Tuesday, June 24, 2014

CEO's Are Highly Paid But Their Compensation Is Determined By Market Forces???

It is impossible to look at the data on CEO compensation without reaching the conclusion that it has been rising at a very rapid rate relative to the wages earned by the average worker.  This creates an opportunity for some economists to justify the increase in CEO compensation and to defend corporate directors against a charge of malfeasance.  I posted an earlier article by Greg Mankiw who justified the rise in CEO compensation by consulting his introductory economics textbook.  According to Mankiw, CEO's compete in a competitive labor market.  The demand for CEO's who have the necessary skills is very high relative to the supply of candidates with the required skills.  Therefore, the rise in CEO compensation has been determined by the laws of supply and demand for rare skills.  Mankiw's argument also assumes that those rare skills have enabled to CEO's to make a contribution to organizational productivity that is a least equal to their compensation.  Mankiw's defense of CEO compensation did not require him to examine the process that corporate boards employ to determine CEO compensation.  He only had to consult his introductory textbook.

Steve Kaplan made a more sophisticated defense of CEO compensation than Greg Mankiw.  He argued that CEO compensation has risen in line with that of other highly paid professionals in the top 0.1%.  Therefore, weak corporate governance is not responsible for the rise in CEO compensation.  They were underpaid prior to 1980, and they are now being paid what they are worth.  Kaplan was at the conservative Cato Institute when he did his research.  He also presented his study at a special meeting of the NBER which honored Martin Feldstein for his many years of leadership at the NBER.  Feldstein was an economic adviser to Ronald Reagan.  He was also the Chair of the economics department at Harvard.  He did what he could to shape the department at Harvard in his image during his tenure. 

In this article, Brad DeLong reports on another study which shows that CEO compensation has risen at a faster rate than that of others in the top 0.1%.  That study used the same data that Kaplan had used to reach a much different conclusion.  DeLong claimed that he could not understand how Kaplan had reached a much different conclusion.  He changed his mind about the debate and argued that CEO compensation is not determined by the labor market.  He believes that an oligarchy which consists of CEO's, corporate board members and financiers makes the rules that better explain the rise in CEO compensation.  Some might wonder why DeLong was shocked that a study funded by the Cato Institute, and presented at an event to honor Martin Feldstein, had found a way to prove that the rise CEO compensation was market determined. 

Hedge fund managers and CEO's who are hired by private equity firms also have seen a rapid rise in their incomes.  Their compensation has not been determined by compliant corporate boards.  Private equity funds find the best executives they can find to run the corporations that they have acquired.  They also compensate them very well.  Some argue that this shows that CEO compensation has not been determined by weak corporate governance.  This argument quickly breaks down.  Private equity firms have to pay CEO level wages in order to recruit CEO's from other firms.  Moreover, the long term performance of firms acquired by private equity firms has been very poor.  The CEO's hired to run these firms have a mission to fix them up quickly in order to sell them.  Cost reductions are the easiest way to reach that goal.  They also strip the firms of assets while they are managed in order to pay fees to the private equity firms while they are under management.  It takes a very special kind of person to operate a business under those guidelines.  Brad DeLong's conclusion about an oligarchy is probably accurate.  Moreover, he should not have been shocked by that conclusion.  Economic textbooks are poor source of information about CEO compensation and so are studies funded by conservative think tanks that receive their funding from the oligarchs.

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