The Means and Berle solution to the rise of the managerial class had prevailed, and it seemed to be working. America’s companies were no longer run by their vigorous and self-interested robber baron founder-owners, but the new salaried stewards who had replaced them weren’t looting the corporate kitty. Governed by a “remarkably effective code,” their incomes were actually falling. They seemed to be doing a pretty good job, too. The companies under their stewardship doubled in size between 1932 and 1976, the total real compound annual return on the S&P 500 was 7.6 percent, and America’s GDP had quintupled.
But by the late seventies and the eighties, when Jensen, Murphy, and their like-minded peers began to investigate CEO pay, the economic picture was starting to darken. Economic growth seemed to stall even as inflation rose—remember stagflation. Corporate America, too, seemed sluggish, risk averse, and under threat from more innovative foreign rivals. These were the conditions that inspired the liberal economic revolution more generally, and also a rethinking of what was happening in the corner office.
As Berle and Means had warned in the 1930s, the problem started with the twentieth-century fact that the economy was largely run by “stewards” rather than owners. But the New Dealers’ fear that these managerial aristocrats would line their own pockets hadn’t come true—indeed, the opposite was the case. And that, Jensen and Murphy warned, was the problem. The social constraints that prevented executive looting also meant executives had weak economic incentives to do an outstanding job. The New Dealers had transformed hired-gun CEOs into capitalist civil servants—public-spirited and self-restrained. The “Worth Every Nickel” business school professors wanted to turn the managerial class into red-blooded capitalist owners.
Their solution was “pay for performance.” Managerial compensation should be more tightly tied to how well they did their jobs and, in particular, to how well their companies performed.
By one measure, the academic advocates of pay for performance were remarkably effective. After falling steadily during the postwar years, CEO salaries began to soar. The real takeoff was during the 1990s: by the end of that decade they were growing by 10 percent a year. As Roger Martin has calculated, for CEOs of S&P firms, the median level of pay soared from $2.3 million in 1992 to $7.2 million in 2001. That’s a lot of money, and a growing share of the overall income of corporate America. Between 1993 and 2003 the top five executives of America’s public companies earned $350 billion. Between 2001 and 2003, public companies paid more than 10 percent of their net income to their top five executives, up from less than 5 percent eight years earlier.
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These were, of course, the decades when the 1 percent broke away from the rest of the pack in society as a whole. That happened inside corporations, too. Rising CEO compensation pulled the boss ever further from the factory floor or the cubicle rows. In the early 1970s, CEOs earned less than thirty times what the average worker made; by 2005, the median chief executive made 110 times what the average worker did. And just as income inequality in society overall has become more pronounced at the very, very top, the gap has grown between CEOs and their direct reports. Until the early 1980s, the chief executive earned about 40 percent more than the next two most highly paid managers; by the early twenty-first century, he made more than two and a half times as much.
This gap is no accident—it is inevitable in an economic model in which the CEO has gone from being the company man of Galbraith’s postwar account to the free-agent superstar of the pay-for-performance era. That shift was made starkly apparent when two economists at the London School of Economics asked a simple question: “Does it matter whether you work for a successful company?” The answer from HR is—of course! And our corporate Web sites duly urge us to be team players and to root for our firm’s overall success. But when Brian Bell and John Van Reenen looked at what actually happens in a sample of companies covering just under 90 percent of the market capitalization of Britain’s publicly listed firms, they came up with a chilling reply. CEOs and executives at the very top are rewarded for corporate success, but almost no one else is: “A 10 percent increase in firm value is associated with an increase of 3 percent in CEO pay, but only 0.2 percent in average workers’ pay.”
These growing chasms within companies didn’t just mirror the broader rise of the 1 percent, they also drove it. Executives working outside finance (a category all its own) were 31 percent of the 1 percent in 2005, the single largest group. They account for an even larger share of the 0.1 percent—42 percent in 2005.
