Why the Rise in Executive Pay?

Responding to my earlier post , Greg Forster writes :

The number of people in the world who are capable of doing a good job running Apple or Exxon or Wal-Mart is extremely small; the consequences of those companies being poorly run would be catastrophic for millions of people; therefore the tiny group of people capable of running those companies well is going to command extreme salaries. This would be true regardless of our economic system, law, policy, or what set of moral values predominated in the culture.  . . .

Executive salaries were kept in check during [the post-World War II era] mostly because the executives were much less capable. They weren’t worth paying as much.

I don’t deny that society benefits from having capable CEOs, but the rise in executive pay is due to many factors, not merely to an increase in their productivity or abilities. One such factor is peer benchmarking, which (as the Washington Post explains ) started as a way for companies to retain talented executives, but now boosts the pay of just about all executives, regardless of their success:

At Amgen and at the vast majority of large U.S. companies, boards aim to pay their executives at levels equal to or above the median for executives at similar companies.

The idea behind setting executive pay this way, known as “peer benchmarking,” is to keep talented bosses from leaving.

But the practice has  long been controversial  because, as critics have pointed out, if every company tries to keep up with or exceed the median pay for executives, executive compensation will spiral upward, regardless of performance. Few if any corporate boards consider their executive teams to be below average, so the result has become known as the “Lake Wobegon” effect . . . .

Researchers have found that about 90 percent of major U.S. companies expressly set their executive pay targets at or above the median of their peer group. This creates just the kinds of circumstances that drive pay upward.

The reason board members may be unwilling to stop using peer benchmarking is another factor in CEO pay: board members’ personal relationships with executives. From the same Post article :

On a typical board, the chief executive considers about about 33 percent of the board of directors as “friends” rather than as mere “acquaintances,”according to a survey of chief executives at about 350 S&P 1500 corporations conducted over 15 years by University of Michigan business professor  James Westphal .

More tellingly, the chief executive is likely to find even more friends on the compensation committees of corporate boards — almost 50 percent.

Other factors, which Megan McArdle draws from Tim Harford’s book The Logic of Life , may include employee motivation:

Many economists believe that CEO pay is structured as it is not to spur the CEO to ever greater heights of achievement, but rather pour encourager les autres. Michael Eisner might work just as hard for $1 million a year [as he does for $800 million a year] . . . but the gigantic payoff to becoming CEO spurs those beneath him to ever-greater heights of achievement. Basically, Michael Eisner has won the employment lottery. And because the prize is so big, all of his subordinates are dutifully beavering away, vying for a chance at the gravy train.

And shareholders, McArdle continues, are unlikely to object: “As Mr. Harford explains, each shareholder’s contribution to even a truly outlandish CEO pricetag is too small for them to take much interest in holding it down.”

McArdle herself  suggests that in addition to those factors, “changes in financial theory, the stock market boom, deregulation, dilution of shareholder interest by changes in the capital markets, even a cultural shift” could have contributed to the rise in executive pay.

And if that rise is not merely the result of executive talent or the natural move of the free market, then we could try to rein in CEOs’ compensation without suffering dire economic consequences.