Oct 02 2008

Will limiting exectutive pay send American business leaders packing for Europe? Probably not…

This post is in response to my colleague and fellow WW blogger Steve Latter’s recent post titled “Private market compesation: AIG CEO vs. Kobe Bryant”. It’s always enlightening to read Steve’s excellent posts, which really put things in perspective. With regards to CEO pay, it is a bit ironic that while Americans are all worked up about the high pay of its top executives, no one’s up in arms about the exorbitant salaries received by America’s professional athletes!

However, I wonder if Steve’s claim that limiting professional athletes’ pay would send the country’s top basketball players packing for leagues in other countries is true. A while back I blogged an article that asked the question of whether Lebron James would be offered a contract from a European club. James claimed that in order for him to even consider playing in Europe, he would require an offer of at least $50 million per year, more than double what he makes playing for Cleveland.

ESPN.com – Source: LeBron would consider European offer of $50M a year or more

…the Cleveland Cavaliers’ strongest competition for LeBron James’ long-term services could be the deep-pocketed new kid on the block — Europe.

A person close to James said Tuesday that the Cavaliers’ superstar would strongly consider playing overseas if he was offered a salary of “around $50 million a year.”

James’ current contract expires after the 2010-2011 season, but he can opt out after the 2009-2010 season, and while several NBA teams are working to create salary cap space for his impending free agency, none could offer a contract beginning at even $20 million a year.

So, would Kobe be on the next plane to Lithuania if the US government (or the NBA) limited his pay to $5 million? I doubt it. That brings us to the more urgent question: Would America’s top business executives begin shipping their families and all their belongings off to Jakarta or Dhaka, Delhi or Singapore, London or Paris, if the US government attempted to limit the compensation packages of its executives? Maybe, but there are many reasons to work and live in the United States beyond the salaries offered by firms for their top executives. And upon a little research, it turns out that European executives’ pay packages have in fact been under regulation by governments for quite some time, and as a result, the incentive for American executives to jump ship for European firms should US executive compensation come under regulation may not be as strong as Steve implies.

Executive pay in Europe | Pay attention | The Economist

How excessive is bosses’ pay in Europe? It has certainly risen sharply in the past ten years, as European firms have had to compete globally for talent.  Foreign bosses now run seven of the firms in France’s CAC 40 index and five of Germany’s DAX 30. American-style bonuses and long-term incentive plans are now the norm.

European firms now benchmark pay against international peer groups in their own industries, rather than against domestic rivals, according to Piia Pilv, a pay expert at Mercer, a consultancy. But they still pay a fraction of the sums trousered each year by American executives. According to Hay Group, a management consultancy, the median European executive earns just 40% as much as his equivalent in America (see chart).

Most importantly, European companies appear to be more determined than American ones to link pay to performance. “Firms in Europe have tended to put more stringent conditions on long-term incentive awards than in America,” says Richard Bednarek, global director of executive remuneration for Hay Group. In America grants of shares are often not tied to performance, whereas European firms generally attach performance criteria to any grant of shares, typically depending on a comparison with a peer group. Such schemes often do not pay out at all, says Mr Bednarek. Dan Vasella, boss of Novartis, a Swiss pharmaceutical giant, and a favourite target of pay activists, earned SFr17m ($14m) in 2007, down 33% from 2006, because he missed his targets.

Clearly, the incentive to head to Europe as a result of increased scrutiny of executive compensation in the US is not as great as it would be if there did not already exist a threefold gap between US and European executive pay.

The liberal in me wonders if there is such a thing as “unfair” CEO compensation. The free market advocate in me points to other markets governments have attempted to control prices in, and the clear inefficiency that such regulation creates. Governments limiting executive pay, in theory, should have a similar effects to rent controls, or price ceilings in other markets. The quality and quantity of apartments available under rent controls declines, and price ceilings on other goods often result in shortages, meaning there’s not enough to go around among consumers… the quantity demanded exceeds the quantity supplied.

