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Tilting at Windmills

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May 25, 2007
By: Kevin Drum

SUPERSTAR CEOs....Eduardo Porter writes in the New York Times about today's insane levels of executive pay and manages to include at least a dozen nuggets worthy of comment. But sort of at random, I'll choose this one:

Processing reams of data, [Xavier Gabaix and Augustin Landier] estimated that hiring the most effective chief executive in the country would, statistically, increase the stock value of a company by only 0.016 percent, compared with hiring the 250th chief executive. But at a company like General Electric, which is worth about $380 billion, that tiny difference would amount to $60 million.

This, the economists argued, helps explain why that top chief executive earned five times as much as the 250th. "Substantial firm size leads to the economics of superstars, translating small differences in ability to very large deviations in pay," the economists wrote.

Needless to say, this is ridiculous. For starters, a microscopic number like 0.016% is probably just a statistical artifact. But let's say it isn't. Let's say it's real. It still doesn't matter because it's still plainly too small to be a predictable difference.

So sure: if you interviewed 250 candidates, the top candidate might be 0.016% better than the 250th candidate. But which is which? With a difference that small it's impossible to say. You have no idea beforehand which one of those candidates is going to earn you that extra $60 million. And since you don't know, statistically you'd be better off choosing someone from the middle of the pack and saving yourself some money.

But that would bring the whole game to a screeching halt, and we can't have that, can we? Much better to keep the rubes conned with stories about "superstar CEOs" and "more complex modern environments." Look! It's Halley's comet!

UPDATE: A reader wrote this morning to say that he thought I was unfairly dismissive of Gabaix and Landier in this post. Unfortunately my email responses keep getting bounced back, so I can't get a fix on exactly what the problem is. But let me clarify something anyway.

Basically, I'm accepting Gabaix and Landier's results here. If their research says 0.016%, then for now I'm willing to assume that's correct. However, if that result is right, I think it's ridiculous to interpret it as explaining skyrocketing CEO pay. If you could systematically predict who was going to deliver a benefit that small, that would be one thing. In that case, maybe the higher pay would be justified. (Maybe.) But the microscopic size of the difference in measured CEO performance makes that vanishingly unlikely. CEO pay has certainly skyrocketed over the past couple of decades, but minuscule and unpredictable differences in performance don't seem likely to explain why.

Kevin Drum 12:50 AM Permalink | Trackbacks | Comments (46)

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Comments

The problem isn't so much in the difference between a top performer and a middle of the pack guy, but in a middle of the pack guy and the bottom rung. It might be hard for a CEO to have a noticeable positive impact on earnings or profits, but a couple of bad business decisions can have a huge negative effect on the same.

Think about Apple and Steve Jobs. For them, he's worth the money, not because all the neato-frito ideas Apple has had over the years came from his particular brain, but because he's made the correct decisions to translate those ideas into dominance of wholly-untapped markets.

Nobody wants to go back to the shareholders with, "Well, we thought we'd save a buck on CEOs, but we never imagined he'd suddenly launch a toaster-sales division and wreck the company!" Boards hire CEOs precisely so that they don't have to oversee company operations; but you can't claim simultaneously that "we expected him to deliver world-class performance for his salary, so we didn't worry about what he was doing!" and "we firmly believe in paying our CEO way less than average". It's like a layer of responsibility insurance, in a bizarre fashion.

Posted by: Avatar on May 25, 2007 at 1:01 AM | PERMALINK

What would be interesting is a study of other positions (CFO, CIO, project leaders, middle managers, secretaries, janitors) to see how much they cause the stock to increase.

Posted by: Andrew Glisson on May 25, 2007 at 1:05 AM | PERMALINK

Ah hell, all the breakthrough ideas come from engineers and designers and all the little guys. The CEO just needs to stay out of the way and comb his toupee. The pay is just fraud.

Posted by: chris on May 25, 2007 at 1:05 AM | PERMALINK

And whenever that highly paid top tier CEO does make a bad decision - and that happens quite frequently - he gets a golden parachute.

