Executive Compensation Should Not Be Tied to Company Profitability
Are Executives Paid Too Much?, 2012 Content Level = Intermediate
Robert P. Murphy is on the faculty at the Mises University, an adjunct scholar at the Mises Institute, is the author of The Politically Incorrect Guide to the Great Depression, the Study Guide to Man, Economy, and State with Power and Market, and the Human Action Study Guide, and runs the blog Free Advice.
It is unfair to claim that CEO compensation should be linked to the profitability of a corporation. In a competitive workplace, some employees are paid more because they bring additional profits to their boss. If the salary of an average worker (for example, an assembly-line worker at General Motors) is not affected when the stock of that company drops, it is not fair to expect that the Chief Executive Officer's salary should be. Additionally, the corporate world might lose some valuable executives if their contracts specify that the amount of their compensation will fluctuate depending on the company's profits. We should also assume that shareholders are careful with their money and realize that the executives are worth the large salaries they command.
One of Reader's Digest's more popular sections is "That's Outrageous!" When the feature spotlights government pork-barrel projects, absurd zoning restrictions on homeowners, or illogical regulations on small business, libertarians can applaud. Unfortunately the October 2005 issue featured a column that focused on "outrageous" CEO packages, an enduring controversy. The writer, Michael Crowley, displayed precious little knowledge of economics, and at times his complaints were downright contradictory.
The article begins with the anecdote about Stephen Crawford, then the co-president of Morgan Stanley. A few months after accepting this promotion, Crawford quit during a "management shake-up" and "strolled off with a severance package that included two years' salary and bonus," which amounted to $32 million. To make sure his readers are sufficiently outraged, Crowley points out that "Crawford pulled in $54,000 per hour!"
Before delving into the conceptual issues, let's be clear on where that number comes from. It is obviously due to Crawford's quitting much sooner than anyone (probably including himself) predicted when the contract was originally negotiated. (Had the shakeup occurred six weeks earlier, Crawford would've earned over $100,000 per hour[, according to this method.) This is certainly a misleading approach, especially when contrasting it with the mean annual earnings of workers (as Crowley does). If one wants to show how much more CEOs get paidand of course they do get paid far, far more than the average workerthen a fairer comparison would have been mean annual earnings of workers versus mean annual earnings of CEOs. (Later, Crowley follows this more reasonable route and reports that in 2003 "CEOs were paid over 300 times what the average production worker made.") To pick an example like Crawford rigs the comparison; one could certainly find cases of average Joes who quit or were laid off after only working a very short time, and hence whose "hourly earnings" would appear vastly inflated.
For example, I myself was once sent home after only working about ten minutes as a receptionist in a law firm; I had been sent there by my temp agency, and it turned out I was unfamiliar with the phone system at the firm. Nonetheless, I still got paid for at least one hour (possibly more, I can't remember) of work. Using Crowley's approach, he could argue that the case of Robert Murphy shows that some Irish workers are paid six times more per hour than the median temp worker.
Even on its own terms, the calculation is suspect. Crowley isn't explicit about where the $54,000 per hour figure comes from, but we do know that the total package was $32 million and that Crawford quit "[a]bout 100 days" after starting in the new spot. Well, $32 million divided by 100 is $320,000 per day, which works out to $40,000 per hour if we assume eight hours of work per day. Thus to get the higher figure of $54,000, Crowley must be assuming that, in addition to working only eight hours per day, Crawford only worked five days per week. Now I don't know too much about being co-president of Morgan Stanley, but even so, I'm quite sure that this job requires more than 40 hours of work per week.
Some Jobs Are Worth More Than Other Jobs
Of course, these minor quibbles about the figure overlook the biggest objection: So what if CEOs earn more money than most other workers? In a free market (and below we deal with the complication that in today's world there is no truly free market), the price of labor corresponds to its marginal product. That is, competition ensures that workers are paid according to how much additional revenue they bring in to their employer. The fact that some types of labor command thousands of times more market value is no more surprising or outrageous than the fact that some goods in the marketplace (such as a house) have a price hundreds of thousands of times higher than the prices of other goods (such as a pack of gum).
Oddly enough, it is the critics of capitalism who implicitly claim that market value should correspond to ethical worth. No competent economist would argue that Stephen Crawford was a good person because he earned so much money, just as no economist would argue that a television set is ethically superior to a copy of the Holy Bible because of its higher price. No, the only thing economic science can say is that Stephen Crawford's services were in higher demand than the services of (say) the janitors at Morgan Stanley. So long as the labor contracts are voluntary, there really isn't an issue of fairness (subject to the complication noted above).
So what if CEOs earn more money than most other workers? In a free market ..., the price of labor corresponds to its marginal product. That is, competition ensures that workers are paid according to how much additional revenue they bring in to their employer.
Later in the article, Crowley raises concerns that may trouble even a genuine supporter of the free market. Of course it makes perfect sense that successful corporate executives earn millions of dollars. But what of the strange cases of "corporate leaders actually failing their way to riches"? Crowley gives us some allegedly outrageous examples of this trend:
Viacom CEO Sumner Redstone took home about $28 million in 2004, including a bonus of $16.5 million, even as his company's stock dropped 11 percent during the fiscal year. Applied Materials CEO Mike Splinter got a tidy $5 million bonus in 2004, despite a stock slide of more than 22 percent. That same year Rick Wagoner, CEO of General Motors [GM], saw GM stock plunge 25 percent, yet he still pocketed a $2.5 million bonusonly slightly less than his award in 2003, when GM stock actually rose. So much for accountability.
