Pay and the Free Market

It came up again in conversation today:  someone was offended and upset over the level of compensation of some senior executives in the U.S. economy.   I have to admit I just do not understand the anger. And I have a fundamental lack of respect for the arguments that have been served up thus far in support of the position.

I have tried to resist drawing the conclusion that the anger is born of envy, but I am very close to throwing in the towel on that one.  Why should we begrudge anyone who earns a healthy salary, especially in an economy that provides each of us the opportunity to aspire to the same?

Even if there were reasonable ways around the practical issues and costs associated with legislative caps on salaries — how to set them, who sets them, using what measures, what value judgements — it simply makes no sense.  It is the antithesis of a competitive market economy where individuals have the incentive to learn, grow, work hard, and succeed.  It ignores the role played by capitalism in creating a strong and vibrant private economy that provides endless opportunities for all who want to put in the hours and the effort to succeed.

U.S. corporate governance rules provide the framework for determining the compensation for senior executives, and it works remarkably well.  Each shareholder, or owner of the company, gets one vote on material issues such as reorganization. The Board of Directors is responsible for hiring and firing senior management on behalf of the shareholders.  If the shareholders do not like the decisions of the board, including those that set the level and form of compensation for senior management, they have at least two, very effective choices. They can either sell their shares in the company or they can vote to replace the board members.  The board can take several steps if, after negotiating the compensation package for senior management, the executive fails to perform. The board can withhold the bonus, renegotiate the terms of the contract, or fire the executive.  Then the long, mostly objective arm of the competitive labor market will determine the market-clearing value for the skills and experience of the recently fired executive.

One thing I’ve never quite understood is why the market doesn’t seem to exact more punishment on senior executives who run their companies into the ground.  Maybe there is an old boys network that looks out for ex-executives; maybe my observations are biased; maybe I notice only those cases where failed executives rise again.  But it’s an empirical question, in any case; we can gather data on the issue and study it objectively.

Regardless of the conclusions of such an analysis, however, decisions about executive compensation must remain in the labor market where your ability to produce economic value still reigns supreme over your ability to curry votes and political favor.

By Sherry Jarrell