Chris Dillow ruminates on executive pay. I’m not sure if there is one theory that is suffiicient to explain this. Not long ago, the cult of personality appeared to be everything. In a zeitgist of deal-driven corporate growth, individuals with a reputation for successful deal-making (which could be a proxy for performance) enjoy the top jobs. When the frenzy dies down, more subdued personalities are preferred who can manage throughout a period of stagnancy or little growth.
Bebchuk, Fried & Walker share wrote several years ago about the influence of managerial power over executive pay. The story is neat, begining with an explanation of why arm’s length bargaining models aren’t good explanations. And independent compensation committees don’t solve this, purely because of psychological and social factors (i.e. the board all know each other, and quite often when determining a CEO’s compensation package, the question of what is ‘fair’ or ‘right’ centres less on the issue of the marginal product of the CEO, but more on vague comparisons with others.
From this it follows naturally that CEOs use their power to extract rents. There are constraints of course, perhaps less so in the US, but in the UK, stories of ‘fat cat’ executives are fairly common. This outrage constraint predicts that a large part of the compensation of the CEO will therefore be camouflaged, as stock options (at the money, of course and not tied to relative performance) and other inducements designed to look performance related.
One explanation not considered is tournament theory. The idea that CEOs enjoy their compensation packages because they have won out in a series of games (either inside or outside the firm). Typically this applies in situations where measuring productivity is difficulty but obtaining a rank ordering is relatively easy. However, when I think of the trading environment in an investment bank, it tends to be the ones with the biggest and most consistent (positive) P&L who enjoy the rewards of promotion and thus greater reward. Related to this is the idea that CEO pay is so high because it serves to motivate individuals below them the hierarchy. Personally I’m not sure about this in the dynamic sense, but I think there probably is an element of “well I’ve worked bloody hard all these years to get here so now I’m going to make sure I rake it in”.
I don’t find the salaries in themselves distasteful, but the idea that we need to pay these people a fortune to induce them to do their jobs. I think that’s rubbish. We don’t need to offer the Prime Minster a fortune to run the country; it’s done out of an emotional and professional committment to the job, and belief in the responsibility. There are many individuals in firms who would gladly take on the job of CEO for far less money than the current incumbent, and their ability to do the job would be far less which leads me to this. Would a sort of Dutch auction, where suitable candidates bid for their willingness to do the job at successively lower compensation levels work? Surely, the winner would be the one who was the most committed to do the job, and cared less about the money?
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