I was talking over drinks with a distinguished retired CEO of an iconic American manufacturing company – and he said these executive compensation numbers are crazy. So I decided to talk about why. To be clear, I do not think this is a pure economic and market issue; I think it is a system failure that involves power and bureaucratic politics.
First, when we talk about CEO pay, we are talking about two phenomena. Average CEO pay has grown way faster than the compensation of the rest of the employees. Twenty-five years ago, CEO compensation was about 24 times the average pay in companies, today it is 227 times.
But what I want to discuss most today is a different issue: the absolutely outlandish pay of CEOs in the financial sector. Richard Fuld of Lehman Brothers received $484 million in compensation between 2000 and 2007. Stanley O’Neal of Merrill Lynch was paid $48 million in 2006, and was given an exit package of $161 million when he was ousted. Lloyd Blankfein of Goldman Sachs received $73.7 million ($27 million as a cash bonus) in 2008. Angelo Mozilo of Countrywide Financial received $69 million in 2006. The list can be extended throughout much of finance.
Let’s go through an exercise.
Over the last decade, corporate profits increased substantially, both absolutely and as a percentage of GDP. In absolute terms they increased 40% from 2002 to 2007, and they increased 27% as a share of GDP. But most of this increase in the share of profits occurred in finance. And it didn’t happen there across the board. The profit increases in finance happened in the “new finance” – in hedge funds, institutional trading for their own book, with derivatives, securitizations.
So perhaps you could argue that the CEOs and senior managements of the new finance were at a special level of genius. This is certainly what they seemed to believe. Therefore their work led to the particularly high profits, which led, in turn, to the high compensation.
But you would probably be wrong. Despite the widely prevalent cult of the CEO, managements just do not contribute that much to success or failure. (See Adam Smith and Billy Beane on this topic.) And in any case, every study I’ve seen over decades shows that senior management compensation is almost completely unrelated to performance. And we’ve seen all of these guys exposed as their companies cratered: they’re not geniuses.
What actually happened was more interesting, and more revealing. Several completely different factors came together to create an entirely new environment in finance. I see seven steps.
First, economic and financial work in academia in the 50’s, 60’s, and 70’s led to new insights about financial markets. This work led, in the 80’s, to the rise of whole new classes of securities.
Second, Moore’s law kept grinding away. Information technology reached threshold points where it made scale application of the new financial insights technically possible.
Third, cracks in the system allowed vast increases in leverage – with hedge funds, off balance sheet special purpose entities, and securitizations. So it became financially possible to use OPM — Other People’s Money — at enormous scale to apply the new insights. Long Term Capital Management was leveraged 99 to 1 when it crashed.
Fourth, there was a lot of Other People’s Money. The dollar was high, there were huge flows of savings. Enormous amounts of capital flowed into the U.S.
Fifth, an adequate supply of stuff to invest in was developed both by accidental, and, I think, semi-intentional misalignments of interest. Much of the mortgage finance chain was corrupted – what else do you call it when bad mortgages are made, everyone passes them on to a next level, everyone makes money, and no one is around to be responsible? At the same time, the ratings agencies provided everyone with “cover.”
So, sixth, profits poured in and “agency theory” struck again. Who got the money? Not shareholders and not investors. Managements found highly logical reasons to keep the money and grow their own take grotesquely. And it was taken in immediate payments as often as possible. It certainly wasn’t paid back when those profits vanished.
There is no economic rationale here. It is about relative power. Managements — particularly in finance — have been able to shift power to themselves and away from shareholders, investors, and employees. As a whole, CEO pay is now 10% of all profits. It was 5% 15 years ago. To paraphrase the immortal words of George Washington Plunkitt, “they seen their opportunities and they took ’em.”
And, finally, our system of complaisant boards of directors allowed this to happen. Once you are let into the club you want to stay. If you cross the CEO you are gone.
So do we care?
Let me be clear. I have no interest in a politics of envy. I want extraordinary gains for extraordinary people. Gates, Jobs, Buffet, Peterson, Welch, and dozens of others – all built something and deserve the gains. CEOs should be paid a lot. But the levels we have now reached make the free enterprise system worse.
That system now gives huge gains to people born on third base and pretending they hit a triple. Most of the profits in finance over the last decade were illusory – if you went back and restated profits subtracting the losses of the last couple of years, you would find there weren’t any. As I said, no one is paying anything back. And compensation at these levels warp everything. Boards. Incentives. Disclosure. Institutions. Processes.
There is a good book written on the politics of Kenya titled, “Our Turn to Eat.” This is much the same thing. If that kind of money is out there for the taking, then whoever wins the CEO lottery is going to try to get it. And isn’t going to be overly fastidious about abstract concepts.
When a lot of important people act this way, there is enormous pressure to let things slide. Our economy becomes less real and less safe. At the same time, transactional practices and businesses morph into transactional ethics. The social contract between business and society changes for the worse. And any sense of corporate social responsibility goes out the window. So, yes, I think we should care.
Roosevelt Institute Senior Fellow and Braintruster Bo Cutter is formerly a managing partner of Warburg Pincus, a major global private equity firm. Recently, he served as the leader of President Obama’s Office of Management and Budget (OMB) transition team.