What they tell you Some people are paid a lot more than others. Especially in the US, companies pay their top managers what some people consider to be obscene amounts. However, this is what market forces demand. Given that the pool of talent is limited, you simply have to pay large sums of money if you are to attract the best talents. From the point of view of a giant corporation with billions of dollars of turnover, it is definitely worth paying extra millions, or even tens of millions, of dollars to get the best talent, as her ability to make better decisions than her counterparts in competitor companies can bring in extra hundreds of millions of dollars in revenue. However unjust these levels of compensation may appear, we should not engage in acts of envy and spite and try to artificially suppress them. Such attempts would be simply counterproductive.
What they don’t tell you US managers are over-priced in more than one sense. First, they are over-priced compared to their predecessors. In relative terms (that is, as a proportion of average worker compensation), American CEOs today are paid around ten times more than their predecessors of the 1960s, despite the fact that the latter ran companies that were much more successful, in relative terms, than today’s American companies. US managers are also overpriced compared to their counterparts in other rich countries. In absolute terms, they are paid, depending on the measure we use and the country we compare with, up to twenty times more than their competitors running similarly large and successful companies. American managers are not only overpriced but also overly protected in the sense that they do not get punished for poor performance. And all this is not, unlike what many people argue, purely dictated by market forces. The managerial class in the US has gained such economic, political and ideological power that it has been able to manipulate the forces that determine its pay.
Executive pay and the politics of class envy The average CEO compensation (salaries, bonuses, pensions and stock options) in the US is 300–400 times the average worker compensation (wages and benefits). Some people are terribly upset about this. For example, Mr Barack Obama, the US president, is frequently quoted criticizing what he sees as excessive executive pay.
Free-market economists see no problem in this pay disparity. If the CEOs are paid 300 times more than the average worker, they say, it must be because they add 300 times more value to the company. If someone does not have the productivity to justify her high pay, market forces will soon ensure that she is sacked (see Thing 3). Those who raise issues with executive pay, like Mr Obama, are populists who engage in the politics of class envy.
Unless those who are less productive accept, they argue, that people need to be paid according to their productivity, capitalism cannot function properly.
One could almost believe in the above arguments, if one made a small concession – ignoring the facts.
I am not disputing that some people are more productive than others and that they need to be paid more – sometimes a lot more (although they should not be too smug about it – see Thing 3). The real question is whether the current degree of difference is justified.
Now, accurately totting up executive pay is very difficult. To begin with, the disclosure of executive pay is not very good in many countries. When we look at compensation as a whole, rather than just salaries, we need to include stock options. Stock options give the recipient the right to buy a certain number of the company’s stocks in the future, so they do not have an exact value in the present and their value needs to be estimated. Depending on the methodology used for the estimation, the valuation can vary a lot.
As mentioned earlier, bearing these caveats in mind, the ratio of CEO compensation to average worker compensation in the US used to be in the region of 30 to 40 to 1 in the 1960s and 70s. This ratio has grown at a rapid rate since the early 1980s, reaching around 100 to 1 in the early 1990s and rising to 300–400 to 1 by the 2000s.
Contrast this to the changes in what the American workers get. According to the Economic Policy Institute (EPI), the Washington-based centre-left think-tank, the average hourly wage for the US workers in 2007 dollars (that is, adjusted for inflation) rose from $18.90 in 1973 to $21.34 in 2006. That is a 13 per cent increase in thirty-three years, which is around 0.4 per cent growth per year.1 The picture is even bleaker when we look at overall compensation (wages plus benefits) and not just wages. Even if we look at only the recovery periods (given that worker compensation falls during recessions), median worker compensation rose at the rate of 0.2 per cent per year during 1983–9, at the rate of 0.1 per cent per year between 1992 and 2000 and did not grow at all during 2002–7.2 In other words, worker pay in the US has been virtually stagnant since the mid 1970s. Of course, this is not to say that Americans have not seen any rise in living standards since the 1970s. Family income, as opposed to individual worker compensation, has risen, but that is only because more and more families have both partners working.
