Semi-Daily Journal Archive

The Blogspot archive of the weblog of J. Bradford DeLong, Professor of Economics and Chair of the PEIS major at U.C. Berkeley, a Research Associate of the National Bureau of Economic Research, and former Deputy Assistant Secretary of the U.S. Treasury.

Wednesday, October 25, 2006

CEO Compensation

Andrew Samwick wrestles with the problems of CEO compensation and with Paul Krugman:

Vox Baby: Mixed Reviews for Krugman Today: In "Incentives for the Dead" (reposted by Mark Thoma for those of you without TimesSelect), Paul Krugman addresses the social and economic aspects of option backdating and repricing. He gets some things right--this is accounting fraud, it is also tax evasion, and the perpetrators should be prosecuted fully. But he gets some of the economic aspects wrong. Consider:

[W]e need to go back to the original ideological justification for giant executive paychecks.In the 1960's... C.E.O.'s of the largest firms were paid... about 40 times as much as the average worker. But executives wanted more -- and professors at business schools provided a theory... a chief executive who expects to receive the same salary if his company is highly profitable that he will receive if it just muddles along won't be willing to take risks and make hard decisions. "Corporate America," declared an influential 1990 article by Michael Jensen of the Harvard Business School and Kevin Murphy of the University of Southern California, "pays its most important leaders like bureaucrats. Is it any wonder then that so many C.E.O.'s act like bureaucrats?"

Jensen and Murphy's article... provides a theory to justify higher pay-performance sensitivities....[O]bviously, nothing in Jensen and Murphy's paper justifies backdating or repricing--quite the contrary.

Krugman continues:

The claim, then, was that executives had to be given more of a stake in their companies' success. And so corporate boards began giving C.E.O.'s lots of stock options -- the right to purchase a share of the company's stocks at a fixed price, usually the market price on the day the option was issued. If the stock went up, these options would pay off.... [E]xecutives would have the incentive to do whatever it took to push the stock price up. In the 1990's, executive stock options proliferated -- and executive pay soared, rising to 367 times the average worker's pay by the early years of this decade. But the truth was that in many -- perhaps most -- cases, executive pay still had little to do with performance. For one thing, the great bull market of the 1990's meant that even companies that didn't do especially well saw their stock prices rise.

The last sentence continues to be something of a mystery in the economics literature--why don't we see more relative performance evaluation? Fair enough.... But the statement just prior to it is extremely misleading.... [T]he data suggest a more limited role for options in generating large pay-performance sensitivities.... Among CEOs, the median incentives received from options are roughly the same as the median incentives received from direct holdings of stock.... I think Krugman is overstating the link between Jensen and Murphy's paper--or any economic theory--and the particular way that options have been used in compensation contracts....

So my revision of Krugman's argument, at least as it pertains to the economics, is... that there was too little bait on the hook to begin with.... CEOs have been pushing their boards of directors to grant them pay increases, the tax code and accounting regulations have favored options as the easiest and most advantageous way to do that, and corporate boards have acquiesced.

Ultimately, all problems of corporate governance derive from inadequate monitoring of the managers by the shareholders. Corporate boards are supposed to do this. Some are obviously failing.

Three comments:

First, at-the-money options do not make CEOs "long" their company as much as long the volatility of their company. It's clear that direct ownership of stock--ideally, restricted stock--is a better mechanism for aligning managers' interests with shareholders.

Second, when I looked at the data I thought I saw an important difference between entrepreneurial-CEO-owners (like Bill Gates, with stock) and manager-CEO-nonowners (with options). I think there is an important difference.

Third, we do have a big organizational problem here. We need diversity of ownership--both to raise capital on the scale required for modern business organizations and to spread risk. But once you have diversified ownership, monitoring and supervising managers becomes a public good from the shareholders' perspective, and it is very hard to get market or market-like or indeed voting political mechanisms to adequately supply public goods: the difficulties of collective action by dispersed owners of corporations has been one of the institutional flaws of modern capitalism for more than a century.

The fear today is that mechanisms of corporate control and governance that used to constrain the ability of top managers to raid the corporation have broken down even more than in the past. Why and how much and indeed whether this is true is a very hard question. To say that "corporate boards are failing" to do their job is true, but leaves the questions of why they are failing and whether they are failing any more than in the past unanswered.


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