CEO Pay is Perverse and Must be Fixed to Avoid Recurrent Crises

By William K. Black

Slate has published a piece by Zachary Karabell entitled “Stop Obsessing Over exorbitant CEO Pay” in which the author appears unaware that he has reported, and then ignored, evidence that scholars he cites favorably are “resoundingly convinced” proves the opposite.  Karabell’s author’s page shows that he has recently joined Slate and promotes theoclassical dogmas about economics.  He is a Wall Streeter of the kind that thinks it is an honor to be a “regular” on CNBC.  He also touts being a favorite of the Davos plutocrats.  In roughly a month with Slate he has managed to be an apologist for high unemployment, inequality, and high frequency trading (HFT) scams.

Karabell begins by acknowledging that we need, urgently, to correct the perverse incentives of modern executive compensation.

“Business school professors who study the effect of excessive executive compensation are resoundingly convinced that too much comp hurts the overall performance of companies. Fifty years ago the ratio of average CEO comp to average salaries was 24-to-1; now it is 204-to-1. Many business scholars believe tying so much of CEO comp to stock and the performance of a company’s shares incentivizes CEOs to make quarterly earnings look good whether or not it benefits the company’s long-term health.”

Karabell concedes that even though the business school scholars are “resounding convinced” on the basis of their econometric studies that executive compensation harms corporate performance CEOs have responded to the research by exacerbating the perverse incentives and personal payoffs.  At this juncture the obvious question, which Karabell never asks, is that since he concedes that executive compensation increases inequality and concedes that it harms business productivity it follows logically that inequality driven by CEO compensation harms other workers.  Business productivity is a necessary condition to workers increasing their incomes, so Karabell has established at least one reason why increased inequality is harming the middle and working classes.  Karabell is oblivious to the logical implications of the business school research.

If Karabell were familiar with the broader literature on executive and professional compensation he would have made a far stronger case on why it is critical to remove the perverse incentives of both forms of compensation.  The accounting and finance literature confirm the criminology literature – executive and professional compensation encourage and aid control fraud.  I have explained these points in scores of articles, so I will only summarize the key conclusions here.

  1. Executive compensation is the principal means by which sophisticated “looting” (Akerlof & Romer 1993) occurs.
  2. Looting through seemingly normal executive compensation makes prosecution far more difficult.
  3. When executive compensation is much larger the incentive to engage in control fraud increases dramatically.  Accounting control fraud provides a “sure thing” of exceptional wealth and prestige for the CEO.
  4. Executive compensation below the CEO level is a superb device for enlisting officers to aid the control fraud while simultaneously providing deniability for the CEO.
  5. The CEO abuses modern professional compensation to suborn the “controls” who are supposed to prevent insider frauds but instead aid and abet the CEO’s fraud.

Control frauds cause greater financial losses than all other forms of property crime – combined.  This means that modern executive and professional compensation are, in conjunction with the three “de’s” (deregulation, desupervision, and de facto decriminalization) the primary factors  that produce the criminogenic environments that drive our recurrent, intensifying financial crises as well as many control frauds that maim and kill thousands of people.  Each of these factors compounds the (much smaller) perverse incentives of executive compensation that Karabell concedes have been demonstrated to the satisfaction of business school scholars using econometric testing.  The non-econometric forms of research used by criminologists, regulators, law, and some accounting scholars also offer the opportunity to determine causality directly.

The rest of Karabell’s article consists of another logical error.  His logic chain is: some scholars believe inequality is very harmful and note that it is correlated with a range of undesirable variable but do not believe that econometric tests can prove causality.  That is, of course, a correct statement on their part because, by definition, econometric tests cannot demonstrate causality.  We can disprove a hypothesis, but we cannot prove a hypothesis through such econometric tests.  Notice that Karabell treated the business scholar’s econometric tests as gospel (“resoundingly convinced”) even though such tests cannot prove that changing the independent variable caused the change in the dependent variable.  “Resoundingly convinced” is an accurate description of the state of business scholar’s confidence on this point, but it not a scientific statement.

The inherent limitations of making statistical inferences about potential causality on the basis of econometric hypothesis testing illustrate the advantages of using multiple research methodologies, particularly ones that can examine causality.  Our “autopsies” of failed S&Ls and our civil, enforcement, and criminal cases in which we had to demonstrate the existence of the fraud and the fraud mechanisms required us to prove causality against skilled legal opponents with enormous resources and insider expertise that allowed them to propose alternative forms of causation.  Econometric studies are particularly likely to fail horrifically when they rely on accounting data that the CEO is systematically inflating through accounting fraud.

If we look at the entire body of research on the perverse incentives of executive and professional compensation we have a compelling case for concluding that that it is vital and urgent to change modern executive and professional compensation.  We cannot use “autopsies” or court cases to establish causality about issues like whether inequality reduces the compensation of middle class and working class workers.  We must rely on logic and the limits of statistical inference.  I explained the logic example above – if Karabell concedes that CEO pay reduces business productivity then it must harm working and middle class compensation.

But Karabell has done something far worse than failing to understand the inherent limits of econometric inferences.  He concedes that inequality at levels we now witness in the U.S. is correlated with a range of adverse conditions, including wage stagnation.  He then takes a totally banal statement – correlation does not prove causality – and fails to understand even the most basic aspects of statistical hypothesis testing.  Here is an example of Karabell’s failure to understand even the concepts he purports to be discussing.

“Progressive economist Jared Bernstein has also found that we can’t prove the assumption that inequality leads to slower growth, given available evidence. It may be true, Bernstein wrote, but we do not have enough concrete proof.”