Now, if we believed in the free-market logic that people are paid according to their contribution, the increase in the relative compensation of the CEOs from 30–40 times that of average worker compensation (which has not changed very much) to 300–400 times must mean that the American CEOs have become ten times more productive (in relative terms) than they were in the 1960s and 70s. Is this true? The average quality of US managers may have been rising due to better education and training, but is it really plausible that they are ten times better than their equivalents were one generation ago? Even looking back at only the last twenty years, during which time I have been teaching in Cambridge, I sincerely doubt whether the American students we get (who are potential CEO material) are three to four times better today than when I started teaching in the early 1990s. But that should be the case, if American CEO pay had risen in relative terms purely because of the rising quality of the CEOs: during this period, the average CEO compensation in the US rose from 100 times the average worker compensation to 300–400 times.
A common explanation of this recent steep rise in relative pay is that companies have become bigger and therefore the difference that the CEO can make has become bigger. According to a popular example used by Professor Robert H. Frank of Cornell University in his widely cited New York Times column, if a company has $10 billion earnings, a few better decisions made by a better CEO can easily increase the company’s earnings by $30 million.3 So, the implicit message goes, what is an extra $5 million for the CEO, when she has given an extra $30 million to the company? There is some logic to this argument, but if the growing size of the company is the main explanation for CEO pay inflation, why did it suddenly take off in the 1980s, when US company size has been growing all the time? Also, the same argument should apply to the workers as well, at least to some extent. Modern corporations work on the basis of complex divisions of labour and cooperation, so the view that what the CEO does is the only thing that matters for company performance is highly misleading (see Things 3 and 15). As companies grow bigger, the potential for workers benefiting or damaging the company grows bigger as well and therefore it becomes more and more important to hire better workers. If that were not the case, why do companies bother with human resources departments? Moreover, if the increasing importance of top managerial decisions is the main reason for CEO salary inflation, why are CEOs in Japan and Europe running similarly large companies paid only a fraction of what the American CEOs are paid? According to the EPI, as of 2005, Swiss and German CEOs were paid respectively 64 per cent and 55 per cent of what their American counterparts received. The Swedish and the Dutch were paid only around 44 per cent and 40 per cent of the American CEOs’ pay; Japanese CEOs only a paltry 25 per cent. The average CEO pay for thirteen rich countries other than the US was only 44 per cent of the US level.4 The above figures actually vastly understate the international differences in CEO remuneration as they do not include stock options, which tend to be much higher in the US than in other countries. Other data from the EPI suggest that, in the US, CEO pay including stock options could be easily three to four times, and possibly five to six times, that of their pay excluding stock options, although it is difficult to know exactly the magnitude involved. This means that, if we include stock options, the Japanese CEO compensation (with only a small stock option component, if at all) could be as low as 5 per cent, instead of 25 per cent, that of US CEO compensation.
Now, if the American CEOs are worth anything between twice (compared to the Swiss CEOs, excluding stock options) and twenty times (compared to the Japanese CEOs, including stock options), their counterparts abroad, how come the companies they run have been losing out to their Japanese and European rivals in many industries? You may suggest that the Japanese and European CEOs can work at much lower absolute pay than the American CEOs because their countries’ general wage levels are lower. However, wages in Japan and the European countries are basically at the same level as those in the US. The average worker pay in the thirteen countries studied by the EPI was 85 per cent of the US worker pay in 2005. The Japanese workers get paid 91per cent the American wages, but their CEOs get paid only 25 per cent of what the American CEOs get (excluding stock options). The Swiss workers and the German workers get higher wages than the US workers (130 per cent and 106 per cent of the US wage, respectively), while their CEOs get paid only 55 per cent and 64 per cent of the US salaries (once again, excluding share options, which are much higher in the US).5 Thus seen, US managers are over-priced. The American workers get paid only 15 per cent or so more than their counterparts in competitor nations, while the American CEOs are paid at least twice (compared to the Swiss managers, excluding stock options) and possibly up to twenty times (compared to the Japanese managers, including stock options) that of what their counterparts in comparable countries are paid. Despite this, the American CEOs are running companies that are no better, and frequently worse, than their Japanese or European competitors.
