Executive Compensation

EXECUTIVE COMPENSATION….Is CEO compensation in America crazy? Mickey Kaus agrees that it is:

It seems obvious that top corporate pay is out of control. But there’s Charles Murray’s argument to contend with: “[W]hen a percentage point of market share is worth hundreds of millions of dollars, the people who can help you get that extra percentage point will command very large salaries.”

That’s true. In any system where there’s a lot of money sloshing around ? think of Hollywood or professional sports ? the pay of the top performers is going to be astronomical if those top performers can increase profits by even a few percent. And in corporate America, there’s a lot of money sloshing around.

But there’s more to it than that. Consider this from Daniel Akst in the New York Times today:

As Rakesh Khurana showed in his insightful book, “Searching for a Corporate Savior: The Irrational Quest for Charismatic C.E.O.’s” (Princeton University Press, 2002), there is a much wider pool of potential chief executives than soaring pay levels would seem to imply. But companies insist on bidding for a savior, not a capable leader who knows the business at hand, which may be why typical C.E.O. tenures are now so short. Even in the boardroom, charisma carries you only so far.

This is the big difference between corporate pay and, say, pro sports pay: owners and general managers may make occasional mistakes when they bid for star quarterbacks or left-handed pitchers, but on the whole their bidding is pretty reasonable. They have good reason to think these guys are going to boost revenue by more than they’re getting paid, and if the player’s performance drops he eventually gets cut or traded. It’s far from a perfect system, but at its core it’s fundamentally rational.

Contrast that to executive pay, where truckloads of studies have shown that, in fact, it’s practically impossible to predict which CEO will help you gain Murray’s fabled couple of points of market share. What’s more, star CEOs mostly don’t do much better than merely excellent CEOs, so the money spent on them is pretty much wasted. As Akst points out a few paragraphs later, the compensation of the top five executives at public companies totaled roughly 10 percent of corporate profits, and it’s almost a dead certainty that those companies would do better on average to hire competent executives at half the pay and then bank that additional 5%.

So why do they keep paying their executives so much? As Akst almost-but-not-quite says, it’s because there’s no one to stop them. Compensation committees are stocked with senior executives from other companies, and they all set each other’s pay. Stephen Bainbridge half-jokes about this when he quotes Jack Welch’s advice about who to put on your compensation committee (“Put someone in charge who is…immensely rich…and enjoys seeing other people get rich”), but it’s no joke. That’s a very big part of the story.

Despite what Akst says, there really are ways to pay for performance that are workable. Not perfect, but workable. But by their very nature, pay for performance incorporates the chance that pay will be low if performance is low, and CEOs, those supposed bastions of risk taking and private enterprise, are simply unwilling to accept that risk.

I don’t have anywhere special to take this, except to insist that we give up on the fiction that CEOs are paid a lot these days because they’re worth so much to their companies. There’s just no evidence for it. It’s not supply and demand that’s responsible for astronomical CEO pay, it’s cronyism and lack of accountability.