A couple of decades earlier, György Konrád and Ivan Szelényi had revealed the politically uncomfortable truth that in the so-called workers’ states the real winners—and the real bosses—were the intellectuals, particularly their technocratic branch. They are coming out on top in market economies, too. It is the MBAs on the road to class power.
Under communism, the rise of the intelligentsia was undeniably a political process. But the academic theory underpinning the rise of the MBA class in the West is all about market forces. The goal of the pay-for-performance revolution, after all, wasn’t to raise CEO compensation, although that was certainly one of its consequences. The point was to get the managerial aristocrats to do a better job by more closely tying their paychecks to their impact. On this reading, the soaring salaries of CEOs, and the growing gap between them and their senior lieutenants, is one chapter in the broader story of superstar economics. Once companies began to do a better job of tying pay to performance, they discovered that some managers were more talented than others, and those stars, like the best singers or lawyers or chefs, could command a significant financial premium.
For the CEO to be a superstar—and to be paid like one—he has to stop being a company man. The executives of the postwar era were corporate lifers. They were the creations and the servants of their companies, and a great deal of their value came from their knowledge of the particular corporate cultures that had created them and the specific business they did. The superstar CEO cannot be tied to a single corporation and, ideally, not even to a single industry. He must be an exemplary talent whose skill is in “management” or in “leadership.” He is more likely to have an MBA—28.7 percent of CEOs did in the 1990s, compared to 13.8 percent in the 1970s—and less likely to be a loyalist of a specific firm. If these are the general skills we believe it takes to lead successful businesses, the world’s companies will engage in a bidding war to secure the services of the men and women who are the world’s best managers and leaders.
That is exactly what has happened. The surge in CEO salaries coincided with a rise in bosses hired from outside the firm. In the seventies and eighties, when CEOs were paid less than they had been in the 1930s, 85.1 percent and then 82.8 percent of chief executives were company men. But in the 1990s, as CEO compensation came to vault upward by 10 percent a year, more than a quarter of chief executives were appointed from outside their firm. Jumping to a new company was a good way to get a raise—external hires, according to research by Kevin Murphy, one of the leaders of the pay-for-performance school, made 21.6 percent more than chiefs appointed from inside. In sectors where these portable general managers are most valued, all CEOs earn more—a premium of 13 percent.
One of the drivers of superstar incomes in other professions is the economics of scale—singers who can perform for millions, designers whose styles can be sold around the world. Size can be a reason to pay CEOs more, too. As companies get bigger thanks to the globalization and technology revolutions, the economic impact of good management increases. The world’s very best CEO may be only marginally better than the hundredth best. But if your company’s annual revenues are, say, $10 billion, then just a 1 percent difference in performance is worth $100 million. Sure enough, as economists Xavier Gabaix and Augustin Landier found in a 2008 paper, “The six-fold increase of U.S. CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large companies during that period.”
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But there is one very big problem with the superstar CEO model, and it goes back to the challenge posed by the rise of the managerial aristocracy that first Berle and Means and later the pay-for-performance school grappled with. It is what economists call the agency problem, and it means that CEOs are a very special sort of superstar: the one who is in charge of the company that pays his salary. Superstar athletes are paid by the owners of sports teams, superstar chefs by their diners, and even superstar hedge fund managers are paid by their investors. But CEOs are paid by the companies they run. Their compensation, to be sure, is determined by the board of directors, but, particularly in the United States, the chairman of the board is often the CEO.
“In the U.S., you can more or less do whatever you want, without having the support of the owners,” Mats Andersson, the chief executive officer of the Fourth Swedish National Pension Fund and critic of corporate governance in the United States, told me after speaking at a conference on the issue convened in Washington by the Securities and Exchange Commission. “Because of the composition of the boards in Sweden, the company’s big decisions all have to be based on the mandate or the support of the owners.
“Who is actually responsible for executive remuneration in U.S. companies?” Mr. Andersson said. “If I could decide on my own salary, I would certainly love that system.”
