On April 1st 2012, my book,”Dagbok från USA”, came out in Sweden. It will also soon be published in English (as an e-book for Kindle and for other readers) with the title: “Diary from the United States – Notes on a society in crisis“. As an appetizer for English speaking readers, I will the coming weeks publish some excerpts from the book.

Freedom ad absurdum

The fact that the Washington Post publishes a so-called Special Report, “Breakaway Wealth”, about the huge income inequalities in the U.S. in general, and about CEO compensation, “executive pay”, in particular, is remarkable by itself. However, this happened some time ago, in September 2011.

The report shows that the U.S. plays in its own league, speaking of how much of the country’s income that goes to a small group of super income earners, defined as the top 0.1%, around 150 000 people in the U.S. This particular group has quadrupled its share of the total income, excluding capital gains income, from 1980 until today. No other Western country comes even close to such a development. The super income earners in Germany, France, and Japan haven’t increased their share of total revenue at all since 1980. The report shows that the top 0.1% income earners in the U.S. consists of roughly 60% corporate executives, mostly CEOs of large corporations. The list otherwise is dominated by lawyers, real estate magnates, entrepreneurs, media celebrities, and a few sports stars, in that order.

In 2010, CEOs of the S&P 500 companies (500 of the largest U.S. companies) earned an average of $11.4 million. This figure consists of just over $1 million in salary, stocks and stock options were an average of $6 million, with other performance-related compensation and paid pension accounting for the remaining $4 million.

That the benefits are high, or rather extremely high when compared with how it looks like in other comparable countries, is one thing. More interesting though is that the benefits to American CEOs have literally exploded since 1980. This is clear from the graph below (click for bigger picture). According to an acclaimed study (see Frydman & Jenter, from whose report the figure is taken), the CEOs of the fifty largest U.S. companies earned around $ 1 million a year from the late 1930s until the 1970s (in constant prices, 2000 dollars). Then, from 1980, the executive top-management of large companies has in 30 years increased their compensation tenfold, to about $ 10 million. It’s an almost incomprehensible rise, especially when you know that the real median wage in the U.S. during the same period increased by less than 1% per year. I will try to sort out how this happened.

In many ways, the time around 1980 was a defining moment in Western economies. A new economic policy paradigm became popular in the early 1980s, first in the U.S. and England under the leadership of Reagan and Thatcher, later gradually in other Western countries. The new policy gave greater leeway to the market and  private initiative, leaving less room for political interference. Privatization and deregulation were the bywords. The deregulation trend also applied to the labor market that became freer, including how to set wages. It was in line with the new thinking that high-performing people, at all levels, would have higher relative incomes. The unions become weaker, especially in the U.S., which facilitated this development. The new strategy loosened up old structures in many areas. Surely it contributed to the rise in CEO salaries.

Another factor was that in the 1980s new types of compensation to top-management was introduced. In addition to salary and bonus, it became common for the top tiers to also get large amounts of shares and stock options. One of the high profile cases in the U.S. was when, in the 1980s, Walt Disney boss Michael D. Eisner got $16 million in stock options (which later yielded huge profits when the price of the Disney stock went up). The magnitude of compensation was something new.

These two factors contributed to American top wages going up after 1980. However, these conditions affected the entire Western world. Market orientation was going on in a similar way in other OECD countries. And even European companies began early in the 1980s to give their top management shares and options. Yet it’s clear that in terms of CEO compensation the United States was in a class by itself. According to American Economic Policy Institute (Michel et al, 2005), the cash payment (salary and bonuses) to chief executives in other Western countries in 2003 was 20-40% of what the American CEOs received that same year. Once stocks and stock options, not included in the study, are taken into account, the gap is even greater.

There must therefore be some additional cause for the American extreme wages to top executives. The explanation must be cultural rather than economic. How can it otherwise happen that the boards of American big business make decisions on the compensation of their top executives that are far beyond what is found in other comparable countries? Remarkably U.S. boards make these decisions even though there are simply no rational economic reasons; large companies in other Western countries are managed successfully on a global market with much lower levels of remuneration to top management. The ratio of average CEO payment to the pay of the average worker is usually taken as a measure of the distortion of the income structure in a country. A few years ago the ratio in the U.K. was 25:1, 13:1 in Sweden, 11:1 in Germany, and even lower in Japan. In the same year, the ratio was 364:1 in the U.S. The U.S. ratio is even more disproportionate if you only look at companies with the highest top management compensation. According to the New York Times, in 2000 the corporations with the 10% highest paid CEOs had a ratio 700:1! At the same time, research showed that there was no clear connection between high relative earnings of a company and high remuneration to the top tiers. In fact, the relationship between compensation of top executives and corporate earnings might even be the opposite. According to one study (Cooper et al, 2009), which included 1,500 U.S. companies and covered the period from 1994 to 2006, the 10% of companies with the highest CEO compensation had in fact lower relative returns than the companies with the 10% lowest paid executives.

American freedom ad absurdum

There is only one possible explanation. The individualism that swept over the Western world from the 1970s onwards took extreme forms in the United States. There was an emerging belief that a person who made extraordinary efforts would not only reap extraordinary rewards, but had an unassailable right to those rewards. This idea rapidly took root in the U.S. after 1980, and much more firmly than in Europe.

It was an idea that in its most extreme form gives the individual, the executive in this case, unrestricted freedom to get what he or she can get in compensation (provided that the decision process was correct and fair). In other words, if I as new CEO of a large company negotiated a giant compensation package for myself, it’s all right and fair. The consequences in terms of justice, fairness, morals, and the social contract affect others, not me. The practical result is that my right to this giant compensation applies regardless of whether it’s good for my company or not (research almost unambiguously has shown that there is no correlation between high CEO reimbursement and relative economic success). “I do not care what politicians, media and ordinary people think.” The unspoken message is: “I am worth the compensation that I have got. Basta.”

It’s my thesis that this “freedom ad absurdum”, a kind of exaggerated individualism, came to grow gradually in American boardrooms after 1980, and eventually made extreme CEO payments seem “natural”. This, I think, is the crucial reason why the curve of payments in the graph above turned sharply upward from 1980 onwards. That the same trend didn’t spread to Europe can probably be explained by the fact that this flaming freedom thinking never took hold here, and probably nowhere else outside the U.S.

One can say that the phenomenon concerns only 150,000 Americans at the most, all people with super incomes as previously defined. One can also say that it seems as if the worst excesses of compensation actually have declined since 2000. At the same time, CEOs with super incomes are most likely just the “tip of the iceberg”. I’m convinced that many other Americans, and especially those on the way up in their careers in business, think the same way but maybe not as extreme.

Literature:

“Breakaway Wealth”, 2011, Special Report, Washington Post, September 2011;

Cooper, MJ et al, 2009, “Performance for Pay? The relationship between CEO incentive compensation and future stock price performance”, working paper, Purdue University, December 2009;

Frydman, C. & Jenter, D., 2010, “CEO Compensation”, Annual Review of Financial Economics 2 (1), December 2010;

Michel, L. et al, 2005, “State of Working America 2004/2005”, Economic Policy Institute, Cornell University Press;

Pearlstein, S., 2011, “Why they’re winning on CEO pay”, Washington Post, June 25th, 2011;

 

First published (in Swedish): October 4, 2011