Heads I win, tails you lose In the US (and the UK, which has the second highest CEO– worker pay ratio after the US), the compensation packages for top managers are loaded in one way. Apart from being paid excessive amounts, these managers do not get punished for bad management. The most that will happen to them is to be kicked out of their current job, but that will almost always be accompanied by a fat severance payment cheque. Sometimes the expelled CEO will get even more than what is required in the contract. According to two economists, Bebchuk and Fried, ‘when Mattel CEO Jill Barad resigned under fire [in 2000], the board forgave a $4.2 million loan, gave her an additional $3.3 million in cash to cover the taxes for forgiveness of another loan and allowed her unvested options to vest automatically. These gratuitous benefits were in addition to the considerable benefits that she received under her employment agreement, which included a termination payment of $26.4 million and a stream of retirement benefits exceeding $700,000 per year.’6 Should we care? Not really, free-market economists would argue. If some companies are stupid enough to pay gratuitous benefits to failed CEOs, they would say, let them do it. They will be outcompeted by more hard-nosed competitors that do not engage in such nonsense. So, even though there may be some poorly designed compensation schemes around, they will eventually be eliminated through competitive pressures of the market.
This seems plausible. The competitive process works to eliminate inefficient practices, be they obsolete textile technologies or biased executive pay schemes. And the fact that American and British companies have been losing to foreign companies, which on the whole have better managerial incentives, is a proof of it.
However, it will take a long time for this process to eliminate wrong managerial compensation practices (after all, this has been going on for decades).
Before its recent bankruptcy, people had known for at least three decades that GM was on a decline, but no one did anything to stop the top managers from receiving compensation packages more fitting to their predecessors in the mid twentieth century, when the company had absolute dominance worldwide (see Thing 18).
Despite this, little is done to check excessive and biased (in that failures are hardly punished) executive pay packages because the managerial classes in the US and Britain have become so powerful, not least because of the fat paycheques they have been getting over the last few decades. They have come to control the boardrooms, through interlocking directorship and manipulation of information that they provide to independent directors, and as a result few boards of directors question the level and the structure of executive pay set by the CEO. High and rising dividend payments also keep the shareholders happy (see Thing 2). By flexing their economic muscle, the managerial classes have gained enormous influence over the political sphere, including the supposedly centre-left parties such as Britain’s New Labour and America’s Democratic Party. Especially in the US, many private sector CEOs end up running government departments. Most importantly, they have used their economic and political influence to spread the free-market ideology that says that whatever exists must be there because it is the most efficient.
The power of this managerial class has been most vividly demonstrated by the aftermath of the 2008 financial crisis. When the American and the British governments injected astronomical sums of taxpayers’ money into troubled financial institutions in the autumn of 2008, few of the managers who were responsible for their institution’s failure were punished. Yes, a small number of CEOs have lost their jobs, but few of those who have remained in their jobs have taken a serious pay cut and there has been an enormous, and effective, resistance to the attempt by the US Congress to put a cap on pay of the managers of financial firms receiving taxpayers’ money. The British government refused to do anything about the £15–20 million pensions payout (which gives him around £700,000 yearly income) to the disgraced former boss of the RBS (Royal Bank of Scotland), Sir Fred Goodwin, although the intense negative publicity forced him subsequently to return £4 million. The fact that the British and the American taxpayers, who have become the shareholders of the bailed-out financial institutions, cannot even punish their now-employees for poor performance and force them to accept a more efficient compensation scheme shows the extent of power that the managerial class now possesses in these countries.
Markets weed out inefficient practices, but only when no one has sufficient power to manipulate them. Moreover, even if they are eventually weeded out, one-sided managerial compensation packages impose huge costs on the rest of the economy while they last. The workers have to be constantly squeezed through downward pressure on wages, casualization of employment and permanent downsizing, so that the managers can generate enough extra profits to distribute to the shareholders and keep them from raising issues with high executive pay (for more on this, see Thing 2). Having to maximize dividends to keep the shareholders quiet, investment is minimized, weakening the company’s long-term productive capabilities. When combined with excessive managerial pay, this puts the American and British firms at a disadvantage in international competition, eventually costing the workers their jobs. Finally, when things go wrong on a large scale, as in the 2008 financial crisis, taxpayers are forced to bail out the failed companies, while the managers who created the failure get off almost scot-free.
When the managerial classes in the US and, to a lesser extent Britain, possess such economic, political and ideological power that they can manipulate the market and pass on the negative consequences of their actions to other people, it is an illusion to think that executive pay is something whose optimal levels and structures are going to be, and should be, determined by the market.
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