Fancy Executive Pay: Does It Make Sense Economically?

ADAM SMITH didn't have much nice to say about company officers when he wrote "Wealth of Nations" in 1776. Capitalism's patron saint said executives "have it more or less in their power to manage in such a manner as to confine the greater part of the trade to themselves and their particular friends." He called the monopolistic firms of his day "nuisances in every respect."

Similar complaints are made today about high salaries of chief executive officers. Republican Pat Buchanan, on the campaign trail, has been harassing the bosses for getting huge pay hikes while letting wages of ordinary workers languish.

Mr. Buchanan could well use, but hasn't yet used, President Roosevelt's phrase, "malefactors of great wealth," chuckles Lester Thurow, an economist at the Massachusetts Institute of Technology in Cambridge, Mass. And the Democrats are "all gutless" for not daring to tackle corporate salary abuses, he says.

Mr. Thurow sees the multimillion-dollar salaries of CEOs as "impossible to explain" by hard-nosed economics. In 1970, these executives on average made 35 times the pay of the lowest full-time worker in their companies. By now it is 160 times greater. Further, the gap in earnings between the No. 1 and No. 2 executive in companies has doubled or tripled.

"Corporations," says John Nash, president of the National Association of Corporate Directors, a nonprofit group in Washington, "are trying to attract the very best talent in this global environment we now operate in. You are buying the talent."

Thurow sees the only explanation for the explosion in CEO salaries to be "sociological." Because of the weakness of trade unions, the demise of communism, and the decline of socialism, company executives "can get away with it" - get company directors to approve enormous hikes in their earnings.

In the 1950s, if executives had gotten such pay hikes as are reported nowadays in The Wall Street Journal, the United Auto Workers would have demanded tripling of its members' wages, Thurow says. If Italian executives had done as well back then, the Communist Party would likely have won power; Socialist parties would have more often defeated conservative parties in France and elsewhere in Europe. Top capitalists, facing no serious threat, no longer feel they need allies among mid-level management and other employees, he says.

Peter Kinder, president of the social investment-research firm Kinder, Lydenberg, Domini & Co. in Cambridge, Mass., finds an explanation for CEO pay hikes in the nature of corporate boards, which set executive compensation. "Boards are inherently not independent," he says. Outside directors are nominated by the CEO, who, with other top executives, also sits on the board. They meet together, dine together, are often friends. "Think of the human dynamics of any group of people," Mr. Kinder says. "People want to get along with each other." So boards are unlikely to be "stingy" on pay.

Mr. Nash differs. Ten years ago it was true that boards weren't independent, he says. "But that is not true today. If a board doesn't perform its oversight function and doesn't hold management accountable with pay for performance, it won't last long." Executive pay must now be explained clearly on corporate proxy forms. "If it looks out of whack, institutional shareholders will be on the back of the board very quickly," he says.

But if a board member really attempted to restrain the compensation of the CEO, he or she "would not be invited to any other board," Kinder says. He objects to the "excessive compensation," often in the form of difficult-to-value stock options, given many board members. His firm surveyed 647 major companies and found 84 paying directors more than $70,000 a year in total compensation. After listing some paying more than $150,000, he asks: "Can directors paid at these levels be objective about cost control? Or CEO compensation? Or downsizing? Just how well can they fulfill their function of representing the shareholders' interests?"

Moreover, consultants on executive pay are unlikely to stay in business if they regularly advocate pay cuts.

Thurow doesn't see the rising clamor over executive pay as a matter of jealousy. Rather, he sees it as an issue of fairness. Most employees are seeing their wages stagnate or worse, and CEOs aren't 160 times smarter than others. He suspects executives will see their pay raises dampened if they get "kicked in the teeth politically."