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Executive pay: what's the problem?

Executive pay: what's the problem?

David Cameron says there is a "market failure" in top bosses' pay. I agree. I suspect their big salaries are due more to their power to extract cash from shareholders than to actual talent.

But so what? Market failure - if we define this as a deviation from the textbook case of perfect competition - is everywhere. As Adam Smith said, there’s a lot of ruin in a nation. The question is: how expensive is this failure?

Viewed from one perspective, the answer is: not very. The average FTSE 100 CEO is paid £3.9m a year. But this is only one four-thousandth (0.025 per cent) of the average market capitalisation of a FTSE 100 company. Viewed in purely static terms, then, bosses’ pay does not greatly diminish shareholders’ returns.

But we shouldn’t think in merely static terms. The question is: what effect does CEOs high pay have upon corporate performance?

One possibility is that such pay is necessary to attract and retain talented bosses who can improve shareholder value. This, though, conflicts with the evidence – that bosses’ pay has soared in recent years whilst share prices haven’t, and that there seems little correlation across companies between pay and performance.

And this raises another possibility – that high CEO pay is bad for corporate performance. There are (at least) four possible mechanisms here:

- People care about fairness. If they therefore believe that pay within their firm is unfair, they might become more distrustful and suspicious of management, and so less productive. Pedro Martins at Queen Mary College in London has found that, comparing similar firms, higher within-firm pay inequality is associated with worse firm performance.

- High pay can lead to a misallocation of talent below board-level. If there are massive rewards for becoming a board member, less senior managers might spend more time on office politics in an effort to get promoted and less time doing proper work. What’s more, they might try to emulate existing board members in the belief that like promotes like. This can cause them to become less productive as they specialize in skills that’ll get them promoted rather than in what they are good at, and can lead to a corporate mono-culture in which some necessary skills disappear.

- High pay doesn’t necessarily cause the best person to become boss. What boards want in a CEO is not so much ability as proven ability. Marko Tervio at Aalto University in Helsinki has shown that this can cause them to hire second-raters with a track record rather than more brilliant people who are less of a known quantity. In this way, he says, high pay is not a reward to scarce talent, but rather to scarce revealed talent – which are different things.

- High CEO pay can demotivate other employees, who rely upon the superstar to raise team performance, rather than use their own initiative. There’s evidence from US baseball – though not basketball – that pay inequality within a team is associated with worse performance.

The question is: how convincing is all this? There’s certainly anecdotal support for it; compare the fate of RBS, which was dominated by Fred Goodwin, to the success of the more egalitarian John Lewis partnership. But this isn't helpful. For one thing, the costs of high bosses' pay lie not so much in firms being prone to collapse, but rather in slightly less good performance than would otherwise be the case - the sort of thing big firms can often live with. And for another thing, there’s also anecdotal evidence that high pay isn’t always disastrous; Xstrata and Reckitt Benckiser haven’t done too badly with well-paid CEOs. Exchanging anecdotes won't get us far.

Ideally, we’d replicate Dr Martins’ research in Portugal, and compare the performance of otherwise similar firms which have different levels of pay inequality. However, this is just not possible for FTSE 100 firms, as these are – almost by definition - idiosyncratic; there isn’t an Xstrata with a low-paid CEO.

For this reason, the debate about CEO pay is likely to be inconclusive.

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By Chris Dillow,
09 January 2012

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Chris Dillow

Chris spent eight years as an economist with one of Japan's largest banks. Here, he provides insightful commentary on the latest economic news and data, along with thought-provoking articles about investor behaviour.

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