Just Deserts; C. W. Baird

The Web site had 250,000 hits in 1997. William Patterson, director of the AFL-CIO Office of Investment, boasts that "We put a face on runaway pay in 1997.".Betsy Leondar Wright, an official of United for a Fair Econ omy, a consortium of religious and activist organizations in league with the AFL-CIO, asserts, "There's nothing like this issue. This one just galvanizes people instantly."! Visitors to the site are invited to "fight back" by send ing messages to boards of directors, using their clout as shareholders, staging workplace actions, and emailing members of Congress. The site promotes enraged envy. Visitors are told that on average, CEOs make 326 times the pay of ordinary factory workers. The site offers a calculator for envious visi tors to compute how long they would have to work to take in what their CEOs took in dur ing the previous year. The AFL-CIO's agenda is clear: to arrest and reverse the declining market share of unionized labor. Unions represented only 9.8 Charles Baird is director ofthe Smith Center for Pri vate Enterprise Studies at California State Universi ty at Hayward and a columnist for The Freeman.

10 percent of the private-sector work force in 1997. That figure has been declining since 1953 when it was 36 percent. The site asserts that "Workers have less power in today's economy, which means that executives can take far more for themselves. That wasn't always the case. When unions represented a third of the workforce in the 1950s and 1960s, workers had an effective counterweight to corporate greed." A more powerful AFL-CIO will be able to seize the ill-gotten gains of CEOs and restore them to their rightful owners. What's really going on with executive com pensation? In Chapter 10 of their new text for MBA students, Richard McKenzie and Dwight Lee survey the literature on executive com pensation and conclude that, in general, the high compensation packages paid to execu tives can be explained by some simple eco nomic theory.2 Far from exploiting workers and stockholders, high executive compensa tion is a means for all corporate stakeholders to benefit. It is part of a positive-sum game.

The authors' explanations fall into two cate gories, which I call productivity and meta productivity arguments. The Productivity Argument Top executives are the ones who control most resources in firms. Their decisions affect the performance of all other managers and employees. Excellent executives are scarce, and their talents are economized by putting them at the top where their productivity is multiplied through its effect on many others. General Electric's CEO, Jack Welch, made 1,003 times the pay of the average U.S. facto ry worker in 1996. His total compensation was $27.6 million in that year. United for a Fair Economy submitted a shareholder resolu tion that asked the GE board to set "a cap on CEO compensation expressed as a multiple of pay of the lowest-paid worker at GE." GE responded by arguing that Welch's compensa tion "is appropriate in light of the value that his superior leadership, vision and dedication provided to the share owners during his 17 year tenure as chief executive officer." The total value of GE shares rose by more than $225 billion during that period. 3 Welch earned what he was paid. Moreover, increas ing shareholder wealth is good for employees as well as stockholders. A successful corpora tion provides higher wages and salaries and offers more job security than an unsuccessful corporation.

At Scott Paper, CEO Al Dunlap rescued the firm through radical downsizing and restruc turing. As a result he produced $6.5 billion in additional shareholder wealth. His compensa tion was only $100 million-less that two per cent of what he produced. Dunlap asks, "Did I earn that? Damn right I did. I'm a superstar in my field, much like Michael Jordan in bas ketball and Bruce Springsteen in rock'n'rol1." He says, "You cannot overpay a good CEO and you can't underpay a bad one. . .. If his compensation is not tied to the shareholders' returns, then everyone's playing a fools game."4 Of course, in the face of imperfect knowl edge mistakes can be made, and McKenzie and Lee illustrate such failures. However, when mistakes are discovered, they usually are rapidly corrected. Corporations that allow failed executives to keep their high-paying jobs soon become ideal candidates for hostile takeovers. The market for corporate control never rests. When hostile corporate raiders gain control, they show the door to failed executives.

