Late Apple CEO Steve Jobs famously made $1 per year, but some say other CEOs’ high pay is driving up economic and market risk. Photo by David Paul Morris/Getty Images).
Income inequality. As one of the defining political issues of the day, it’s no stranger to the headlines. Your friendly MarketMinder editors have deliberately stayed out of the fray—we try not to touch the third rail if there are no direct economic or market implications. Lately, though, a growing chorus claims it is an economic and stock market risk. Last month’s World Economic Forum deemed it one of the top global risks of the next decade. A recent paper ruled it responsible for the relatively slow speed of this expansion, claiming slower income growth in lower strata weighs on consumer spending growth (to which we ask, where is the counterfactual?). Now some claim high salary growth at the top is the result of execs effectively looting the economy and their own companies—implying a big risk for stocks when the party ends. And so, at the risk of plunging into rough ideological waters, it’s time for us to weigh in: Rest assured, there is no evidence this is at all a risk for capital markets. Higher executive pay isn’t evidence of looting—it’s partly the natural consequence of the supply and demand for CEO-caliber talents, partly plain old math, partly economic growth and partly an unintended consequence of 2002’s Sarbanes-Oxley Act.
Despite what some say, nothing in the available data on income growth and distribution says the current trajectory is unsustainable or a sign of a deteriorating economic environment. Perhaps the most widely cited study documenting rising inequality, by Professors Thomas Piketty and Emmanuel Saez, has quite a few holes—it doesn’t include taxes and transfer payments, and it counts capital gains as income, which the IRS hasn’t done for decades. It also doesn’t account for demographics, including changes in household formation, which other economists (namely Stanford research fellowRuss Roberts and University of Michigan Professor Mark J. Perry) bear much of the responsibility for the widening gap. This factor might explain why social mobility prospects are as ripe as they were 50 years ago, according to another study by the same Mr. Saez (and others)—opportunity abounds.
But the latest theory says it doesn’t. Its adherents say the high growth at the top is the result of what economists call “rent extraction”—the notion that companies are extracting more money from the economy than they contribute, and executives are in turn pocketing the surplus. By taking out more than they put in, these folks are allegedly robbing other people and firms of wages and investment capital—an economic risk. The theory also says they’re paid more than they should be based on company performance and shareholder value, effectively creating an incentive to bankrupt their own company for personal gain—a market risk.
The evidence for this argument is executive pay, particularly within the Financials sector, and its theoretical underpinning is a 1993 paper from Nobel-winning economist George Akerloff (aka Mr. Janet Yellen) and fellow Cal Professor Paul Romer, which argued perverse incentives for CEOs of thrifts to “loot” their own companies caused the Savings & Loan crisis (which tells you our Fed head’s husband doesn’t believe in markets, but I digress). It also hypothesizes that the same incentives could induce CEOs throughout the private sector to siphon off as much as they can without regard for their companies’ long-term health. Right off the bat, the comparison is flawed—setting aside the validity of Messrs. Akerloff and Romer’s hypothesis, most of the institutions they studied weren’t publicly traded. The CEOs had no accountability with shareholders. CEOs of publicly traded firms do.
CEOs of publicly traded firms also report to boards of directors, who have the power to hire, fire and set their pay. They’re also legally obligated to put shareholders’ interests first—in most cases, that means making their best effort, based on all they believe and know, to make the decisions that maximize the firm’s long-term enterprise value. That means not siphoning all available cash into executive pay instead of investing it and putting it back to work for the company and broader economy—it’s a guard against the overpaid rent-seeking CEO. Does it mean all boards make perfect long-term decisions? No—they’re human. They can be wrong, and their personal values might not always mesh with what’s right (e.g., Ken Lay of Enron infamy). But this is by far the exception and not anything close to the rule. To assume boards will always and everywhere do what’s best for executives and worst for the actual companies ignores Corporate America’s amazing long-term growth and the fact some of today’s biggest, most profitable companies have been around for decades or more. Our economy isn’t a house of cards. Companies can be mismanaged and go bankrupt, but that doesn’t mean outsized pay is why.
Boards also have a responsibility to fire execs who aren’t up to snuff—and have a long track record of doing so. If boards believe CEOs make more than their performance merits, they can cut their pay or claw back bonuses. Post Dodd-Frank, US public firms' shareholders also have the right to periodically vote on executive comp under “say on pay” rules. And all shareholders of any publicly traded firm can vote with their wallets, bidding shares down if they think execs are hindering future earnings growth. Markets are extraordinarily good at dealing with this—it just takes a faith in capitalism and free enterprise to believe it.
And still, executive pay is high. Why? Well, as Harvard Professor Gregory Mankiw explained in a recent New York Times op-ed (which touched off the latest debate), many of them just plain earn it—guiding corporations to profitability year after year is difficult (to put it mildly), and the skills and temperament required are rare. It’s a supply and demand issue. “Say on pay" vote results support this thesis too. To the chagrin of some, few firms' shareholders actually vote against executive comp packages, for fear of losing a hugely valuable business leader.
But it goes further than that. Being a CEO isn’t just hard—it’s risky. Thanks to Sarbanes-Oxley, CEOs are criminally liable for any inaccuracies in corporate reporting. Financials CEOs have double the liability, courtesy of the Volcker Rule. Think about this. If someone offered you a job but told you there is a chance you can go to jail if you sign off on a report with an error in it—whether or not you or the person who made the incorrect entry had the intent to defraud—you’d demand a heck of a lot in return for that risk. You’d also ask the board to do its utmost to help you guard against error by hiring other capable executives, accountants and attorneys—all of which takes more money and drives up top incomes.
Yes, it’s money that could otherwise go toward investment—but that isn’t rent extraction. It’s the burden of regulatory compliance. Businesses don’t enjoy this—most boards and executives alike would prefer to put money to work productively than spend it on compliance and oversight. Again, boards have a duty and incentive to maximize long-term value. CEOs, too, have an incentive in the form of higher future pay if they’re successful. That’s just how free markets work! If productive capital has evaporated in recent years (and I’d be remiss not to point out business investment has grown leaps and bounds since 2002), Sarb-Ox stole it. Not CEOs.
As a hasty reaction to the Enron and Arthur Andersen scandals, Sarb-Ox was intended to prevent the “bankruptcy for profit” approach people assume exists today—so it’s ironic that people see its unintended consequences and assume corporate malfeasance is the cause. It also makes the repeated calls for the government to “do something” about inequality a touch misguided, in my view—the track record of government intervention just isn’t good. (And not just because Communist tyrants from Lenin and Stalin to Mao, the Kims, Chavez and more have tried and failed utterly to address inequality, with dire human consequences. And, by the way, those efforts largely concentrated what little wealth existed in the hands of "the Party.") I’m not arguing the current system is perfect. But it doesn’t present economic or market risk, it goes hand in hand with higher wealth and better quality of life at all strata over time, and it offers no fewer opportunities than previous generations had—a “Downton Abbey” economy, where the scullery maid and footman have zero prospects, this is not. Changes to the status quo, no matter how well-intended, would create winners and losers—and in all likelihood introduce market risk that just isn’t there today.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.