In the case of CEO pay in America, limiting compensation should, in theory, result in a shortage of highly qualified executives willing to head up American firms. But let’s be honest, even if the government placed highly stringent limits on the compensation of the country’s executives, the average executive in America would still likely be earning more than his counterpart in Europe. And since the average American CEO earns something on the order of 250 times what the average worker in his firm gets paid, increased regulation of CEO pay only help narrow this enormous gap slightly, but the incentive to make it to the top will still be strong among American workers.

Conclusions? It’s a tough issue. I want to have faith in the free market, in the price mechanism, in the efficacy of laissez faire economics. But the moral hazard of “golden parachutes” is a real concern. Should an American CEO be rewarded if he fails in his job? Steve makes the case that this “insurance” policy is necessary to attract the best and brightest to the firms willing to pay them most. Then again, something about the way the free market has created such a huge gap between executive pay and the pay of the average worker, and the threefold gap between America’s CEOs and Europes makes me think, “forget the free market, we need to get this insanity under control.”

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

2 responses so far

2 Responses to “Will limiting exectutive pay send American business leaders packing for Europe? Probably not…”

  1. Steve Latteron 03 Oct 2008 at 1:10 am

    Hi Jason,

    All good points, as always and its always a good idea to have a balanced perspective. A little rock 'n roll or a little country…there's always another great perspective around the corner which is why we call the application of economic principles "normative" economics! And I certainly agree with you that not all US talent would go running for Europe or Asia. The question would, of course, be how much would compensation limits affect the talent pool and of course that would depend on the extent to which the compensation would be limited and what the compensation would be for alternative choices.

    Here's another view, just for fun:

    This is a good ratio that might show CEOs are not so highly paid relative to their value.

    2007 Wal-Mart Actual results:

    2007 Profits: $12, 731,000,000 ($12.7B)

    2007 Profits excl. CEO comp $12, 701,000,000 ($12.7B)

    CEO compensation/Company profits: .2% (owners get 99.8% of profits)

    Of course, this is one of the very best CEO comp/profits ratios along with, say, an Exxon-Mobil, Johnson & Johnson, or Coca Cola.

    If we did this comparison this year with an AIG, Lehman brothers, or Merrill Lynch it would be CEO compensation on top of losses which is why it is being discussed so much.

    Here's another perhaps more powerful analogy: On average, I would estimate that CEO compensation as a % of Corporate profits of the 500 largest companies is about .5%. Hey I usually tip 15% of my bill to my waiter, so giving a .5% "tip" to my CEO is nothing even if he screws up on me. On really bad restaurant service (analogous to losses in Corporate America)) I still give at least a 5% tip to my waiter 'cause it really might not be the waiter's fault.

  2. Gary Williamson 26 Mar 2009 at 4:12 am

    1. Baseball researchers look at the concept of the "replacement-level player"; one with a level of skill that, while far better than that of most of us, is, nevertheless, readily available for the 30 or so slots at a major league level. The question is: what do these relatively modestly-compensated players save a team in dollars versus what they cost in wins. Has any such research been done with respect to CEOs? How much would a "replacement-level" CEO have cost Wal-Mart, how much would one have cost a less successful company, in terms of profit-loss vis-a-vis what he would have saved them in salary? I suspect such research would be incredibly difficult to do well; but without it, how can we form any reasonable idea as to what a CEO is really worth?

    2. Adam Smith, I understand, was not particularly keen on the concept of the corporation, for he felt that hired management would always have its own interests rather than the interests of the owners as its first priority. An attempt to align the interests of owners and management was the stock option; but this has backfired as CEOs (maybe influenced by their boards and current stockholders' expectations) have been mightily tempted to play for short-term stock price increases rather than to take a longer-term view of what is good for the firm. Would there be any merit to a compensation system that compensated CEOs with stock options, but provided that the options could not be exercised for, say, five years from issuance? Since the CEO would be getting new options each year with an exercise date at least five years away, he would be always looking at least that far ahead. And as a side benefit, he'd have at least some incentive to train a good replacement to make sure that he really would have something worth cashing in five years after his retirement. Is such a concept being considered by compensation committees, or by economists?