Sense and Salary

It’s proxy season again, which means that if you’re so inclined, you can peruse page after page of the obscene option grants and sky-high salaries received by America’s CEOs, who inhabit a Lake Wobegon-like world where everyone is above average and deserves to be compensated accordingly. According to Business Week, CEO pay at the 365 largest companies in the United States rose 36 percent in 1998. That’s a tad more than the 3.9 percent increase enjoyed by the average white-collar worker last year.

At this point, the gap between pay for corporate executives and pay for all other corporate employees is so extreme as to be laughable. But nothing is going to be done about it because executive salaries are not determined by the free market. The people paying the salaries–shareholders–are not the people who determine the salaries, namely boards of directors. (In fact, corporate salaries are generally excluded as possible subjects of shareholder resolutions. Even if a company’s owners wanted to limit executive pay, it’s not clear that they could.) And boards of directors are made up of … well, generally other executives or CEO cronies. How likely it is that one CEO is going to vote to cut another CEO’s salary, when he knows that his own salary depends on the overall level of executive pay?

The increased use of stock options was supposed to curb excesses by linking pay to performance. But since companies don’t index their stock options to something like the S&P 500, executives get rich even when their companies underperform. And the increased use of repricing options has essentially severed any punitive element to options plans. (You’d have to force executives to exercise their options and hold on to real shares for there to be any downside to these stock grants.)

OK, but all this is obvious, though no less painful for being so. What I’m interested in here is the most common defense for this indefensible situation, namely that there’s a lack of top-flight management talent out there. You have to pay Jack Welch so much because if you don’t, you’re screwed.

Although no one in corporate America will admit it, this is simply wrong. In fact, there’s perhaps more top-flight management talent out there now than there ever has been before. The baby boomers are this century’s largest generation, and they’re now in the prime years to become CEOs. The pool of executive talent now includes women and minorities. And if we’re going to take the rhetoric of globalization seriously, let’s recognize that it means that CEOs no longer have to be American as well. So it’s not just the United States that companies can draw from. They’ve got the whole world to look to. Everyone–except a few cranks–understands that baseball is better today in no small part because of the explosion in the number of Latino players. The same is presumably true–on an even wider scale–of the ranks of executives. And it’s not like the number of large companies is getting any bigger. You only need one CEO to run DaimlerChrysler now, after all.

On a deeper level, though, the argument for high CEO pay depends on a fallacy that you might call the “No one’s hitting third” mistake. You see this mistake all the time when people write about salaries in baseball. The best players are overpaid relative to their peers because everyone says, as they do about Jack Welch, “There’s no way you can give up Barry Bonds’$2 40 home runs and 110 runs batted in. That’s worth anything.” But when people say that, in their minds they’re comparing Barry Bonds with, well, no one. They’re saying that without Bonds in the lineup the Giants would have had 40 fewer home runs and 110 fewer RBI.

But of course this isn’t true. If Bonds weren’t on the Giants, someone else would have played left field and hit third. And even if that someone was just an average-hitting left fielder, he would likely have slugged 25 or 30 dingers and driven in 80-to-90 runs. The difference between those numbers and Bonds’ is important. But it’s not important enough to make Bonds worth anything you please.

The same principle is at work when it comes to CEOs. Yeah, compared with what would have happened if no one ran GE, Jack Welch has created enormous amounts of shareholder value. Hell, compared with what would have happened if I ran GE, Jack Welch has created even more enormous amounts of shareholder value. (I’d be destroying value, through no fault of my own, left and right.) But compared with what would have happened if another experienced GE exec ran the company, I suspect that Welch has created–by his own unique effort that is–a lot less shareholder value than everyone thinks.

That doesn’t mean that Welch isn’t an awesome executive. He is. But look at him relative to his predecessors at GE. By that standard he’s a solid, but not extraordinary, performer. The company’s ROE under him is around its historical average, as is its growth rate. GE’s stock has done better under Welch than under other GE CEOs, but other CEOs didn’t live through the greatest bull market in history. There’s no question that Welch is worth a lot of money. It’s just not clear that he’s worth so much more money than those who came before him. And it’s not clear that he’s worth so much more than all those other potential CEOs who are floating around out there.