Tuesday, January 30, 2007

Executive Pay

“When I graduated from college, the average corporate CEO made 20 times what the average worker did; today, it's nearly 400 times. In other words, it takes the average worker more than a year to make the money that his or her boss makes in one day.”
- from the Democratic response to President Bush's State of the Union address, as delivered by Sen. Jim Webb, D-Va.

i’m not really sure why executive pay would pop up on a politician’s radar. short of outright wage controls, there doesn’t seem to be much the government can do to change what a CEO makes. the libertarian in me thinks that if politicians stuck to doing their job, they might actually get a few things accomplished. of course, the libertarian in me also thinks the less politicians actually get done, the better off things will be. so, maybe i shouldn’t look a gift horse in the mouth. nonetheless, there is a point of view in webb’s comments that i find particularly disturbing.

perhaps i am being too literal and sen. webb mentions executive pay not because he has any designs on government regulation of private salaries, but rather to make a point about growing inequality and the decline in wages among the middle class.

if that is the case, then i would ask webb just why it is that i ought to care what my “boss” makes in a year or even in one day. this is a curious class of argument, in that there really is no argument. all webb does is state a fact: CEOs used to make x times more money, now they make y times more. nathan smith makes this point in an article on TCSDaily. as smith puts it, webb’s argument concerns relative wealth and does not address whether there has been a real increase in worker’s salaries. since i am not the sort of person who would think less of my own cadillac just because my neighbor got a porsche, it makes much more sense to focus on my own earning power rather than somebody else’s.

this might be a good time to make a baseball analogy. at one point players basically belonged to the team that signed them. they could be traded by the team, but had no real freedom to negotiate a contract with any other team. as a result, they made relatively modest salaries. teams enjoyed a monopoly when negotiating with their own players. after free agency, teams were forced to compete with one another to sign players not under a present contract. off to the races went player salaries.

the relative question to ask is this: if a-rod didn’t make $25 million a year, would a peanut vendor at yankee stadium be making more money? probably not. it seems more likely that the peanut vendor’s salary has much more to do with the price of peanuts and the number of people who come to the ballpark. the more fans and the cheaper a bag of peanuts, the more peanuts he will tend to sell.

now, you could argue that if the yankees paid a-rod less and lowered ticket prices then more people would come to the stadium and our peanut guy would make more money. however, this is only true if ticket price is the only variable that contributes to attendance. it’s not, and there’s no definitive way you could argue that more people would show up at the stadium to pay $10 and watch a team of utility veterans and young talent than would be willing to pay $20 to watch a team of all-stars. likewise, i don’t see how you can make a definitive argument that if CEOs made less money then workers would make more, in terms of real dollars.

there is still a dimension to webb’s argument that may ring true. if large numbers of corporate executives are being overpaid for shoddy work, you could argue that workers, and shareholders, are losing out on the basis of opportunity costs. that is to say, if CEOs were paid sparingly and according to performance then companies, and consequently our economy, would perform better.

so, are executives being paid more than they are worth? i am neither an economist nor an expert on management, so i won’t even pretend to offer a definitive answer on this. the economist just did a special report on executive pay and it seems to imply that big corporate profits have indeed followed from increased executive pay. of course, there are always those cases where executives are paid huge sums of money for performance that can be quantitatively judged as sub par. the home depot’s departing CEO offers the latest example. in terms of the baseball analogy: a-rod sucks, nobody wants to see him play and his $25 million salary is a waste of money.

there are two problems with that approach. the first is that it implies salaries have but one purpose: to reward people for a job already done. that is only one part of the function that a salary fulfills. in a sense, it is a secondary function. for the most part, people negotiate their pay before ever actually performing the job in question. salary is as much an enticement to take a job as it is compensation for fulfilling your duties. unless you work purely on commission, your salary will tend to be more of a reflection on what your employer thinks you can do then on what you have already done.

the other problem lies in the particular comparison that sen. webb makes. for political purposes, it may make sense to compare a CEOs salary to the lowest paid worker in that firm, but it’s a rather meaningless relationship. that is because when companies look for a CEO, they rarely look among the ranks of the lowest paid. a security guard’s salary will tend to reflect more on the market for security guards and less on whether he works for an investment bank or at the gap. i would expect that the only significant differences might arise from the tendency of the investment bank to hire guards with more corporate security experience, whereas the gap may have lower standards for employment.

it might be more useful to compare the pay of CEOs to those who fall directly below them on the chain of command. after all, that is the pool from which new CEOs are most likely drawn.

i read an article in the nytimes a few weeks ago about how fewer and fewer police officers are taking the sergeant’s exam. it turns out that sergeant’s only make a little bit more money than police officers, but they have to deal with the headache’s of being a supervisor. as a result, fewer and fewer officers wish to be sergeants. it’s a perfectly rational decision. why deal with the hassle of being management and make $55,000 a year, when I can make $50,000, work significantly fewer hours and have a lot less pressure on me?

i cannot say anything for certan about the relationship between CEO pay and what other executives make, but i assume they address the above-mentioned phenomenon. if CEOs made only marginally more money than excutive vice presidents, then who in their right mind would want to be a CEO? if there is any truth to what i’ve just written, then exponentially rising CEO pay makes perfect sense. it’s the only way to consistently attract good talent. so, a board of directors may not know for certain that they are getting their money’s worth, but they do know that if they refuse to pay what the market demands they have much less of a chance at hiring a good CEO.

the bottom line is this: if CEOs were paid according to what everyone else thinks they ought to be paid, then we would likely end up with an overabundance of CEOs obsessed more with their public image and less with running their companies well. there’s a word for those types of people… politicians.

No comments: