A contrarian look at CEO pay

by on May 18, 2006 at 7:45 am in Economics | Permalink

Here is my latest New York Times column (non-gated).  Excerpt:

Their [Gabaix and Landier) core argument is simple. If we look at recent history,
compensation for executives has risen with the market capitalization of
the largest companies. For instance, from 1980 to 2003, the average
value of the top 500 companies rose by a factor of six. Two commonly
used indexes of chief executive compensation show close to a
proportional sixfold matching increase (the correlation coefficients
are 0.93 and 0.97, respectively; 1.0 would be a perfect match).

By the way, Japanese CEOs are paid much more than many popular or Internet sources indicate.  American CEOs are paid about three times more than their Japanese counterparts (on average), but not forty or so times more.

1 spencer May 18, 2006 at 8:43 am

Is it valid to relate CEO pay to market capitalization since they have little to do with the value of stocks?

why not just relate it to the earnings growth where they do play a major role in determining what happens.

For example if you look at the S&P 500 from the 1949 bottom to the 2000 peak the S&P 500 PE on trailing operating earnings rose from 5.9 to 26.5 and accounted for some 78.5% of the increase in the S&P 500 capitalization. Why should CEO compensation be related to inflation and/or monetary policy that largely determine the PE when their actions have little or no impact on them. EPS is what they influence strongly, and that accounted for only 21.5% of the rise in market capitalization.

If you look at a different period in the 1975 to 2000 period EPS only accounted for 27% of the rise in market capitalization.

We have had a sharp growth in CEO compensation but there is essentially no evidence that EPS growth has changed significantly from its long term trend — 7.5% for the S&P 500, 7.8% for after tax profits reported by BEA, etc.

Interestingly, if you look at pre-tax profits the trend growth rate has actually slowed.

It looks to me like stock owners have a major agent problem.

2 Matthew Cromer May 18, 2006 at 8:54 am

I should elaborate.

Anyone observant who works in corporate America knows that in a large corporation, agency problems and management self-incentives are a huge drain on corporate efficiency and profitability.

3 William Goodwin May 18, 2006 at 9:45 am

I also think the productivity argument is a complete red herring. We know that France’s productivity is roughly the same as the U.S.’, yet American executives are paid vastly more.

More important, American productivity growth was massive during the period 1946-1973, earnings growth was exceptional , etc., yet somehow CEOs were paid significantly less in relative terms than they are today. What changed?

4 Half Sigma May 18, 2006 at 9:55 am

Indeed, the efficiency of white collar workers decreases as the size of the company increases.

5 Patrick R. Sullivan May 18, 2006 at 11:23 am

‘ More important, American productivity growth was massive during the period 1946-1973, earnings growth was exceptional , etc., yet somehow CEOs were paid significantly less in relative terms than they are today. What changed?’

Income tax laws. The top marginal rate in that period was between 90% and 70%. Since 1983 it’s been as low as 28%, and as high as 50%.

6 q May 18, 2006 at 11:54 am

Sure private equity pays its people very well, but all of those pay packages are tied directly to performance — most with some sort of clawback if you do really well one year and then suffer a terrible year the next. If you get rich in private equity, it’s because your investors got rich along the way. Not necessarily the case with the executive comp that is now getting all the attention.

7 David J. Balan May 18, 2006 at 12:04 pm

The idea that CEOs get paid for performance is hard to empirically distinguish from the idea that they (with the help of their buddies on the board) pay themselves as much as they can get away with until someone squawks. A few years ago Marianne Bertrand and Sendhil Mullainathan came up with a very clever way to distinguish between these two stories in a paper entitled “Are Ceos Rewarded for Luck? The Ones without Principles Are.” No pay-for-performance scheme would ever pay a CEO for something completely beyond his/her control (e.g., a change in oil prices in an oil-consuming industry), because that only adds risk to the CEO without improving incentives. But luck might play a role under the “steal until someone squawks” story–when there’s more money around, even due to pure luck, there’s more to help yourself to before someone gets excited about it. They find that CEOs do indeed get paid for luck, unless they work for a firm in which a single shareholder owns a substantial fraction of the firm. The idea is that in those cases, there is some individual who has a sufficient incentive to monitor CEO pay, whereas this is not the case when ownership is diffuse.

