Can mere economics explain the meteoric rise of CEO pay since the 1980s? If we liberate our minds from that warped construct known as “perfectly competitive markets,” then the answer is yes. As we’ll soon see, economics can even explain the effect of such disparate influences as government intervention and charisma.
Taking nothing for granted, let’s first confirm that the thing we’re trying to explain has actually occurred. Well, one survey of publicly held corporations found that the full pay package of chief executives jumped 535% in the 1990s, while the Standard & Poor’s 500 rose 297% and profits 116% over the same period.
Another study, for the years 1992 to 1996, found an even more revealing trend. In ’92, the mean compensation of CEOs was 2.5 times larger than the mean for the next five executives on the corporate ladder. By ’96, the gap had widened to 2.9.
Economics teaches that the greater the number of firms bidding for your services, the higher the salary you’re likely to receive. One reason Japanese executives earn less than their American counterparts is their lack of job mobility. While nothing so extreme applied to corporate executives in the 1950s and 1960s, the rise of executive-search firms in the 1970s made it much easier for those at the top to move to other firms.
At least one statistic testifies to the change in job mobility at the top: In 1980, 1 out of 14 of the 850 largest firms had hired its CEO from outside the company. By ’96, it was 1 in 3.
Other factors came into play to propel CEO pay skyward, all courtesy of government. One provision in the Clinton tax bill of ’93 placed a cap of $1 million a year on executive pay that could be deducted against profits. Dollars paid in excess of $1 million weren’t tax-deductible. But no such cap was placed on “performance-based” pay, and nothing exemplified that slippery concept better than stock options.
But that wasn’t the main reason options so quickly became the corporate coin of the realm. The real lure was that their cost didn’t have to be expensed against earnings in the income statements issued to shareholders. In ’94, the Financial Accounting Standards Board tried to require that companies do so, but the initiative was beaten back by Congress.
With this perverse set of incentives, firms showered options on their executives. The bull market of the ‘Nineties did the rest, turning the options into a rich harvest of cash, especially since most executives cashed them in as soon as possible.
So far, everything I’ve said applies to nearly all highly paid executives. Why did CEO pay rise the fastest of all?
Harvard Business School professor Rakesh Khurana provides the answer in his fascinating and grimly entertaining book, “Searching for a Corporate Savior: The Irrational Quest for Charismatic CEOs” (2002). Starting in the 1980s, says Mr. Khurana, chief executives were no longer paid for competence, but for charisma.
I find Mr. Khurana’s argument persuasive, even though I don’t quite accept the reasons he gives for just why the image of the CEO changed so dramatically. But he does locate the year when the myth began to emerge that in firms employing thousands of people, the boss determines all.
It was 1979, when Lee Iacocca was appointed head of Chrysler. The company’s dramatic turnaround under his stewardship elevated him to god-like status, and resulted in his publishing the best-selling CEO autobiography of all time.
The business media is clearly complicit in reinforcing the myth of the CEO as the hinge on which the entire organization turns, often publishing articles that go into more detail about their personalities than about the strategy and finances of their companies. In one telling statistic, Mr. Khurana counts the number of times per year that Business Week pictured a single chief executive on its cover. From nine covers in 1983, the number doubled to 18 by 1999.
Where charisma is the main criterion of employment, qualified candidates are extraordinarily scarce. Also, their potential value to the company is subjectively perceived as being very nearly equal to every dollar the company might earn. Combine this with the fact they can take their services elsewhere if they feel they’re underpaid. In that case, economics tells us that money becomes almost no object.
If CEOs as a group are “overpaid” by as much as $5 billion, that sum is trivial beside the $6 trillion to $7 trillion of revenue their companies earn. The real economic drag lies elsewhere. For one thing, since charisma isn’t the main quality required to head a large corporation, CEOs hired for that reason often perform quite poorly, just as Mr. Khurana shows. Also, when these folks start believing their own reviews, they begin to think the rules of society no longer apply to their actions.
So, market outcomes can be in error, sometimes persistently so. Let’s hope the fall from grace some chief executives have lately suffered punctures the cult of charisma once and for all.