Sometimes failed executives leave their firms with very golden parachutes. Michael Ovitz walked away from a 14-month tenure with Disney with a $90 million severance 11 package, and it took Gilbert Amelio only 17 months on the job at Apple to get $7 million.5 More recently, David Coulter was dismissed from Bank of America, after two years on the job and large hedge fund losses, with over $40 million as a consolation prize. Golden para chutes like these are likely to seem excessive to everyone except the recipients, but McKen zie and Lee suggest an explanation. A newly hired top executive is likely to be much more risk averse with respect to the activities of the firm than its stockholders are. This is because stockholders have diversified portfolios; they own shares in many different firms. If one gets into trouble, perhaps others can make up the losses. In contrast, the exec utive has all his human capital tied up in the firm. This one firm is the executive's sole employment, and he will be reluctant to undertake risky, but possibly high-yielding, ventures. By consenting to golden parachutes in executive hiring contracts, boards of direc tors may just be trying to overcome excessive executive risk aversion. On this reading, gold en parachutes merely align executive and shareholder attitudes toward risk.

McKenzie and Lee report on several sys tematic empirical studies of the connection between executive pay and executive produc tivity. Consider three examples. Sherwin Rosen's research indicates that on average, when a company's rate of return increases by 1 percent, top executive pay increases by 1 to 1.25 percent.6 Inasmuch as executive pay is a small fraction of company income, those executives earn their keep. Michael Jensen and Kevin Murphy say that on average, exec utives get only two cents more in cash pay and $3.25 in added wealth for every $1,000 they add to stock values. Murphy concludes that "top executives are worth every nickel they get."? James Brickley, Sanjai Bhagat, and Ronald Lease report that on average, stock prices increase by 2.4 percent within two months of the adoption of executive incentive pay over what they would otherwise have been.8 The most common form of incentive pay for top executives is stock options, which are rights to purchase shares at a fixed, low price.

If the executive is successful, the market price 12 THE FREEMAN/IDEAS ON LIBERTY. MARCH 1999 of shares will rise, and he will reap large cap ital gains. This aligns the interests of the exec utives and the stockholders. On average, stock options make up two-thirds of top executive compensation. That means that two-thirds is at risk. Therefore, part of the high yields received through stock options may be con sidered just a risk premium. Meta-Productivity Arguments Yet many top executives get compensation that cannot be explained by the productivity argument. They get paid more than they are worth in the narrow productivity sense. McKenzie and Lee offer three arguments to explain such "overpayments." Discovery. Knowledge of who has the abil ity to become a successful top manager is given to no one. Within a firm top executives have to discover who among the ranks of lower-level managers is deserving of significant promotion. When such a person is identified and promoted, his discovery is announced to the general business communi ty. If the promoted manager were paid only what could be justified by his direct produc tivity, executive raiders from other firms could easily bid for his services. In doing so, these outside bidders would be avoiding their own costs of search for executive talent.

Therefore, a firm that promotes an executive is well advised to pay more than his produc tivity can justify to be assured of keeping the executive and conserving on future search costs for executive talent. An interesting implication of the discovery argument is that some people who are not pro moted may be just as good as those who are. They are simply undiscovered. To be discov ered, it may pay for lower-level managers to acquire self-promotion and schmoozing abili ties as well as basic skills for the job. It is pos sible, McKenzie and Lee write, to acquire "too much in the way of basic skills and not enough of, say, political savvy."9 Self-Monitoring. It is very difficult, and often impossible, to monitor the performance of top executives accurately. A good executive doesn't follow any prescribed routine that a monitor could observe. A good executive is alert to possibilities of turning all sorts of daily encounters, on and off the job, into profit opportunities. One may say a really suc cessful executive is one who knows how to make it up as he goes along. The only effective monitoring of an executive is self monitoring. An executive can be induced to self-monitor by a compensation package that substantially exceeds his opportunity cost (worth in the market). An executive who knows that shirking, once detected, means losing the difference between current com pensation and what other boards of directors are willing to pay is likely to avoid shirking.

This implies that the amount of the overpay ment will be positively related to the difficul ty of detecting shirking. The more subtle the executive's operations, the higher the neces sary overpayment. Tournaments. One way for top executives to motivate lower-level managers to work as hard and smart as they can is to make clear that rungs on the managerial ladder get increasingly narrow as it is climbed. Firms following this strategy purposefully hire many more low-level managers than they can possibly promote, and they make sure that new hires understand that this is true. Promo tions are awarded to the few who can success fully compete for them. At each stage the tournament prize is a promotion and a sub stantial increase in pay that cannot be justified on narrow productivity grounds. Why does the pay increase have to be so large? Because the contestants will naturally discount the increase by the probability of achieving it.