Posted by: Jörgen in Germany on May 25, 2007 at 1:14 AM | PERMALINK

Andrew,
Do you think the CEO is the one who dreams up things like the iPod? Of course not. They just have to be convinced it will add to the profitability of the company. Of course the reverse of that is like Xerox(I think) of the mid 70's. They had the chance to jump out in front with PC's, and decided it wasn't worth the gamble. We all know how that worked out. Or how Microsoft licensed Windows, and IBM allowed them to license to competitors as well.

Posted by: Joe Klein's conscience on May 25, 2007 at 1:25 AM | PERMALINK

If these guys are really so good at increasing shareholder value, they should have no problem in accepting pay deals that truly reflect their contribution. I.e. outperforming the related index, both for their industry and stockmarket overall, and less inflation.

And as Jurgen(?) in Germany points out, they have no problem in getting golden parachute buy-outs when they do a lousy job.

NorthWest execs rewarded themselves with $120 million worth of stock for returning from bankruptcy which was mostly achieved by squeezing bloodless each union in turn and their 100% dependent feeder airline. I couldn't understand the union tactics, nor the courts ability to take away their only weapon, withdrawal of labour, but the shamelessness of these execs is stunning.

Anybody know if this is much the same group that put the company into bankruptcy, too?

Posted by: notthere on May 25, 2007 at 1:34 AM | PERMALINK

All this blather only applies to the US. The rest of the world does things differently.

Posted by: Name on May 25, 2007 at 1:35 AM | PERMALINK

All this blather only applies to the US. The rest of the world does things differently.

Posted by: Name on May 25, 2007 at 1:35 AM | PERMALINK

All this blather only applies to the US. The rest of the world does things differently.

Posted by: Name on May 25, 2007 at 1:36 AM | PERMALINK

Hiring the biggest name to top the company and paying them outrageous money justifies paying all the board members and the ``search'' teams and the No. 2s and 3s and 4s in the company THEIR outrageous wages. Game, indeed.

Posted by: secularhuman on May 25, 2007 at 1:43 AM | PERMALINK

For starters, a microscopic number like 0.016% is probably just a statistical artifact.

In defense of the study (I haven't read it, so I can't say if it's any good, but I can say that the points of criticism don't make much sense), the question whether the increase is a statistical artifact isn't answered by the magnitude, but by the statistical confidence, so you'd have to look at standard error or t-score to say whether that calculated value is somewhere between -0.024% and +0.056% or between +0.012% and +0.020%. My hunch is that the guys got that right, since it's a pretty basic concept in hypothesis testing.

it's still plainly too small to be a predictable difference.

But that only matters if the CEO pay is upfront, which in most cases it isn't. Most CEO pay comes in the form of bonuses from positive firm performance.

The problem with CEO pay is that unlike in empirical analysis, in the field you usually can't establish causality – Is better company performance solely the result of better CEO performance? As it is now, CEOs stand to gain from good performance more than any other employee, but they rarely suffer to the same degree from poor performance.

Posted by: ogmb on May 25, 2007 at 2:11 AM | PERMALINK

So pay the CEO of GE 60 million dollars, I don't care.

...But isn't his pay package like five times that?

Posted by: Crissa on May 25, 2007 at 2:44 AM | PERMALINK

The article mentions the CEO of Office Depot makes $12 Million a year. Since ODP is a $9.5 Billion company, 0.016 percent of that is 1.5 million. So even if the study is right about the 0.016 percent, Steve Odland is overpaid.

Posted by: mcdruid on May 25, 2007 at 2:56 AM | PERMALINK

Here are a few lines from the Gabaix paper that aren't mentioned in the New York Times article:

In particular, the model highlights contagion as another potential source
of increased compensation. If a small fraction of firms decide to pay more than the other firms (perhaps because of bad corporate governance), the pay of all CEOs can rise by a large amount in general equilibrium.

If 10% of firms want to pay their CEO only half as much as their competitors, then the compensation of all CEOs decreases by 9%. However, if 10% of firms want to pay their CEO twice as much as their competitors, then the compensation of all CEOs doubles.

Posted by: Joel on May 25, 2007 at 2:59 AM | PERMALINK

It is? Where?

Oh.

