Chatterbox

To Explain Is Not To Justify

Tim,

If you agree with me that 1) CEO pay is outrageous on social and ethical grounds; 2) the best way to rein it in (and rein in the even more outrageous pay of hedge-fund and private-equity fund managers) is by increasing the marginal tax on the highest incomes; and 3) shareholders won’t and can’t be counted on to do the job, then our disagreement is over the economics of CEO pay. You say the current level can’t be explained by supply and demand; I say it can—at least, to a very large degree.

There’s an important difference between explanation and justification.

Markets have lots of effects that cannot be justified morally—a point that market fundamentalists on the right often fail to acknowledge. One of the biggest of such effects is CEO pay, and the growing gap between it and the wages of average workers. Every two weeks, Lee Scott Jr. of Wal-Mart rakes in roughly the same amount his average employee earns in a lifetime. That’s a bigger gap than used to be the case, even at Wal-Mart. Is it because CEOs such as Scott have become greedier than they used to be, or so much more adept at packing their boards with cronies who will award them princely sums? I doubt it. CEOs have always been greedy, and they used to have an easier time handpicking their boards than they do now in the post-Enron era.

A simpler explanation is that boards of directors choose their CEOs from a relatively small pool of proven executive talent. Few executives have been tested and succeeded at the top job. Boards don’t want to risk error. The cost of recruiting the wrong person can be huge. This wasn’t nearly as much the case decades ago, when competition for investors and customers was far less intense and shareholders were far more placid. But under supercompetitive capitalism, boards are willing to pay more and more for CEOs because their rivals are paying more and more, and the cost of making a bad decision is so much greater than before. As I argue in Supercapitalism, the stakes are higher because, in effect, consumers and investors have more choice than ever before, and are pressuring all companies to offer them better deals. If they don’t get them, consumers and investors will find them somewhere else.

This doesn’t mean CEOs have to be Nietzschean supermen or -women. And of course a company’s overall performance depends on a lot more than the wisdom of a single head honcho. It just means that boards of directors are willing to pay far more than they used to, just as Hollywood studios are paying lots more for celebrities. As TheNew Yorker’s James Surowiecki has reminded us, Clark Gable earned $100,000 a picture in the 1940s, which translates into roughly $800,000 today. But that was when Hollywood was dominated by a handful of big studios. Today, Tom Hanks makes closer to $20 million per film. Movie studios are now competing intensely not only with one another but with every other form of entertainment. They’re willing to pay Hanks and other celebrities these colossal sums because they’re still small compared with the money these stars bring in and the profits they generate.

Last year, Ford Motor Co.—which, as everyone knows, has been slashing its payrolls—gave its chief executive, Alan Mulally, a $2 million “base salary,” $7.5 million as a signing bonus, options and stock units valued at more than $15 million, and more than $11 million worth of other perks and benefits, for a grand total of around $36 million. Did the Ford board offer Mulally this much because Mulally had filled the board with golfing buddies? No. He hadn’t even worked at Ford before being offered this package. It was put together by Ford’s board in order to lure Mulally to Ford from Boeing. Mulally had done well at Boeing, and Ford was desperate to find someone who could turn around the company and, just as importantly, convince Wall Street it had found someone who could turn around the company. Is Mulally “worth it” in social or moral or ethical terms? Of course not. Is it nonetheless understandable that Ford’s board felt it needed him, and therefore was willing to pay him this much? Sadly, the answer is yes.

That the market for CEOs results in such exorbitant levels of pay doesn’t make it right to pay CEOs this much; it only makes such pay understandable. This is why I’ve argued that we can’t rely on shareholders to rein in CEO pay. It’s also why our understandable moral outrage about CEO pay should be directed at changing the rules of the game—such as increasing the marginal tax on the super-rich.

Bob