In Defense of CEO Compensation

Robert Murphy
Posted: Sep 13, 2007 12:22 PM

If someone wants to bash corporations and the "excesses" of raw capitalism, there's no easier target nowadays than CEO pay. Recently critics were in a tizzy over a report claiming that CEOs make 364 times what the average worker earns. For example, in this MSN article Michael Brush declares:

In recognition of the just-completed Labor Day weekend, I'd like to offer a salute to American workers, who the United Nations just reported are second only to Norway's laborers when it comes to productivity.

And now, a bit of bad news for those same workers: You're not getting credit for that productivity. Instead, top executives at your companies are reaping the rewards in the form of increasingly fat paydays.

It's sad that this is the level of economic literacy among the media. If the press ignored advances in other scientific fields as much as they do in economics, we'd see weathermen advising readers to offer sacrifices to the rain gods.

What Mr. Brush apparently doesn't realize is that there isn't a fixed pie of income, such that high pay for CEOs necessarily translates into lower pay for workers. He's also ignoring the fact that competition impels companies to pay workers what they're generally worth. If Company A were paying its workers $25,000 per year when the workers were really adding $30,000 to the bottom line, why wouldn't Company B offer them a few thousand dollars more to switch?

In our increasingly global economy, certain individuals are incredibly productive and can command incredibly high earnings as a result. Corporate executives really do perform valuable tasks, and it really does make a difference who is running the company. Once we concede that productive individuals will earn more than less productive ones, the fact that some make 364 times what others do is largely irrelevant. After all, a TV set might be 364 times more expensive than a gumball. Is that "unfair" or does it merely reflect the forces of supply and demand?

Fortunately, some financial commentators would concede my points above. What these people object to, however, is CEOs making a bundle even when they fail. This viewpoint is expressed in a recent BusinessWeek piece by Bill George:

The public is outraged these days over CEO compensation, with good reason. Far too many chief executive officers get paid large sums even when they don't perform. I believe that CEOs should be well-paid when they do perform, but there is no justification for paying for nonperformance.

Now this raises an interesting question: Why in the world would shareholders agree to compensation schemes that are so "obviously" ridiculous? It offends the public (and Bill George) when Home Depot's "former CEO Bob Nardelli [received] a $200 million termination settlement after declines in market share and shareholder value." Yet the people who should really be upset are Home Depot shareholders. Are we to conclude that shareholders care less about their money than outside observers?

Let's not rush to judgment. It's risky to take a job as CEO. Highly talented individuals know that, despite their best efforts, they might perform poorly. Indeed, maybe a company has dug itself into such a hole that nobody could prevent the stock from falling. Now imagine that you are such a person, and you could (say) get a sure $10 million working in some other capacity with much less stress. Your other option is to take the job as Home Depot's CEO, where you will earn $250 million if the stock price goes up, but $100,000 if the stock price tanks. Does that sound like a good deal? Would Home Depot attract many qualified candidates with such a proposal?

Obviously I am simplifying matters, and in the real world companies have all sorts of mechanisms to align the long-run incentives of management with the shareholders. My point, however, is that the typical critic who spends five minutes thinking about the issue often overlooks the large element of risk. If corporations don't want to simply hire daredevils, they will need to have lucrative contingencies in place in case things turn sour. No one objects to this at the lower levels, either: If the stock price tanks, nobody expects the janitor to give back half his salary.

Finally, I should deal with the objection that in the real world, shareholders can't exercise control over management. This is true to varying degrees. But the market has an elegant solution to bloated management who fritters away shareholder value: the corporate raider. Ironically, the government's restrictions on so-called hostile takeovers make it harder for shareholders in large corporations to clean house and install managers who will look out for their interests. As usual, the imperfections of the marketplace can be traced to the unintended consequences of earlier government interference.