Posted by: Christopher M on May 25, 2007 at 3:12 AM | PERMALINK

The whole concept of CEO sycophancy is ridiculous. Sometimes they lead, and sometimes they follow. Pharmaceutical companies, for ex., are led by researchers coming up with new drugs. Therefore they should be paid according to increasing value of stocks. Actually they should be paid royalties on patents as the Founding Fathers intended, but that is another topic. Japanese car companies lead because of good engineering and quality in the manufacturing departments. Don't matter how much you pay some CEO dunce to lead a U.S. car company. If they don't have it in engineering and quality, they don't make it despite some "brilliant" strategy from the top. A business is a team effort. Paying CEO's on stock value is a non-sequitur such as we often hear from athletes. Why is a basketball player worth so much? Ans: Because he is an entertainer. Most people accept some sort of answer no matter how nonsensical it is under analysis.

Posted by: Luther on May 25, 2007 at 3:17 AM | PERMALINK

When politicians in third world countries skim off enormous amounts of wealth, just because they can, we realize it is economically unproductive, yet when the people running our financial and industrial organizations do it, it's just a cost of doing business.
The big problem with the economy is that while globalization is keeping prices and wages stable, low interest rates are causing enormous inflation in asset prices and when this leaks into the regular economy through higher energy, material, infrastructure cots, more and more people are going to sink beneath the flood of speculative cash and what is eventually going to pop the liquidity bubble will be the enormous social unrest it causes, through nationalism, etc. These people who think they need infinite amounts of wealth might find they overdid a good thing.

Posted by: brodix on May 25, 2007 at 6:42 AM | PERMALINK

KD:"if you interviewed 250 candidates, the top candidate might be 0.016% better than the 250th candidate. But which is which? With a difference that small it's impossible to say. You have no idea beforehand which one of those candidates is going to earn you that extra $60 million."

Agree totally, Mr. Wonky Stats-man. If you are dealing with the top 250 performers, the range restriction is such that no one can make predictions. Boards pay more and more because it makes them feel as if they have control. It is superstitious or circular reasoning; Because they pay so much compensation, they must have hired a top star.

Everyone agrees that effort and performance should be rewarded. It is the absolute magnitude of that compensation that appalls.

There was this CEO in MN--head of a company that later went bankrupt. He got a $120 million dollar bonus one year. I calculated that every employee in the company could have received a bonus equal to their salary, the top cadre of executives could have received bonuses equal to triple their salaries, and the CEO would STILL have gotten a $20Million bonus. How does giving that one man $120 Million make rational, moral or even economic sense?

Posted by: PTate in FR on May 25, 2007 at 7:30 AM | PERMALINK

Most CEO pay comes in the form of bonuses from positive firm performance.

No, most CEO pay comes in the form of bonuses.

Posted by: Dan on May 25, 2007 at 8:27 AM | PERMALINK

PTate: Boards pay more and more because it makes them feel as if they have control. It is superstitious or circular reasoning; Because they pay so much compensation, they must have hired a top star.

Yes, and even more, boards pay so much because they're largely composed of CEOs from other corporations keeping the sacred circle of outlandish CEO salaries and perks unbroken.

Posted by: shortstop on May 25, 2007 at 8:29 AM | PERMALINK

Lack of understanding of even the most basic statictical principles is one of the key maladies of modern journalism (and public discourse generally).

Executive pay has become more or less entirely divorced from performance--due to, in effect, a "hostile takeover" of publically traded companies by boardroom insiders. That's just too obvious to merit serious argument

Posted by: Matt on May 25, 2007 at 8:41 AM | PERMALINK

Hey, Superstars don't come cheap - Home Depot is still paying and paying and paying.

But, occasionally you get lucky - Why, we pay our guy in DC 400 Grand a year and what a bargain. Hard to find a dictator that dear.

Posted by: thethirdPaul on May 25, 2007 at 9:15 AM | PERMALINK

And so precious, to boot.

Posted by: Alberto the Gonzo on May 25, 2007 at 9:16 AM | PERMALINK

I believe that Freakonomics explained it like the gang-leader example. The gang leader needs to look like he's making money at all times, even when he isn't, lest he look weak, giving his rivals a chance to attack. This means buying expensive cars, handing out favors to friends, and wearing expensive clothes. Even if (especially if) times are bad.

