Saturday, May 20, 2006

News Flash: CEOs Are Overpaid

by Tom Bozzo

Over the last 25 years, corporate CEO pay has increased about sixfold, adjusted for inflation. This just happens to be about the same as the increase in firms' market capitalization. As Marginal Revolution's Tyler Cowen reported in his NYT column yesterday, two economists (Gabaix and Landier) have a recent working paper that purports to explain the latter as the cause of the former, without resorting to the usual array of CEO labor market failures. Mark Thoma and Brayden King are skeptical at best. Gary Becker — whose Becker-Posner contribution beat Cowen to the virtual presses by a couple days — suggests that grossly overpaid CEOs are just a few bad apples and that the CEO pay trajectory is just tracking the growth in the resources that CEOs manage.*

My two cents is that this paper (which would-be clickers through should note uses a fair amount of math) presents some interesting results derived from fantasy fundamentals — you read a sentence like "Our [CEO] talent market is neoclassical and frictionless" and try to resist the urge to snort.

An appeal to the scarcity of CEO talent as an explanation for CEO pay levels and distributions likewise rings hollow. In the model, the market works to assign the most talented CEOs to the "largest" (market capitalization) firms, yet Gabaix and Landier really make no effort to establish that the largest firms actually employ the most talented CEOs. Among other things, the ability to exercise market power and to ride good market fortune make some CEOs wealthy beyond their demonstrated managerial skill. Or, from a different angle, look at Suzy Welch's stenography of Neutron Jack (BW subscription req'd) at the back of BusinessWeek.**

That said, I have even more substantial objections to the result.

First, using alternative measures of firm size, the "fundamentals" don't support the magnitude of the CEO pay increase as obviously as Gabaix and Landier suggest. The authors wave their hands around the connection between the present value of profits and firms' measured market values, and in fact offer that profits could be an admissible measure of market size. In the aggregate, though, corporate profits adjusted for inflation (as measured by the BEA) have increased by a factor of three; the leadoff comment at Marginal Revolution also highlights the excess growth of CEO pay relative to corporate earnings and the potential dissconnection between profits and market valuations.

This points to a second, and arguably bigger, problem. Even if you were to accept market capitalization as the appropriate benchmark, the growth of market capitalization reflects various factors that are not causally attributable to CEO talent or effort. Investors' willingness to pay more for a dollar of earnings than they were in 1980 (for the time being, anyway) is Exhibit A.

Even the earnings growth, though, has substantial autonomous components. The recent spike in corporate profits seems to have a public "policy" component — it's hard to believe that other fundamentals have been that much better in the laggard recovery than at the peak of the '90s boom. (CEO-type money may have bought the policies — on account — but the growing consensus is that the public at large wish they hadn't.) Also, over the 25-year period in which real corporate profits have tripled, real GDP has increased by a factor of a bit over two, so much of the growth in profits is tracking general economic growth. CEOs are being rewarded for this, but not as obvious consequences of their efforts and talents; welcome back imperfect CEO labor markets.

Last, Gabaix and Landier's result would create a conundrum: why has executive pay diverged from that of the non-executive ranks? Their model setup offers no reason not to expect that any employee whose talent increases corporate profits shouldn't see pay tracking firm size. As an attempt to address the conundrum, some Marginal Revolution commenters argued that the value creation resides at the top of the corporate hierarchy. This is not especially consistent with the reality that many corporate decisions are developed or refined at lower ranks and 'sold' to various levels of upper management, often with easily digested action recommendations. So attributing all of the value to the final sign-off is arbitrary. Brayden reassures me that strains of organizational theory view employees as "carriers of value," in conjunction with corporate institutions; embodying all value creation in the CEO doesn't hold water.

Where does that leave us? Back in imperfect markets territory, almost certainly.
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