Adam Smith forthrightly warned that the consequence of the agency problem was “negligence and profusion.” Academic economists today use a more delicate term: “skimming.” A decade ago, two young economists, Marianne Bertrand and Sendhil Mullainathan, came up with an original way to investigate whether CEOs were superstars, being rewarded by their firms for exceptional performance, or whether they were stewards who were rigging the rules of the game in their own favor. The test was to see whether performance-based CEO pay responded as strongly to external good fortune as it did to managerial prowess. Two of the examples of outside luck were changes in the price of oil and changes in the exchange rate. Bertrand and Mullainathan found that luck matters: “CEO pay is as sensitive to a lucky dollar as to a general dollar,” which is to say for overall good company performance. They found, for instance, that a 1 percent increase in the revenues of oil companies because of an increase in the price of oil led to a 2.15 percent increase in CEO pay. Better still, from the perspective of the oil chief, while an increase in the price of oil always correlated with an increase in the CEO’s paycheck, when the price fell, the CEO’s salary didn’t necessarily decline: “While CEOs are always rewarded for good luck, they may not always be punished for bad luck.”
Thanks to the financial crisis and the global recession it triggered, public opinion and politics in much of the world are catching up to this ivory tower critique. Consider Britain, where a Conservative-dominated coalition government began 2012 with a proposal to rein in executive pay. “We cannot continue to see chief executives’ pay rising at 13 percent a year while the performance of companies on the stock exchange languishes well behind,” Vince Cable, the business secretary, told parliament as he announced the new measures. “And we can’t accept top pay rising at five times the rate of average workers’ pay, as it did last year.”
Cable’s reference to the gap between CEO salaries and those of average workers is telling. We may frame our complaints about rising executive compensation with arguments about skimming—that the millions are unearned. But part of our unease stems from something entirely different—that the final outcome, the gap between CEOs and the rank and file, is wrong.
This second concern may very well not be solved by doing a better job of coping with the agency problem. Bertrand and Mullainathan’s finding that there is a lot of skimming going on in the corner office doesn’t, it turns out, make them complete skeptics of the pay-for-performance revolution. Pay for performance actually works, but only in companies where the board is strong enough to truly oversee the chief executive. Boards are best able to do that, Bertrand and Mullainathan discovered, when they have a large shareholder. “An additional large shareholder on the board reduces pay for luck by between 23 and 33 percent”—a big number, especially when you consider how tricky it is in real life and in real time to distinguish between lucky profits and hard-earned ones.
There’s a reason for CEOs to position themselves as superstars—highly talented people being paid for their skill—that goes beyond getting a great deal from the comp committee. Even in an age of tension between the 99 percent and the 1 percent, we love our superstars. That’s because, as the New York Times’s David Carr put it in a deft analysis of the popularity of basketball player Jeremy Lin, in aspirational America, we all like to think that we are superstars-in-waiting, on the verge of our big break: “The Lin story has broken out into the general culture because it is aspirational in the extreme, fulfilling notions that have nothing to do with basketball or race. Most of us are not superstars, but we believe we could be if only given the opportunity. We are, as a matter of practicality, a nation of supporting players, but who among us has not secretly thought we could be at the top of our business, company or team if the skies parted and we had our shot?” That’s the irony of superstar economics in a democratic age. We all think we can be superstars, but in a winner-take-all economy, there isn’t room for most of us at the top.
FOUR
RESPONDING TO REVOLUTION
It is better to lead revolutions than to be conquered by them.
—Otto von Bismarck
A lesson from the technology industry is that it’s better to be in front of a big change than to be behind it.
—Reid Hoffman, cofounder and chairman of LinkedIn
He who does not risk, does not drink champagne.
—Russian proverb
On August 9, 2007, BNP Paribas froze withdrawals from three of its funds. Fearing that move would halt interbank lending, the world’s worried central bankers, led by the European Central Bank’s Jean-Claude Trichet, pumped billions into global money markets. Those twin steps eventually came to be viewed as the opening shot in the global credit crisis.
