Sunday, November 24, 2013

The Triumph of Incentive

The Swedish people voted on a law this weekend that would have capped CEO pay to never exceed ten times the lowest-paid worker. The law, as presented, failed to win approval from the people.

Now, to be fair, the Swedish system of getting ballot initiatives up for a vote is remarkably easy. You only need 100,000 signatures. Sure, Sweden is small, but it's not that small. You could get a million Americans to sign a proposal to outlaw apple pie. So this may not necessarily be a reflection of the best and brightest of any nation, let alone the Swedes.

Still, it's telling that it got that far. Things like taxing the rich or outright capping their pay always sounds great in theory; whether it's borne from jealousy or economic plans or a grade-school concept of "fairness," it always sounds good to soak it to the rich and powerful. And yet ham-fisted attempts like these always end up disastrous, for the simple fact that it's an economic reality.

For any sort of economic system that wants economic growth, there has to be a system in place where what people produce and what they make is related. A company isn't going to hire someone if it costs them $15 an hour but they only get $14 an hour out of them; likewise, a worker isn't going to get paid $14 an hour if they can get $15 elsewhere. There are, of course, a lot of nuances with this--worker skills and expertise make a different, and the market may not demand what a worker can do--but, generally speaking, people get paid what they are worth.

Capping CEO pay never makes sense. CEOs don't just magic up some number from the bank account and takes it home; C-level salaries are almost always determined by a board of directors or the shareholders; if a CEO is making $20 million dollars, they must feel that they bring at least $20 million in productivity. If not, the CEO gets fired. It's the exact same principle as the factory line worker.

About a decade ago, the ice cream company Ben & Jerry's tried to find a new CEO. They're hippies, and so declared that they would not pay more than five times an entry-level worker. Once their existing CEO left, they couldn't find anyone qualified to fill the spot, so they had to abandoned it. It was from the stark reality that the CEO was certainly going to create five times as much productivity as someone on the assembly line, because that is something that the CEO specifically does. 

Granted, one can make the case that the board of directions and shareholders are just helping their friends out, and while that certainly can be the case, it's unlikely in the long term. A board of directors is ultimately held responsible by the shareholders. If anyone things that a CEO is being paid unfairly, it will eventually come back to the case. Most of the vitriol against CEOs is that people can't believe that anyone is worth that much money; a single day with a CEO would probably prove that to be highly unlikely.

There's also a lot of irritation at CEOs since even if they do bad or if the company tanks under their tenure, and yet they still take home a fat check. That ignores a very important reality: CEOs are often put in those positions deliberately. Some CEOs are installed because they know they are going to lose money, but they want to stop as much loss as they can. Sometimes they know a company is going to go bankrupt, so they create a strategy to make their company attractive for a buyout (which may include lowering its value). To an outsider, it simply looks like "Oh, when the CEO was installed the company was worth $125 million, but now it's worth $100 million. What a disaster!" But internally, that's exactly what was needed; the CEO often make things better, especially if the alternative was $80 million or a complete liquidation.

Now, don't get me wrong--there are lousy CEOs out there that are paid an unfairly large amount of money. But you could say the same about all the everyday workers out there, too. And given the outsized and very public performance of highly-paid CEOs, there's a lot more of the latter than the former.

The Pledge: Yeah, some CEOs are overpaid, but by and large all people's pay is roughly translated into how much value they produce. Artificially capping this is a really, really dumb idea.

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