Saturday, March 06, 2004

Kristof: The market failure of CEO Compensation

Op-Ed Columnist: Millions for Moochers
...The problem with "the great C.E.O. pay heist," as Fortune magazine once called it, is that the free market is not at work here. The average C.E.O. of a major corporation now gets $10.8 million a year, almost 20 times as much as in 1981, as the result of a classic market failure.

"The salary of the chief executive of the large corporation is not a market award for achievement," John Kenneth Galbraith noted back in 1980. "It is frequently in the nature of a warm personal gesture by the individual to himself." ...

... These pay packages are negotiated, reflecting what a good C.E.O. brings on the free market. How's that? There is a huge supply of would-be C.E.O.'s and negligible demand from companies for new ones, so their price should be cheap — if boards would use their leverage. When Jack Welch retired, General Electric held a contest among three underlings to succeed him. Each was desperate to get the job. If G.E. had done its usual tough bargaining, it could have signed Jeffrey Immelt on a 15-year contract for a mere $750,000 a year in salary, plus reasonable incentives for long-term success.

If you don't pay a chief executive an obscene sum, you'll lose him. Nope, it doesn't happen. Except for turnaround experts, C.E.O.'s have few transferable skills and are in little demand elsewhere. The average 63-year-old head of a plastics company has almost zero chance of finding a better job elsewhere. One study found that of 77 cases when a major company had to find a new boss, only twice was this because the C.E.O. had left for another corporate job.

Kristof does a very nice job of summarizing and dismissing the usual vapid explanations of multimillion dollar CEO packages. Yes, it's often brutally hard work -- but it doesn't need to be. I suspect many CEOs would make better decisions if they slept more, exercised better, and traveled a bit less. CEOs work like crazed loons not because they have to, but because it's their nature. It's the same reason many of the tenured professors I know work 60 hours a week. It's just the way they are.

On the other hand Kristof is wrong when he suggests the CEO has to accept a lower wage because they've nowhere to go. Kristof should know better. A highly compensated CEO will almost always have a net liquid asset value of over $10 million. That's known in the industry as f___-you money, because anyone with that asset value can leave work at any time without undue suffering. The alternative to lower pay for these CEOs is to retire, start another company, etc.

CEO compensation is indeed a classic example of market failure. The last 20 years have been very hard on the religion of the invisible hand. Markets are still the best method we have to allocate resources, but they do fail. When they fail we need to find ways to resuscitate the market.

When you have eight strong candidates fighting to be CEO, let's try dropping the compensation package until only three remain.

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