In Paul Krugman's recent column on stock options (Incentives for the Dead), he cited a 1990 paper by Jensen and Murphy as one of the reasons CEO compensation committees began offering stock options to CEOs. The idea in Jensen and Murphy is that if the pay of CEOs does not rise and fall sufficiently with company fortunes, then CEOs will have little incentive to manage the companies efficiently. Linking pay to performance through stock options and other means was intended to overcome this problem. As Krugman says:
They argued that a chief executive who expects to receive the same salary if his company is highly profitable that he will receive if it just muddles along won’t be willing to take risks and make hard decisions. “Corporate America,” declared an influential 1990 article by Michael Jensen of the Harvard Business School and Kevin Murphy of the University of Southern California, “pays its most important leaders like bureaucrats. Is it any wonder then that so many C.E.O.’s act like bureaucrats?”
The claim, then, was that executives had to be given more of a stake in their companies’ success. And so corporate boards began giving C.E.O.’s lots of stock options...
Of course, the stock option scandal is partly about the "bait and switch" that occurred - selling stock options as though they are linked to performance and therefore provide the right incentives to CEOs, then backdating the stock options to ensure that they paid off even if the company didn't perform especially well.
Krugman didn't mention it in his column, but the paper is worth reading for another reason, its explanation of why executives weren't given sufficient incentives. Jensen and Murphy say the reason was political pressure and social norms which prevented companies from paying executives as much as they should:
CEO Incentives—It's Not How Much You Pay, But How, by Michael C. Jensen and Kevin J. Murphy, Harvard Business Review: ...The arrival of spring means yet another round in the national debate over executive compensation. ... Political figures, union leaders, and consumer activists will issue now-familiar denunciations of executive salaries and urge that directors curb top-level pay in the interests of social equity and statesmanship. The critics have it wrong. There are serious problems with CEO compensation, but “excessive” pay is not the biggest issue. The relentless focus on how much CEOs are paid diverts public attention from the real problem—how CEOs are paid. In most publicly held companies, the compensation of top executives is virtually independent of performance. ... Is it any wonder then that so many CEOs act like bureaucrats rather than the value-maximizing entrepreneurs companies need to enhance their standing in world markets? ...
Compensation policy is one of the most important factors in an organization’s success. ... This is what makes the vocal protests over CEO pay so damaging. By aiming their protests at compensation levels, uninvited but influential guests at the managerial bargaining table (the business press, labor unions, political figures) intimidate board members and constrain the types of contracts that are written between managers and shareholders. As a result of public pressure, directors become reluctant to reward CEOs with substantial (and therefore highly visible) financial gains for superior performance. ... Are we arguing that CEOs are underpaid? If by this we mean “Would average levels of CEO pay be higher if the relation between pay and performance were stronger?” the answer is yes.
The point, then, is this: Those of us who say that the increase in inequality has a lot to do with power and changing norms are ridiculed - but back when people were arguing for a big increase in corporate pay (and they did say that their proposed changes would increase the average level of pay), it was considered perfectly sensible to say that power and norms were keeping CEO pay down.