Adding “concrete” before the word “proof” is a dead giveaway that Karabell is lost.  Econometric tests can disprove “that inequality leads to slower growth.”  They sometimes fail to disprove a false hypothesis because sufficient “evidence” (data) are not “available” to test the hypothesis.  Econometric tests inherently cannot “prove” any “assumption that [X] leads to slower growth.”  It doesn’t matter what the “X” is – we cannot prove through econometric tests that the (putative) independent variable causes predictable changes in the (putative) dependent variable.  We can find a correlation.  We can add “control” variables to try to tease out the impact of alternative independent variables.  Neither process allows us to “prove” causality.

Karabell reverses the scientific method and misses its logic.  He claims that because econometric tests inherently cannot “prove” that inequality leads to slower growth it follows logically that “income inequality isn’t as harmful as we think.”  That is a nonsensical statement.  He concedes that if inequality reduces growth it is very harmful.  Karabell seems to believe that because an econometric study that shows a negative correlation between inequality and economic growth inherently cannot “prove” causality it must not be causal.  We inherently cannot prove through econometric tests that racism is bad for economic growth.  This does not, logically, imply that we have proven that racism “isn’t as harmful as we think.”

11 responses to “CEO Pay is Perverse and Must be Fixed to Avoid Recurrent Crises

  1. I believe James Galbraith wrote a number of years ago about the loss of investment back into businesses due to the lowering of top marginal tax brackets. Specifically, the profit that used to be invested back into companies in the form of new office buildings and renovations of existing facilities which could be deducted from future tax bills. Now these profits are kept by the CEOs and other senior board members causing more of the money paid into the company to be concentrated at the top of the food chain .

  2. Pingback: Links 4/22/14 | naked capitalism

  3. Douglas Reaves

    I think we have to publicly question the outrageously high salaries of athletes and entertainers, too.

    • The salaries of entertainers are as high as they are for reasons similar to those explaining executive pay. Highly successful entertainers are major beneficiaries of market consolidation. Modern technology allows them to sell their product, themselves, to a very large marketplace. Whereas Babe Ruth was a wealthy man in the days of newspapers and radio, Barry Bonds is a very wealthy man in the days of television. Perhaps the people operating the technology are selling their services too cheaply.

      The CEOs also understands that game. Their big market consolidation technology is corporate mergers. Whereas a small business proprietor might direct as much as 30% of his business revenue to his personal salary and be left with a small sum, the executive consolidates his market to turn 1% of revenue into a very large sum.

      In these ways, without even needing to resort to the sort of chicanery William Black describes, the successful entertainer or executive turns market control into personal wealth.

    • Douglas.
      Are you quoting from Entreposto to support your claim that “I think we have to publicly question the outrageously high salaries of athletes and entertainers, too.”. If so Entreposto is claiming that “The salaries of entertainers are as high as they are for reasons similar to those explaining executive pay.” This is wrong. What Professor Black is stating is that the outrageously and dangerously high pay of executives is the result of accounting control fraud, which emanates from the “C Suite”. Athletes and entertainers are not in a position to cook the books in order to direct high salaries to themselves. Nor are they the officers Professor Black identifies when writing “Executive compensation below the CEO level is a superb device for enlisting officers to aid the control fraud while simultaneously providing deniability for the CEO.” Athletes and entertainers are employees.
      A cursory look at the history of the salaries of athletes and entertainers shows that those salaries now (for Barry Bonds) are much higher than in the past (for Babe Ruth) because athletes in particular organized to demand more of the revenue that they were generating from their talents. There may be valid reasons to be concerned about the high salaries of athletes and entertainers, but the control fraud reasons stated by Professor Black for high CEO salaries are not among them.

      • Yeah. Athletes and entertainers are merely expensive raw materials, commodities. They are not executive management. They are in no position to commit accounting control fraud, to loot the productions of which they are parts.

      • I wasn’t disregarding Prof Black’s research, I was just pointing out that, even without control fraud, larger firms, which arise often due to corporate mergers, usually have much more highly paid executives than smaller firms. I’d agree that entertainers are expensive commodities, but they are expensive because they can be sold to a large market. Ty Cobb never made Barry Bonds levels of money selling his services to one ballpark at a time. Sarah Bernhardt never made Julia Roberts levels of money selling her services to one theatre at a time.

  4. “In 1996, when I recommended the minimum wage be raised, Republicans and the [U.S. Chamber of Commerce] screamed that it would ‘kill jobs.’ In fact, in the four years after it was raised, the U.S. economy created more jobs than were ever created in any four-year period.” – Robert Reich

  5. Jerry Hamrick

    You and the rest of your associates who write on this blog are extermely innovative as your ideas about MMT prove, so why do you stop before the whole job is done? I don’t think you will get very far advocating for reductions in executive pay, even though your arguments are, as far as I am concerned, correct and urgent, so why keep beating your head against the wall? Why not propose a system in which outlandish executive paychecks are possible but do not affect the pay of other employees and do not increase inequality? As I understand your theory of MMT, and I probably don’t understand it at all, you have already put in place the tools to do what I am suggesting. Why not take the next step? Actually why not take several more steps because executive pay is not the only thing that needs correcting?

  6. Robert Avila

    For much of the 20th Century the Us had a very simple means of controlling CEO pay: High Marginal Tax Rates. No board of Directors would approve endlessly increasing a CEOs pay when 90% of the increase went to the Federal Government. Sure they handed out perks, sure they got shares in the company but capital gain laws required that they hold the shares for 5 years or be taxed as income. The result was that up into the 1970s CEO pay was typically only 40 times what their average employee made. CEO pay only got out of line after the Reagan tax cut. Once marginal rates dropped there was no more lid on CEO pay.

    Wall Street compensation went through a similar transformation over the same time period for the same reason.

    This is not subtitle. Find a retired tax attorney or accountant and ask him what it was like back in the 1960s when he first started practicing.