Lack of justification for high executive pay

2015-05-28

in Economics, Politics

The most convincing proof of the failure of corporate governance and of the absence of a rational productivity justification for extremely high executive pay is that when we collect data about individual firms (which we can do for publicly owned corporations in all the rich countries), it is very difficult to explain the observed variations in terms of firm performance. If we look at various performance indicators, such as sales growth, profits, and so on, we can break down the observed variance as a sum of other variances: variance due to causes external to the firm (such as the general state of the economy, raw material price shocks, variations in the exchange rate, average performance of other firms in the same sector, etc.) plus other “nonexternal” variances. Only the latter can be significantly affected by the decisions of the firm’s managers. If executive pay were determined by marginal productivity, one would expect its variance to have little to do with external variances and to depend solely or primarily on nonexternal variances. In fact, we observe just the opposite: it is when sales and profits increase for external reasons that executive pay rises most rapidly. This is particularly clear in the case of US corporations: Bertrand and Mullainhatan refer to this phenomenon as “pay for luck.”

Piketty, Thomas (Translated by Arthur Goldhammer). Capital in the Twenty-First Century. 2014. p. 334-5 (hardcover)

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. May 20, 2017 at 2:35 pm

In 1980 the bosses of the 100 biggest listed firms earned 25 times more than a typical employee. In 2016 they earned 130 times more. Their swollen salaries come with fat pensions, private health-care and golden hellos and goodbyes.

The justification for this bonanza is that you get what you pay for: companies claim they hire chief executives on the open market and pay them according to their performance. But the evidence is brutal. Most CEOs are company men, who work their way up through the ranks, rather than free agents. In 2000-08 the FTSE all-share index fell by 30% but the pay for the bosses running those firms rose 80%. J.K. Galbraith once said that “the salary of the chief executive officer of the large corporation is not market reward for achievement. It is frequently in the nature of a warm personal gesture by the individual to himself.” Corporate Britain is more subtle: CEOs sit on each other’s boards and engage in an elaborate exchange of such gestures.

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