CEO Pay

Hope everyone had a great holiday! I just got back from the American Economics Association meetings. You have not lived until you've gone to some econ conferences, that's for sure.

Two notes about CEO Pay for today:

(1) A former student mails this link from Sunday's NYT:

Should Congress Put a Cap on Executive Pay?

I'd be surprised if Congress did any sort of hard cap on pay --- it's just too obviously a bad idea, for the reasons Frank identifies.

(2) My paper (co-authored with Rachel Hayes) on CEO Pay and the Lake Wobegon Effect is now forthcoming the Journal of Financial Economics. Here's a non-technical press-release type summary that the marketing folks here at the DESB put together:

In humorist Garrison Keillor's fictional hometown of Lake Wobegon, all children are above average. Now, University of Utah finance professor Scott Schaefer says that corporations might want investors to believe the same thing about highly paid CEOs. "CEO Pay and the Lake Wobegon Effect," a study by Schaefer and Utah accounting professor Rachel Hayes, argues that this effect may help explain high CEO pay. The paper is forthcoming in The Journal of Financial Economics.

The Lake Wobegon Effect in CEO Pay is the idea that a firm might want to convince investors that the firm's CEO is above average. An above-average CEO might, after all, be able to deliver above-average performance, which is what investors are after.

But how can a firm convince investors of a CEO's quality? "Everyone knows that in well functioning labor markets, better performers earn higher salaries," Schaefer points out. "The reason the Yankees are paying star pitcher C.C. Sabathia $161 million is that some other team was willing to pay him $160 million."

Schaefer applies this reasoning to CEOs like this: Think about a firm that hires a bargain-basement CEO. The CEO's labor-market options probably aren't that good, so suppose the firm can pay the CEO a low salary; say, $1 million a year. Investors, seeing that salary, might conclude the CEO isn't so great, and will downgrade the firm's stock.

The firm might wish it could hire a better CEO, but good help is hard to find. What if, instead, it simply decided to pay its bargain-basement CEO as if he were a superstar? If the firm bumps the salary to $3 million, investors might conclude the CEO is a superstar ---- and the firm's share price might jump. If the increase in the stock price is bigger than the increase in the CEO's salary, then this could be a good move for the firm.

Schaefer notes that this idea --- which has been around in the business press since at least the late 1990s --- has not received much careful scrutiny by economists. "The big problem with the Lake Wobegon idea as applied to CEOs," he says, "is that it seems to presume investors aren't very smart. You can imagine investors getting fooled by this trick once or twice, but over time they'd probably catch on as highly touted and well paid CEOs consistently fail to deliver." And if investors understand a firm's incentives to goose CEO pay just to pump up stock prices, then wouldn't firms give up trying?

The answer, Schaefer argues, is no. "What we show in our research is that the Lake Wobegon Effect can drive up pay even if investors are super smart about it. The key," he notes," is the role of investors' expectations."

His reasoning goes like this: Suppose investors expect the firm to play this game. Then, when investors observe a CEO being paid $3 million, they think "Oh, that's a bargain-basement CEO who should really only be paid $1 million. So we're not impressed." But should the firm then pay its CEO only $1 million? Perhaps not; if investors are expecting CEO pay to be inflated, then they'll figure any CEO who is paid "only" $1 million must be truly unqualified for the job. And the firm's share price will drop like a rock. The firm might therefore be better off overpaying its manager, even if investors are not fooled.

Although Schaefer believes he's demonstrated that the effect can occur, and identified conditions under which it can occur, one question remains: Is it actually occurring? Finding the answer, Schaefer says, might prove to be difficult with the data that's currently available.

"It's hard to calculate the exact financial impact a CEO has on a company," he says. "We would like to know what the firm's profits would've been if the CEO had not been there. It's hard to tell whether firms are profitable because of their CEO or in spite of their CEO."

With CEOs' pay packages in the headlines following the recent wave of bankruptcies, Schaefer says the practice of rewarding managers regardless of companies' success deserves to be re-examined.

"Pay packages for CEOs have gotten so high that the repercussions of getting fired are minimal because these guys are so wealthy," he says. "It can useful if CEOs are afraid of getting fired because this makes them cautious. Exorbitant pay packages can make it so they're not afraid of taking risk."

Despite this, he's not a proponent of limitations on pay levels. "If we limit CEO pay amounts, then it will be harder for firms to hire top talent. If private equity guys or investment bankers are earning tens of millions per year but CEOs are capped at a million, well, talent tends to follow the money." Instead, he thinks corporate America need to find better ways of rewarding managers for the long-term success of the firm.