News this morning that executive pay in big UK companies rose by 10% in the past year, about five times the rate of increase in average earnings. My question is rhetorical. This latest manifestation of economic opportunism by the executive classes (that is, seeing what they can get away with) is of course unseemly as well as immoral. But what of the economic drivers? My old favourite, Oliver Williamson’s [amazon_link id=”068486374X” target=”_blank” ]The Economic Institutions of Capitalism[/amazon_link], was published in 1985. It notes that earlier discussions of governance, at least since [amazon_link id=”0887388876″ target=”_blank” ]Berle and Means[/amazon_link], had paid little attention to the role of management, but the book’s own perspective on management does not discuss the reasons for the power of executives. After all, they were not yet flaunting it, and the book pre-dates the modern greed-fest.
I think the explanation requires a beefed-up principal-agent asymmetric information approach. Intangible value accounts for a massive proportion of the market cap of all large corporations, and it is impossible for any party other than the internal executives to monitor the contribution of those individuals to the value of the company. In fact, executive pay structures have also become a signalling device to indicate the individual’s contribution. (Are there any models of this kind around? I’m not up to date with this bit of the literature.) Shareholders, workers and customers alike have to trust the board. Looking at this morning’s reaction to the latest pay news, I rather think that trust has been torpedoed.
[amazon_image id=”068486374X” link=”true” target=”_blank” size=”medium” ]The Economic Institutions of Capitalism[/amazon_image]
The defence is that these wages are ‘market determined’. This is, I’m afraid a fraud. They are determined by the board of the company and approved by the shareholders. The board, both executive and non-executive, have a clear vested interest in boosting salaries. Most of the institutional shareholders do too, because they can then point to the rising earnings of similar people in other companies. But the biggest reason that it is a fraud is the marginal productivity argument: “Chasing Stars” by Boris Groysberg is a beautifully argued analysis of this in relation to the ‘stars’ of Wall St. In summary, it debunks the notion of the ‘star-investor’ and effectively says that no-one in the world of work is better than the team around them. This is the real message that these executives should heed but, of course, we’re all programmed to perceive that we’re better than actually we are at any task…
I’ve often thought it would be terrific if a board would test ‘the market’ by calling the bluff of their well-remunerated executive!. I agree with you about the Boris Groysberg book, very persuasive evidence.