Companies are the same way as the gang leader. They need to show that they're "in charge" and rich. That means spending money on corporate jets and expensive CEOs. If they didn't do that, then they'd look vulnerable to expose themselves to hostile takeovers or increased pushes for competition from market rivals. When a firm blows $100 million on a CEO, they're saying, "Don't screw with us. We have the resources to take you on."

Posted by: Constantine on May 25, 2007 at 9:26 AM | PERMALINK

"...statistically you'd be better off choosing someone from the middle of the pack and saving yourself some money."

This line of thought seems roughly akin to the Dogs of the Dow investment strategy, that someone at the bottom of a business cycle is poised for a comeback.

Conversely, buying the "best" CEO is parallel to "buy high, sell low," the worst way to invest of all.

Meanwhile, 35 percent of CEO departures are involuntary and are based on underperformance.
http://www.management-issues.com/2006/8/24/research/ceo-turnover-hits-new-record.asp

It's fascinating how little attention is paid to the actual performance of CEOs as a financial product in and of itself, particularly considering their role in our ever-more-privatized economy.

Posted by: skimble on May 25, 2007 at 9:42 AM | PERMALINK

I think whoever wrote this was being paid off by a superstar CEO. It seems like just a way to keep the rich, rich and the poor, poor. When people make such gobs of money, they're going to say anything to justify that amount and avoid a pay cut.


Curious? Check out Christopher Ruddy

Posted by: ShelbSpeaks on May 25, 2007 at 9:47 AM | PERMALINK

I would be very interested to see a study of CEO pay in firms that are privately held or owned by Private Equity firms. For a big public company with millions of outstanding shares, it's hard for an individual smalltime shareholder to feel like they are getting ripped off.

But for a private firm (or a firm where 1 or 2 people own the majority of voting shares), outrageous CEO pay pretty much comes directly out of the pockets of the owners. That's their profits disappearing up the chimney.

In other words, is the CEO of Microsoft or Dow Jones paid substantially less than the CEO of General Motors or General Electric?

Posted by: Victory on May 25, 2007 at 10:05 AM | PERMALINK

ogmb said what I was gonna.

Posted by: luci on May 25, 2007 at 11:04 AM | PERMALINK
So sure: if you interviewed 250 candidates, the top candidate might be 0.016% better than the 250th candidate.

That does not follow from the excerpt you posted. Unless one assumes that, e.g., that when the best executive was hired, the next 249 best employed executives would be the other people interviewed for the job if 250 people were interviewed.

Most likely, the alternatives would range much wider.

Executive pay certainly may be ridiculous and unjustified by performance, but the particular abuse of numbers that you are doing to make that argument isn't a good way of advancing it.

Posted by: cmdicely on May 25, 2007 at 11:13 AM | PERMALINK

If this were meaningful, then CEO compensation would be based on corporate size only - if you are 250, you are CEO of the 250'th largest corp.

Posted by: couser on May 25, 2007 at 11:33 AM | PERMALINK

Another danger of "rock star" CEO pay involves the structure of pay increases and bonuses. These usually encourage short term profitability or stock price increases. Those factors are easily manipulated in a manner that will also harm the long term performance of the company. How many times have we seen a new CEO take over a company. Stock prices rise (reduce pay of the workers, re-allocate income to earlier accounting periods, rosy prediction of profit and cost to book initial profits and other tricks) and then crash as bad contracts, accounting tricks and other bad news is discovered. The CEO is kicked out after negotiating payments in addition to the usual golden parachute. Indeed, modest compensation increases can cause any employee to work harder to earn the additional compensation. "Insane" bonus, stock option and compensation potential encourages inappropriate risk taking and outright criminal activity. When someone can earn millions or tens of millions more by meeting certain short term profitability and stock price goals, the tempation to act immorally or criminally becomes irresitable to many.

Posted by: JMOHR on May 25, 2007 at 11:52 AM | PERMALINK

As mentioned by Avatar, Apple is an interesting case study. During the time of the big name CEOs Sculley, Spindler and Amelio Apple suffered a lot and nearly died. With the return of Jobs we have seen a stunning turn around.