Eight days later, George Soros hosted twenty of Wall Street’s most influential investors for lunch at his Southampton estate, on the eastern end of Long Island. It was a warm but overcast Friday afternoon. As the group dined on Long Island striped bass, fruit salad, and cookies, their tone was serious and rather formal. The meal was one of two annual “Benchmark Lunches,” held on successive Fridays in late August and organized by Byron Wien, a Wall Street veteran who had befriended Soros four decades earlier thanks to a shared interest in then obscure Japanese stocks.
James Chanos, the influential short hedge fund manager, was one of the guests. It was a group, Chanos told me, of “pretty heavyweight investors.” Other diners included Julian Robertson, legendary founder of the Tiger Management hedge fund; Donald Marron, the former chief executive of PaineWebber and now boss of Lightyear Capital; and Leon Black, cofounder of the Apollo private equity group.
In a memo about the luncheon discussion he distributed a few weeks later, Wien wrote that the talk focused on one issue: “Were we about to experience a recession?” We all know the answer today. But just over a year before the collapse of Lehman Brothers definitively plunged the world into the most profound financial crisis since the Great Depression, the private consensus among this group of Wall Street savants was that we were not. According to Wien’s memo, “The conclusion was that we were probably in an economic slowdown and a correction in the market, but we were not about to begin a recession or a bear market.”
Only two of the twenty-one participants had dissented from that bullish view. One of the bears was Soros. “George was formulating the idea that the world was coming to an end,” Wien recalled. Far from being won over by his friends, Soros saw their optimism as reinforcing his fears. He left the lunch convinced that the global financial crisis he had been predicting prematurely for years had finally begun.
His conclusion had immediate and p
ractical consequences. Soros had been one of the world’s most successful and most influential investors: for the thirty years from 1969 through 2000, Soros’s Quantum Fund returned investors an average of 31 percent a year. Ten thousand dollars invested with Soros in 1969 would have been worth $43 million by 2000. According to a study by LCH Investments, a fund owned by the Edmond de Rothschild Group, during his professional career Soros has been the world’s most successful investor, earning, as of 2010, a greater total profit than Warren Buffett, the entire Walt Disney Company, or Apple.
But in 2000, following the departure of Stan Druckenmiller, who had been running Quantum, Soros stepped back from active fund management. Instead, he recalled, “I converted my hedge fund into a less aggressively managed vehicle and renamed it an ‘endowment fund’ whose primary task was to manage the assets of my foundations.”
On August 17, 2007, he realized he had to get back in the game. “I did not want to see my accumulated wealth be severely impaired,” Soros told me during a two-hour conversation in December 2008 in his thirty-third-floor conference room in midtown Manhattan, with views overlooking Central Park. “So I came back and set up a macro account within which I counterbalanced what I thought was the exposure of the firm.”
Soros complained that his years of semiretirement meant he didn’t have the kind of “detailed knowledge of particular companies I used to have, so I’m not in a position to pick stocks.” Moreover, “even many of the macro instruments that have been recently invented were unfamiliar to me.” At the moment he made his crisis call, Soros was so disengaged from daily trading that he didn’t even know what credit default swaps—the now notorious derivatives that brought down insurance giant AIG—were. Even so, his intervention was sufficient to deliver a 32 percent return for Quantum in 2007, making the then seventy-seven-year-old the second-highest-paid hedge fund manager in the world, according to Institutional Investor’s Alpha magazine. He ended 2008 up almost 10 percent, the same year that saw global destruction of wealth on the most colossal scale since the Second World War, with two out of three hedge funds losing money, and he was ranked the world’s fourth highest-paid hedge fund manager. Druckenmiller, his former first lieutenant and a self-confessed admirer of Soros’s approach to investing, came in at number eight.
Plutocrats: The Rise of the New Global Super-Rich and the Fall of Everyone Else Page 17
