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Thursday, May 18, 2006

Is CEO Pay Excessive?

Tyler Cowen discusses a paper supporting a controversial position on CEO pay:

A Contrarian Look at Whether U.S. Chief Executives Are Overpaid, by Tyler Cowen, Economic Scene, NY Times: ...Not surprisingly, many people think ... American executives are overpaid. Their salaries are set by corporate boards, often filled with insiders or friends. Salaries for the top executive are far from transparent, especially when stock options and complex compensation plans are used. Nor is pay always linked to performance...

But in a new paper "Why Has C.E.O. Pay Increased So Much?," the economists Xavier Gabaix of the Massachusetts Institute of Technology and Augustin Landier of the Stern School of Business at New York University ... suggest that the higher salaries for chief executives can largely be explained by increases in the value of the stock market. Viewed as a whole, these salaries are a result of competitive pressures rather than the exploitation of shareholders.

Their core argument is simple. If we look at recent history, compensation for executives has risen with the market capitalization of the largest companies. For instance, from 1980 to 2003, the average value of the top 500 companies rose by a factor of six. Two commonly used indexes of chief executive compensation show close to a proportional sixfold matching increase (the correlation coefficients are 0.93 and 0.97, respectively; 1.0 would be a perfect match). ...

As Professors Gabaix and Landier predict, chief executives' salaries in different sectors are higher when the capitalization of that sector is higher. A stronger sector means more bidders for a chief executive of a particular kind; an executive who has run one car company can go run another. Chief executives in large industries, therefore, receive more, even after adjusting for the size of their current companies. Business services, computers and banking turn up as exceptions for this comparison; their top executives are overpaid relative to ... market capitalization... Perhaps chief executives can add more value in more dynamic sectors.

The authors are still working on their international comparisons... But the preliminary results suggest that the total value of the companies in the sector helps predict how chief executives' salaries vary from country to country... The two also find that the best chief executives do not seem to have much more talent than other chief executives in ... the top 250. By their calculations, replacing the No. 250 chief executive with the No. 1 will increase the value of the company by only 0.014 percent. The No. 1 chief executive receives much more compensation, but that is mostly because he manages a larger company...

The Gabaix-Landier argument does not cover all objections. We do not have adequate data for longer stretches of American history. There are important cultural differences across countries. Lucian A. Bebchuk of Harvard Law School, a leading critic of chief executives' pay, argues in response to the paper that pay remains insensitive to performance, that high executive pay is correlated with bad corporate governance and that chief executives take great care to hide their true compensation. For those reasons, he does not believe that executive pay is driven by productivity.

In any case, the debate over chief executives' salaries has moved a step forward. Yes, there are numerous examples of corporate malfeasance. But it is not obvious that the American system of executive pay — taken as a whole — is excessive or broken. ... [T]he rate of productivity growth in the United States has been the envy of the world. Chief executives must be doing something right.

The growth in executive compensation reflects how much more is at stake in American companies. Is not the real question which policies and institutions have led to this explosion of value?

There is evidence on the other side as well (some of it is cited in the paper), and there are other explnations for the correlations in the data, so I can't say I'm convinced.

    Posted by on Thursday, May 18, 2006 at 12:42 AM in Economics, Market Failure | Permalink  TrackBack (0)  Comments (28)



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