But once we relax the idealized premises of the story, it’s not hard to see why executive pay is a lot less tied down by fundamental forces of supply and demand, and a lot more subject to changes in social norms and political power, than this story implies.
First, neither the quality of executives nor the extent to which that quality matters are hard numbers. Assessing the productivity of corporate leaders isn’t like measuring how many bricks a worker can lay in a 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?
Second, even to the extent that corporate boards correctly judge both the quality of executives and the extent to which quality matters for profitability, the actual amount they end up paying their top executives depends a lot on what other companies do. Thus, in the corporate world of the 1960s and 1970s, companies rarely paid eye-popping salaries to perceived management superstars. In fact companies tended to see huge paychecks at the top as a possible source of reduced team spirit, as well as a potential source of labor problems. In that environment even a corporate board that did believe that hiring star executives was the way to go didn’t have to offer exorbitant pay to attract those stars. But today executive pay in the millions or tens of millions is the norm. And even corporate boards that aren’t smitten with the notion of superstar leadership end up paying high salaries, partly to attract executives whom they consider adequate, partly because the financial markets will be suspicious of a company whose CEO isn’t lavishly paid.
Finally, to the extent that there is a market for corporate talent, who, exactly, are the buyers? Who determines how good a CEO is, and how much he has to be paid to keep another company from poaching his entrepreneurial know-how? The answer, of course, is that corporate boards, largely selected by the CEO, hire compensation experts, almost always chosen by the CEO, to determine how much the CEO is worth. It is, shall we say, a situation conducive to overstatement both of the executive’s personal qualities and of how much those supposed personal qualities matter for the company’s bottom line.
What all this suggests is that incomes at the top—the paychecks of top executives and, by analogy, the incomes of many other income superstars—may depend a lot on “soft” factors such as social attitudes and the political background. Perhaps the strongest statement of this view comes from Lucian Bebchuk and Jesse Fried, authors of the 2004 book Pay Without Performance. Bebchuk and Fried argue that top executives in effect set their own paychecks, that neither the quality of the executives nor the marketplace for talent has any real bearing. The only thing that limits executive pay, they argue, is the “outrage constraint”: the concern that very high executive compensation will create a backlash from usually quiescent shareholders, workers, politicians, or the general public.[11]
To the extent that this view is correct, soaring incomes at the top can be seen as a social and political, rather than narrowly economic phenomenon: high incomes shot up not because of an increased demand for talent but because a variety of factors caused the death of outrage. News organizations that might once have condemned lavishly paid executives lauded their business genius instead; politicians who might once have led populist denunciations of corporate fat cats sought to flatter the people who provide campaign contributions; unions that might once have walked out to protest giant executive bonuses had been crushed by years of union busting. Oh, and one more thing. Because the top marginal tax rate has declined from 70 percent in the early 1970s to 35 percent today, there’s more incentive for a top executive to take advantage of his position: He gets to keep much more of his excess pay. And the result is an explosion of income inequality at the top of the scale.
The idea that rising pay at the top of the scale mainly reflects social and political change, rather than the invisible hand of the market, strikes some people as implausible—too much at odds with Economics 101. But it’s an idea that has some surprising supporters: Some of the most ardent defenders of the way modern executives are paid say almost the same thing.
Before I get to those defenders, let me give you a few words from someone who listened to what they said. From Gordon Gekko’s famous speech to the shareholders of Teldar Paper in the movie Wall Street:
Now, in the days of the free market, when our country was a top industrial power, there was accountability to the stockholder. The Carnegies, the Mellons, the men that built this great industrial empire, made sure of it because it was their money at stake. Today, management has no stake in the company!…The point is, ladies and gentlemen, that greed—for lack of a better word—is good. Greed is right. Greed works.
What those who watch the movie today may not realize is that the words Oliver Stone put in Gordon Gekko’s mouth were strikingly similar to what the leading theorists on executive pay were saying at the time. In 1990 Michael Jensen of the Harvard Business School and Kevin Murphy of the University of Rochester published an article in the Harvard Business Review, summarizing their already influential views on executive pay. The trouble with American business, they declared, is that “the compensation of top executives is virtually independent of performance. On average corporate America pays its most important leaders like bureaucrats. 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?” In other words, greed is good.[12]
Why, then, weren’t companies linking pay to performance? Because of social and political pressure:
Why don’t boards of directors link pay more closely to performance? Commentators offer many explanations, but nearly every analysis we’ve seen overlooks one powerful ingredient—the costs imposed by making executive salaries public. Government disclosure rules ensure that executive pay remains a visible and controversial topic. The benefits of disclosure are obvious; it provides safeguards against “looting” by managers in collusion with “captive” directors.
The costs of disclosure are less well appreciated but may well exceed the benefits. Managerial labor contracts are not a private matter between employers and employees. Third parties play an important role in the contracting process, and strong political forces operate inside and outside companies to shape executive pay. Moreover, authority over compensation decisions rests not with the shareholders but with compensation committees generally composed of outside directors. These committees are elected by shareholders but are not perfect agents for them. Public disclosure of “what the boss makes” gives ammunition to outside constituencies with their own special-interest agendas. Compensation committees typically react to the agitation over pay levels by capping—explicitly or implicitly—the amount of money the CEO earns.[13]
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Michael C. Jensen and Kevin J. Murphy, “CEO Incentives—It’s Not How Much You Pay, but How,”