There is also a paper by Kevin Hallock called “Reciprocally Interlocking Boards of Directors and Executive Compensation.” He finds that if you are on the board of the company that I’m the CEO of, and vice-versa, we both end up getting paid more.
I don’t know about this new research, and I’m open to revising my opinion, but I am at least tentatively convinced that a lot of CEO pay really is rich guys paying themselves and each other lots of money.

8 Matthew Cromer May 18, 2006 at 12:59 pm


You have to do these comparisons ceteris paribus. And comparing companies in Japan vs. the US, that obviously does not hold true.

9 DK May 18, 2006 at 1:25 pm

OTH, why doesn’t CEO No. 1 hire CEO No. 250 to run a division, which might be larger than the 250th largest company?

10 Bernard Yomtov May 18, 2006 at 2:07 pm


I don’t think you were responding to me. I said nothing about Japan.

11 Sebastian Holsclaw May 18, 2006 at 3:18 pm

“One still has to show why executive pays grew with market capitalization while non-executive pay did not. Unless one wants to say that labor productivity do not contribute to market capitalization.”

I’m perfectly willing to believe that CEOs are overpaid. But the reason why the labor productivity issue you raise isn’t related to market capitalization is that in most cases as the firm expands more people will be hired so the per person contribution of non-executives is not increasing.

12 Matthew Cromer May 18, 2006 at 5:22 pm

I was talking to the other Bernard, Bernard. 🙂

13 Teller May 19, 2006 at 3:58 am

“I also think the productivity argument is a complete red herring. We know that France’s productivity is roughly the same as the U.S.’, yet American executives are paid vastly more.†

No, the US has 30% higher productivity. France has the same productivity PER HOUR, because they are forced to work few hours, and because the least productive are unemployed and not part of the statistics.

The “agency theory† argument is not very strong. Have agency problems become worse? Remember you are trying to explain growth. By the way high salaries can also be a effective way to solve agency problems.

Three further points:

†¢ All of the economy has seen skill biased wage growth and superstar economics, not only CEO:s. The share of the top 0.1% income that goes to professionals and entrepreneurs has gone up sharply. Maybe you need a more general explanation (larger markets and non-divisibility, value of top human capital higher as complement to rest of economy etc.)

†¢ Do Japanese and European stockowners do worse than Americans? Looking at firm from start should give you the average return of capital, which is what you want. Does anyone want to bet there is no effect with CEO pay? (you could argue the CEO pay as a share of firm costs is small).

†¢ The market capitalization argument is actually pretty interesting. The cost of making bad decisions (and value of good decisions) goes up when one person runs a larger firm. The one person part is the key.

Non-divisibility of superstar talent, you can’t hire 5 CEO:s, plus larger and larger firms may well be the key. The 300 billion dollar firm can only have one CEO, and wants the best available. Firms bid up, as they become larger the value of top management goes up.

Really CEO:s are underpaid if you think about it. 63% of American billionaires are self made. If you startup a firm and add value you can become a billionaire, shouldn’t the market give that as a salary to a CEO that can add a few percentage to firm value?

14 Michael Foody May 19, 2006 at 10:18 am

My theory is that CEOs are compensated to the extent they are because the frictional costs of replacing a ceo are so massive for a large company. Changing a CEO is very destabilizing and costly even if a CEO is not particularly good it is still often preferable to avoid the costs associated with a shake up. CEOs are paid relative to damage that their leaving could do.

15 Josh May 19, 2006 at 2:40 pm

One additional thought: as stock options and stock grants were considered CEO compensation in the research study, increases in market capitalization would directly increase CEO pay. As stock options become a larger percentage of CEO compensation the effect will increase. Seems like the same variable is being used in both sides of the equation.

16 Jack May 20, 2006 at 4:18 am

Why has CEO compensation risen with market cap but the rest of labour’s share not?

I haven’t read the paper but is the relevant figure a covariance or a correlation?

Teller: Suggesting that high salaries are a solution to an agency problem is like saying protection money is a solution to the mafia.

In terms of company efficiency surely per hour productivity is a better measure than per capita.

17 Jack May 21, 2006 at 8:24 pm

Teller, you say solution, I say manifestation.

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Tyler’s column and these comments have inspired me to write a post at my blog about overpaid CEOs.

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