunk of options, and under his leadership Yahoo! stock rises tremendously, why shouldn’t he be rewarded in proportion to this gain? At this point we can see past Crowley’s other alleged arguments; his basic objection is obvi ously that $230 million is more than anyone should earn, period.

Arbitrary Limit

There are three problems with this popular view. First, the upper limit that “decency” allows is arbitrary; no doubt many people would also deny the fairness of Semel’s $600,000 base salary. (“We’ve got starving children in the streets and some guy who heads a company of spammers gets 600 grand a year?!”)

Second, we must accept that in the modern economy, with billions of potential consumers worldwide, certain individuals have extraordinary earning power on the open market. If someone like Semel (or, a stronger case, Bill Gates) can add hundreds of millions of dollars of value to an organization (as judged by the spending habits of consumers), then to not pay him accordingly just means that someone else gets the money. Whatever happened to the principle of labor being paid the full value of its product? If Semel only got, say, $1 million, then Yahoo! shareholders (a group hardly in need of charity) would be $229 million richer. Would this outcome be fairer than what actually happened?

Third, we must consider the problem of incentives. If certain market exchanges are prevented because people such as Crowley find them unconscionable, then the individuals involved may stop working as much or as hard. For example, if Semel knew that outsiders would confiscate his stock options if the stock price rose too much, then he wouldn’t have put in the long hours and sleepless nights that he undoubtedly did during the year in question.

This is a point liable to misinterpretation, and it’s probably easier to switch contexts to professional sports. Economics tells us that placing a limit of, say, $1 million on salaries would reduce the incentives for star athletes. Now the critic might scoff and say, “Come on! Whether they make $1 million or $30 million, people will still go into the NBA. That type of cap isn’t going to affect anybody’s career choice.” Yet this objection overlooks the marginal nature of economic decisions. Yes, a first-round draft choice will still go pro (rather than become an accountant) even with a $1 million cap. But he’ll probably retire much earlier. (In the extreme, consider the heavyweight champion of the world—once he earns his title, he won’t defend it nearly as often if people like Crowley get to dismiss multimillion-dollar payments as unfairly high.)

This reasoning applies even more so to leadership positions in large companies. Especially when considered in the aggregate, if “outrageous” compensation packages are forbidden, the quality of corporate leadership will suffer. These people aren’t qualified for just CEO spots, and they’re well aware of the social stigma against big business. If the compensation packages are as high as they are, it’s because that’s what firms need to offer to attract and retain these highly skilled individuals. Of course, this phenomenon isn’t peculiar to corporate-leadership positions; if we declared tomorrow that brain surgeons could only make 50 percent of their current salaries, the frequency and quality of brain surgery would plummet.

Entrenched Management?

Of course, any reader who has actually worked in (or owns stock in) a large corporation may reject the above description as naïve. In the real world, such a reader might object, most shareholders in practice exercise no control over management. Suppose, for example, that 85 percent of the shareholders (consisting of thousands of people who each owned far less than 1 percent of the stock) thought the CEO made far too much money. Even so, would it really be worth it for them to organize and demand that the corporate board do something? After all, the increased dividends made possible by such cost-cutting wouldn’t translate into very much per shareholder. In this environment, management becomes entrenched and a lavish corporate culture takes over, with kept board members approving the jet-setting lifestyle of the CEO and his cronies.

As some of the recent scandals suggest, there definitely seems to be at least a grain of truth in such claims. Yet it nonetheless remains a puzzle to the free-market economist. For even if individual shareholders wouldn’t find it worthwhile to organize and put an end to profligate abuses by management, such waste would nonetheless show up in the stock price of the firm. If, for example, management collectively frittered away $10 million per year in unjustifiable expenses, the total shares of the corporation would be valued around $200 million less than they otherwise would be, assuming an efficient stock market and an interest rate of 5 percent. (This is because $200 million is the present discounted value of a perpetual stream of $10 million annual dividends.) Such a corporation would then be a prime target for the much reviled corporate raider. The raider would institute a “hostile takeover,” in which he bought up a controlling share in the corporation (by offering far more than the current price per share to the stockholders) and then used his power to fire or straighten out the inefficient managers. After cleaning house the corporation’s dividends and/or stock price would rise accordingly, netting the raider a profit.

Thus we see that in the free market, even the realistic problems with “democratic” mechanisms can always be overcome in the final analysis by a “strongman,” i.e. the corporate raider. (It should go without saying that these political metaphors are just that; in a free market all transactions are voluntary exchanges of property.) Consequently, if CEOs and other members of upper management make incredibly high earnings year after year, it must be that the shareholders find their services worth the expense. In some cases it may take the outside analyst some effort to discover how, but we shouldn’t doubt that the shareholders are careful with their money.

Unfortunately, I cannot close the analysis on this optimistic note. For the above relies on the assumption of a free market in corporate takeovers, and that is decidedly lacking. In the present legal and cultural environment, so-called corporate raiders are even more despised than golden-parachuting CEOs. Regulations severely restrict so-called hostile takeovers, and hence hamper the ability of shareholders to restrain their managers. For example, the federal Williams Act (1968) compels a would-be raider to declare his intentions after acquiring 5 percent of a corporation’s shares. Declaring one’s intention to take over a company would likely push up the stock price, making the takeover plan unfeasible.

The market’s other checks on inefficient management are stifled as well. After all, even before the financial innovations allowing the issue of “junk bonds” and hostile takeovers, there was always a sure-fire way to keep corporate officers in line: any firm that wasted too much money on fancy offices and executive perks would be vulnerable to its competitors. Again, this initially poses a puzzle for critics such as Crowley; if outrageous compensation for CEOs is so endemic in American corporate culture, why don’t new firms enter these industries and drive the old ones out of business?

But as with hostile takeovers, so too with new entrants to industry: Government regulation muffles this threat and thus allows entrenched businesses a margin of profligacy that they otherwise would not enjoy. Many people (especially young students) new to the ideas of laissez faire believe that big business opposes government meddling, but this is naïve and contradicted by the history of actual legislation. Ironically, the profitability of big business can actually be enhanced when the government regulates an industry, because the big firms can more easily handle the fixed costs of filling out paperwork, providing a “safe” working environment, proving that they are making every effort to comply with affirmative action goals, and so on. In this environment, would-be competitors face additional hurdles if they want to challenge the large incumbents, and thus the latter may indeed get away with lavish expenditures that would be short-lived in a truly free market.

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