Now, do I think some of the salaries are excessive at the top? I do. I do, and I've spoken so publicly. I don't think it's a role of government to regulate salary. But I do believe it's the role of boards of directors to be very transparent with shareholders about these different packages, the employment packages that these executives get. And I do think it's very important for a board of directors to make sure that the shareholder benefits more than the chief executive officer does, or the chief operating officer does. I don't care for that situation where the company loses money, but the people at the top benefit. I am concerned about that.
—President Bush in a Wall Street Journal interview(registration required), Oct. 12, 2007
The modern CEO must … be sufficiently ruthless and driven to find and pull the levers that will deliver competitive advantage. There are no standard textbook moves, no well-established strategies to draw upon. If there were, rivals would already be using them.
Boards of directors well understand this, which is one reason why executive talent is in such high demand. The pool of proven talent is small because so few executives have been tested and succeeded at the job of running a company. … When demand rises while the supply remains limited, prices soar. Boards are willing to pay more and more for CEOs and other top executives because their rivals are paying more and more for them. And all are willing to pay more because, in effect, consumers and investors are pressuring them to.
—Robert Reich in Supercapitalism: The Transformation of Business, Democracy and Everyday Life, published September 2007
While nobody was looking, Robert Reich positioned himself to the right of President Bush. Reich was Bill Clinton's Labor secretary, and while he was never the left-winger caricatured by the right, he was more reliably liberal than most of the Clinton Cabinet. Reich is still a liberal, but in his new book, Supercapitalism, he argues that corporate chief executives deserve their stratospheric pay.
The typical CEO of a Fortune 500 company is paid $10.8 million, or 364 times what an average employee makes. By comparison, 40 years ago that CEO would have been paid only 20 to 30 times what an average employee makes. "As citizens," Reich concedes,
we may feel that inequality on this scale cannot possibly be good for a democracy. It undermines solidarity and mutuality on which responsibilities of citizenship depend. It creates a new aristocracy whose privileges perpetuate themselves over generations. It breeds cynicism among the rest of us. But the super-rich are not at fault. By and large, the market is generating these outlandish results. And the market is being driven by us as consumers and investors.
In an op-ed headlined "CEOs Deserve Their Pay" (registration required) published Sept. 14 in the Wall Street Journal, Reich wrote that if voters can't stomach what CEOs get paid, they should raise the top income-tax rate. But if stockholders feel nauseated by CEO pay, they shouldn't protest. Rather, they should reconcile themselves to the idea that they're getting their money's worth. Reich's larger point (he explains in Supercapitalism; the Journal's conservative editpage doesn't care) is that corporations generate wealth, democracy generates social justice, and when you allow one to meddle in the other, mischief will likely result.
I agree with Reich to the extent that he is warning not to be credulous when corporations voluntarily embrace "social responsibility" or when government gets too interested in helping this or that private industry. (What's good for General Motors isn't necessarily good for America.) But I thought it was self-evident that compensation to top corporate officers, far from being a pure expression of market imperatives, was distorted by all sorts of internal bureaucratic imperatives. Joseph Nocera described this in his Oct. 13 "Talking Business" column in the New York Times:
[T]he market for executive compensation is so clearly rigged. Chief executives sit on one another's boards, so they have an incentive to take care of one another. Directors are predisposed to want to make the chief executive happy since, after all, he or she is the one who picked them for the board. Far too often, a chief executive's pay isn't a result of an arms-length negotiation, but a result of a kind of a corporate buddy system.
Graef Crystal is a longtime expert on executive pay. His Bloomberg column regularly cites examples of top executives whose pay is grotesquely out of whack with the performance of the company they run. Reich concedes that this can happen now and then, but that when it does it's "unlikely to last long" because market pressures will soon force that top executive's resignation. But in a July 11 column, Crystal reported that Edward Whitacre, who the month before had departed as chief executive officer of AT&T, had managed to underperform the Standard & Poor's 500 Index "during his entire 17 and a half years of running the company," yet managed to amass well over $500 million in compensation. How did he get away with it? According to Crystal, the board "swooned over his empire building and rewarded him accordingly." More recently, in an Oct. 17 column, Crystal cited a business review article that suggested paying a CEO with a large stock option sometimes motivates him to take "such great risks that he ends up making decisions that can backfire for shareholders [italics mine]."
According to the professors' research—and this is the big news here—the possibilities of outsized gain or outsized loss aren't equal. Their analysis of companies where 50 percent or more of the pay package comes from option grants (measured at the grant date using the Black-Scholes model) shows that 6.8 percent of the cases produced large gains for shareholders while 10.1 percent produced large losses.
Why should this be so? The authors of the article were apparently uncertain, but their working hypothesis, Crystal wrote, went as follows: To shareholders, when a risky decision backfires the result is actual monetary losses. To a CEO with a large stock option, when a risky decision backfires the result is "that his options will expire underwater. He won't lose any real dollars." If that's true, then even to executives, the stupendous level of compensation must feel like play money.
Stepping back a little further, we might question the very premise that a CEO's pay increase should be commensurate with the increase in the value of his company's stock. Between 1980 and 2003, Reich writes in Supercapitalism,
as the average value of America's largest five hundred companies rose by a factor of six, adjusted for inflation, average CEO pay in those companies also rose roughly sixfold.
Reich offers this up as evidence that CEO pay makes economic sense. But CEOs aren't puppeteers. As Paul Krugman writes in his smart new book, The Conscience of a Liberal,
Assessing the productivity of corporate leaders isn't like measuring how many bricks a worker can lay in an hour. You can't even reliably evaluate managers by looking at the profitability of the companies they run, because profits depend on a lot of factors outside the chief executive's control. Moreover, profitability can, for extended periods, be in the eye of the beholder: Enron looked like a fabulously successful company to most of the world; Toll Brothers, the McMansion king, looked like a great success as long as the housing bubble was still inflating. So the question of how much to pay a top executive has a strong element of subjectivity, even fashion, to it. In the fifties and sixties big companies didn't think it was important to have a famous, charismatic leader: CEOs rarely made the covers of business magazines, and companies tended to promote from within, stressing the virtues of being a team player. By contrast, in the eighties and thereafter CEOs became rock stars—they defined their companies as much as their companies defined them. Are corporate boards wiser now than they were when they chose solid insiders to run companies, or have they just been caught up in the culture of celebrity?
One might wonder the same about Reich.
[Update, Oct. 26: Sally Bedell Smith's new book about the Clintons, For Love of Politics, describes a July 1995 dinner attended by Reich, his wife Clare, and Bill and Hillary Clinton:
Reich was ... gladdened by Hillary's passionate condemnation of corporate-executive compensation—one of the Labor Secretary's favorite populist topics. "These are real issues, Bill," she said, pointing out that the average CEO of a big company "is now earning 200 times the average hourly wage. Twenty years ago the ratio was about forty times ... People all over this country are really upset about this." When Bill demurred, saying he couldn't be "out front" on such issues, Hillary said sharply, "Well, somebody in the administration ought to be making these arguments," turning to Reich. "I agree," replied Bill with a nod.
As late as August 2000, Reich said (on CNN's Crossfire) that out-of-control executive pay was "a terrific new issue" for Democratic presidential nominee Al Gore. Clearly, Reich has changed his mind. Hillary, I'm pleased to report, has not. In a campaign speech delivered in May she said:
We need to open up CEO compensation to public scrutiny and public challenge and ensure that boards of directors are independent when determining CEO pay.