As noted, this phenomenon is initially quite puzzling. Why would firms reward incompetent executives? Don't they want to make money? Yet before dismissing power brokers in the business community as self-destructive and/or incredibly stupid, perhaps we should give them the benefit of the doubt and search for a rational explanation.
Average Worker Salaries Are Not Affected by a Company's Stock
The most important point that scoffers like Crowley overlook is that the business world is uncertain. When a company brings in a new executive, it is not at all obvious what steps he or she should take to turn the company around and boost profits. (If it were obvious, the company wouldn't waste millions of dollars hiring the executive.) Now regardless of the executive's competence, it is entirely possible that the plan will failand the executive knows this as well as anyone else. Because of this, it would be very risky for such an executive to sign a contract in which, say, he or she earned $20 million if the company were profitable, but $50,000 if the company tanks. Rather than sign that contract, the executive (who must be quite skilled to be offered such a job in the first place) could consult or take a less glamorous position and earn, say, $5 million for sure.
This principlethat an executive gets paid handsomely even if the company does poorlydoesn't seem outrageous when the numbers are lower. For example, when GM stock plunged 25 percent, did Crowley expect the assembly-line workers to give back a quarter of their wages for that year? If not, why not? After all, if the public stops buying GM vehicles, the services of the assembly-line workers aren't as valuable. The simple answer, of course, is that the assembly-line worker doesn't want his contract contingent on the overall profitability of the company; he wants to be paidand to get his pension and other benefits should he retire or quitwhether or not the company's stock does well. If it's acceptable for the assembly-line workers, why not for the CEO too?
A CEO Should Be Paid Well If a Company Does Well
Naturally, there is one obvious difference in this respect between assembly-line workers (or janitors and receptionists) and CEOs: Far more so than these other employees, the CEO can greatly influence the profitability of the company. Rather than giving the CEO a well-specified set of instructions to mechanically implement, the people hiring him allow far more discretion. After all, the CEO is brought in to run the company.
Yet this difference shows up quite clearly in the market: CEOs and other executives do get paid according to how well the company does. In addition to a base salary, these executives are often paid in stock options. A stock option (specifically a calf) gives its owner the right to purchase shares of stock at a specific price, called the strike price. Therefore, if the actual market price of the stock is lower than the strike price, the option is worthless. But if, through their behavior, executives can boost the company's stock price above the strike price, the options are valuable in proportion to the difference between the strike and actual prices.
Given his outrage over executives being paid regardless of profitability, one would expect Crowley to be a huge advocate of paying CEOs in nothing but stock options, which perfectly tailor earnings to the success of the company. Yet Crowley complains about the fairness of this too, even with highly successful companies. He cites the case of Yahoo! CEO Terry Semel, who took advantage of $230 million in stock options in 2004:
The average Joe might be more outraged if he understood the sorts of payouts and benefits that corporate brass are getting. Stock grants still provide a windfall for many chief executives, despite new regulations that force companies to account for options as expenses. Yahoo! CEO Terry Semel exercised $230 million in options last year. His company has had strong earnings of late so it's fair to say that Semel earned his $600,000 salary, plus a hefty award for boosting the stock price. But $230 million? Come on.
Now what exactly is Crowley's definition of fairness? If Semel is paid a large chunk of options, and under his leadership Yahoo! stock rises tremendously, why shouldn't he be rewarded in proportion to this gain? At this point we can see past Crowley's other alleged arguments; his basic objection is obviously that $230 million is more than anyone should earn, period.
Corporate Leadership and Performance Will Suffer If Pay Is Limited
There are three problems with this popular view. First, the upper limit that "decency" allows is arbitrary; no doubt many people would also deny the fairness of Semel's $600,000 base salary. ("We've got starving children in the streets and some guy who heads a company of spammers gets 600 grand a year?!")
Second, we must accept that in the modern economy, with billions of potential consumers worldwide, certain individuals have extraordinary earning power on the open market. If someone like Semel (or, a stronger case, Bill Gates) can add hundreds of millions of dollars of value to an organization (as judged by the spending habits of consumers), then to not pay him accordingly just means that someone else gets the money. Whatever happened to the principle of labor being paid the full value of its product? If Semel only got, say, $1 million, then Yahoo! shareholders (a group hardly in need of charity) would be $229 million richer. Would this outcome be fairer than what actually happened?
Third, we must consider the problem of incentives. If certain market exchanges are prevented because people such as Crowley find them unconscionable, then the individuals involved may stop working as much or as hard. For example, if Semel knew that outsiders would confiscate his stock options if the stock price rose too much, then he wouldn't have put in the long hours and sleepless nights that he undoubtedly did during the year in question.
This is a point liable to misinterpretation, and it's probably easier to switch contexts to professional sports. Economics tells us that placing a limit of, say, $1 million on salaries would reduce the incentives for star athletes. Now the critic might scoff and say, "Come on! Whether they make $1 million or $30 million, people will still go into the NBA [National Basketball Association]. That type of cap isn't going to affect anybody's career choice." Yet this objection overlooks the marginal nature of economic decisions. Yes, a first-round draft choice will still go pro (rather than become an accountant) even with a $1 million cap. But he'll probably retire much earlier. (In the extreme, consider the heavyweight champion of the worldonce he earns his title, he won't defend it nearly as often if people like Crowley get to dismiss multimillion-dollar payments as unfairly high.)
Continued
.........so she decided to quit and they paid her $8 million dollars to leave. 
