It's Lucrative at the Top

Yet CEOs might be worth every penny, despite the image put forth by critics of fat cats lining their pockets with millions in salary, bonuses and stock options at the expense of employees' benefits and shareholders' returns. Landier, along with Princeton Prof. Xavier Gabaix, argue in their joint paper, "Why Has CEO Pay Increased So Much?", that skyrocketing compensation has more to do with exploding market capitalizations and small talent pools than unfettered greed.

"What we show is that if you believe what matters is the money at stake, the pay is pretty reasonable," says Lanier.

Thanks to huge run-ups in the stock market and strong economic growth, U.S. corporations have exploded in size in the past few years. As such, every business decision made by a CEO has more of a financial impact riding on it. What's more, there aren't very many men and women qualified to sit in the corner office of a major corporation, making competition for the few who are fierce. As the laws of supply and demand kick in, compensation packages climb exponentially.

"To become the CEO of an S&P 500 company, you need experience managing divisions," says Lanier. "Ultimately these people are drawn from a small pool. Yes, we have more and more people with MBA degrees, but the people who can be a CEO of those big companies are from a small pool."

And as long as U.S. companies continue to grow, there's little likelihood this trend will reverse. Landier calls it part of the price of success of the American economy. No matter how obscene the multimillion-dollar bonuses, private jets and country club memberships appear, shareholders and employees will probably have to get used to it.

SmartMoney.com: The subject of executive compensation has caused a stir in the past few years. How did you look at CEO pay that's different from how shareholders and securities regulators have looked at the issue?

Augustin Landier: There's a lot of outrage around this topic, and the feeling that CEOs are paid too much. The question for us economists is what's too much? How should we benchmark this thing? If you think seriously about it, what's the right benchmark to measure compensation? But the facts are true: There has been a spectacular growth in CEO pay. The average compensation package has increased by 500% in real terms since the beginning of the '80s. That's a huge number.

The question is why. Many journalists and commentators believe it's a sign of deterioration in corporate governance. That somehow a lack of governance in American companies lets these guys exploit the naivete of boards to get paid a lot. What we show is that if you believe what matters is the money at stake, the pay is pretty reasonable. By money at stake, we mean the value of the company — the equity of a company plus its debt — that has increased by about 500% in this time. It's increasing market caps.

The impact of a CEO — when he makes a mistake, has a new idea — this has a direct impact on the value of the company. Companies are competing for the best talent. So CEO pay should increase one for one with the aggregate value of companies. This is something people got confused about; everyone knew compensation was increasing with the value of companies. But if your company is bigger than the next company by 100% at a given point in time, the CEO's pay shouldn't increase by 100%.... [The important thing is] what are your competitors paying their CEOs? If there are very few big companies, your compensation should be small because not many companies are as big, and are competing for that talent.... The idea that if you're the CEO of a company double in size than my company, your pay should double is not true. If all companies increase in size, then the compensation should increase. It's determined by competition between companies, competing for top talent.

What we argue is that the order of magnitude of the pay increases is not so big.... It's because of supply and demand effects here for managerial talent. Indeed, governance matters. I think it's a little contra-factual to say that governance is deteriorating in the U.S. [The huge rise in executive pay] is not for lack of governance. There is a lot of governance in this country.... But we believe it's an effect on a smaller order of magnitude than the 500% [growth in market cap]. Governance can't explain that large increase.

SM: So chief executives' salaries aren't really driven by talent or track record but by competition effects of the CEO market itself?

AL: When you think about these numbers, the levels of compensation of CEOs, what they reflect is not the belief that CEOs are supermen, that they're so unique.... It comes from the difference in function and talent. When we calibrate the model, we show that if you replace the most talented CEO in the economy by the number 250 in the scale of talent, then you decrease the value of your company by something like 0.02%. That's a very small amount. But the money at stake is so big; these companies are valued at hundreds of billions of dollars. If you multiply that 0.02% by dozens of billions, say, you get a very big number. That's how we should think about CEO compensation. It's going to be very hard to decrease CEO compensation. It doesn't make sense to try to get a cheap CEO because it's little money compared with how much the company is worth.