Market Discipline: The Most Powerful Tool for Fair Executive Pay
What is talent, and how should we pay for it? Among the many who aren't sure of the right answer is -- you guessed it -- Congress. Last month, the House moved to shame some key, ambitious, highly paid risk-taking players in an industry by passing the Corporate and Financial Institution Compensation Fairness Act. The same day, the House dealt with a key, ambitious, highly paid risk-taking player in another industry by drafting a resolution of congratulation.
In the first instance the House focused on financial executives. In the second instance the key player was, literally, a player -- pitcher Mark Buehrle, whom Congress was rewarding for an action rare and sublime -- pitching a perfect game.
The compensation bill is fairly mild. Congress wants to make it easier for shareholders and the Securities and Exchange Commission to police executives and their hefty pay packages. Still, this legislation makes some basic assumptions that are important to the future of our economic growth. And a baseball team is enough like a company to remind us of the limits of those assumptions.
The first assumption is that a snapshot of a highly paid executive at a failing company is proof that the executive is overpaid and that something in the company structure is broken. Rep. Barney Frank (D-Mass.), the legislation's chief proponent, has noted that there are moments when it looks as though "the company loses money and the economy may suffer, but the decision-makers do not."
But as baseball fans know, such snapshots get taken all the time. Buehrle got a four-year, $56 million contract in 2007. Yet this spring his company -- the Chicago White Sox -- was doing so poorly that Chicagoans weren't showing up for games. "The White Sox stink," wrote one columnist. At that point, Buehrle's pay looked awfully high relative to what the owners and the fans were getting for their investment in the team. Yet no one said that this required a bailout for the Sox, or a hearing and a government-set pay cut for Buehrle.
And now, after that storied game against the Tampa Bay Rays, just about everyone feels like lining up behind the House members to congratulate the White Sox for their prophetic hire. No one thinks about Buehrle's pay, even though we know it is sure to go up. That ugly snapshot no longer matters. Overall, we see, Buerhle was a good investment, for himself, for his team, for his fans and for baseball.
Work by Steven Kaplan of the University of Chicago suggests that corporations really are like baseball teams in this way. Bad snapshots? Politicians care about them because they provide "gotcha" moments for hearings. But employers don't care about snapshots. They find it rational to pay a lot over a long period for even a sliver of a chance of one sublime performance.
After all, people hire for the long term, not just for one recession or recovery. And talent is rarer than we tend to think. "In a world where skill is in great demand and markets are large -- when a lot of money is at stake, whether it's baseball or finance -- market forces insure that those skilled people get paid a lot," says Kaplan. Pay caps, or even too much harassment from regulators, will drive the talent to jobs where there aren't such obstacles. The result will be fewer perfect games in the corporate world: "You pay peanuts, you get monkeys," says Kaplan.
The second assumption in our executive-comp policymaking is that corporations just don't adjust pay to react to performance, so Washington must. It's true that corporations can't adjust pay instantly, just as the White Sox couldn't instantly recalibrate the pay of players like Buehrle this spring. But evidence suggests that over the longer term, the market does drive pay up or down according to performance. Kaplan's work shows that the pay of corporate stars went down relative to that of others -- lobbyists, hedge fund partners -- after the dot-com bubble popped.
A third assumption -- that of Frank -- is that tricky executives wiggle out of paying as much as the rest for their own errors in stewarding their company. But the same week that Buehrle pitched The Game, Rene Stulz of Ohio State University published a paper looking at one of the classic allegations: that the current corporate structure encourages bank CEOs to sell their stock before crises and spare themselves the pain that shareholders will feel. Stulz found that bank CEOs tend to own lots of company stock and generally do not cut their holdings enough before or during crises to escape serious damage to their own net worth. They pay along with the rest.
It is, of course, possible to stretch the baseball metaphor too far. But clearly America has two cultures: the bail-out-and-redistribute culture of politics and the more hopeful, more meritocratic culture of baseball. To reach solid recovery, we all need to think less in Washington's terms and more along the lines of the nation's pastime. The shift sounds impossible, but all it may take is a few more miracles on the mound.
Amity Shlaes, a senior fellow in economic history at the Council on Foreign Relations, is writing a biography of Calvin Coolidge.