The positive effect of Steve Jobs is the exception, the bumbling of the previous three CEOs is the rule. Most CEOs don't understand the business they are in very well. This doesn't mean they can't provide a general leadership fostering teamwork and maybe something to do with corporate structure. However, you don't want them to be involved with product design, pricing, marketing or sales as they have no clue what they are doing. Another positive example would be Lee Iacoca. Someone who really knew the car business.

The tenor of the discussion has been that CEOs are interchangeable and that you just need to go find a good one to run your company. The evidence is that CEOs are people who are generally knowledgeable about one field and when you get them out of their area of expertise they fumble like you or I would.

With the rare exceptions of Jobs or Iacoca I'm sure you could get any competent business school graduate who's had a decade or two of experience and they would perform just as well for one or two million a year as the current crop do for hundreds of millions per year.

Posted by: JohnK on May 25, 2007 at 12:28 PM | PERMALINK

Why not outsource CEOs? There are lots of Chinese and Japanese who could do a better job at a tenth of the cost.

Posted by: Bob M on May 25, 2007 at 12:29 PM | PERMALINK

Wow. An "Up The Creek" reference. Haven't seen one of those in years. Next up it'll be "Down Liver" or "It's those GI Joe guys."

Posted by: Timewalker on May 25, 2007 at 12:32 PM | PERMALINK

commenter ogmt has it right. Causality is the key. The lucky CEO's get a windfall and it backs up their statistical advantage. It's all a bunch of BS and Kevin is truly on to something.

Posted by: wt on May 25, 2007 at 1:27 PM | PERMALINK

if you interviewed 250 candidates, the top candidate might be 0.016% better than the 250th candidate. But which is which? With a difference that small it's impossible to say.

C'mon, Kevin. That's not what they're saying. They're saying that the top CEO can be way, way better then the 250th, but when it all shakes out it amounts a 0.016% difference in overall company profits.

By your logic the quality of a CEO would the only thing that determines profits.

Posted by: withnail on May 25, 2007 at 1:44 PM | PERMALINK

Curious to dive into the methodology here. Seems to me that if you hire #250 you will have to pay him like a top ten choice because, by hiring him (or her, but really him) at GE, he just became a top ten candidate. In other words, regardless of who you pick you will pay through the nose because of the size of your enterprise, not the weight of his credentials or your predictions about his performance.

Of course, if you hire #250 and pay him like a top ten, you invite dissention and disaster. See Ovitz, Michael. Best to play it safe and just get the consensus top guy....

Posted by: G Spot1 on May 25, 2007 at 2:36 PM | PERMALINK

Actually its worse.

First of all, the example is cooked: GE is regularly in the top 3 US companies ranked by market capitalization. But take Safeway: it is ranked #50 in the Fortune 500 and has a market cap of $15 billion. .016% of that is... 2.4 million.

Furthermore, annual salary is a *flow* while market value is a *stock*. In other words the alleged change in the stock price reflects *the CEO's entire tenure*. So if our CEO lasts 10 years, that would work out to about $240,000 extra per year at Safeway. (Or perhaps a little more if you want to factor in interest rates).

Similarly, that might boost GE pay by $6 million/yr, provided this magic candidate could be identified.

Posted by: Measure for Measure on May 25, 2007 at 5:06 PM | PERMALINK

Re: Apple.

(1) Jobs was significantly involved in the design of the iPod.

(2) regarding John Sculley, when JohnK says "During the time of the big name CEOs Sculley, ... Apple suffered a lot and nearly died." he must have meant "grew annual revenues by $9 Billion from $1 Billion to $10 Billion"

Posted by: OwnedByTwoCats on May 25, 2007 at 6:11 PM | PERMALINK

JohnK says:
"As mentioned by Avatar, Apple is an interesting case study. During the time of the big name CEOs Sculley, Spindler and Amelio Apple suffered a lot and nearly died. With the return of Jobs we have seen a stunning turn around."

It's funny to see OwnedByTwoCats misquote JohnK, then attack the misquote. I think it's fair to say that at the end of the 3 Amigo's tenure, Apple was in a sorry state.

---
Whether Sculley was head and shoulders above Spindler and Amelio is unclear to me. Though somehow, I suspect that Apple's growth during the Sculley administration was due to the efforts of more than 1 man.

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