The cult of the CEO

Young Ezra Klein complains that he never hears me talk about "the trouble with CEO's". Well, he is young, and can therefore be forgiven for not remembering this piece, along with several other opus magnii (she wrote, hoping that this was the correct latin construction, but very much fearing that it was not), on the principal-agent problem. Presumably he had better things to do, like learn to drive.

I too rue tendency of some conservatives to state, as if the thing were already proven, that anything done by a CEO is for the best because otherwise he wouldn't have done it. (I do note that this is not a vice limited to libertarians; I cannot count the number of times that I have heard some liberal "prove" that advertising makes people buy things they don't "really" want by arguing that if it didn't work, corporations wouldn't spend all that money on it. Corporations spend gargantuan sums of money on projects of little or no value all the time, for which management consultants should get down on their knees and thank God every day.)

Some CEOs really are nearly that brilliant; it's not an exaggeration to say that without Steve Jobs, Apple would currently be a not-very-profitable division of Xerox. Some are really dreadful, driving their companies into the ground while collecting a ton of money from the shareholders.

Most are pretty good at their jobs--arguably not worth what they're paid for them, but that's another rant. But they're all dogged by the principal-agent problem; unless they're the company's founder (and sometimes, even then) their incentives are not the same as those of the shareholders. CEO pay is the most visible, but by far the least damaging, way in which CEOs feather their nests at the expense of the shareholders. As far as the economy is concerned, CEO pay is irrelevant; even if you took the total compensation of all 500 or so CEOs who make more than $1 million and divided it among the bottom 3 income quintiles, it wouldn't cover much more than a modest sampling of the McDonalds dollar menu. Excessively compensated CEOs are a problem for shareholders, who would probably rather have the money to invest in a Blu-Ray player. On the other hand, if the shareholders are really bothered by it, they can hustle down to the annual meeting and vote against it.

Large CEO pay packages may very occasionally create larger problems by demanding large pay packets from an ailing firm--though even there you have to be careful, because what looks like grotesque looting by executives is often a desperate bid by shareholders to keep the officers from deserting a sinking ship. But at any rate, this really doesn't happen all that often, and when it does, it is usually at companies whose CEOs are relatively modestly compensated. Most of the time, their salaries just don't make much difference to the rest of us.

No, my problem with CEOs is that they don't always do what they ought. They've been hired to do what's best for shareholders, i.e. building long-term value by creating exciting new products, or getting better at the production of the things the company already makes. What is good for the CEO, however, is whatever makes him rich and famous. Thankfully, creating exciting new products and building long-term shareholder value often do have that effect, which is why most CEOs do a fairly good job. Unfortunately, they are not the only things that increase the power, prestige, and purchasing power of our erstwhile executives, and those other things often come at the expense of the rest of us.

CEOs are too often empire builders, squandering retained earnings and diluting share values in order to make dubious corporate acquisitions. Or they become enamored of visionary projects which have a low probability of success--but which could, if all the stars align and the moon goes into half eclipse and Glinda the Good arrives with her magic wand, cement the CEO's reputation as a genius of inestimable proportions. Talent that might threaten their sinecure is ruthlessly quashed, and company assets are used to pursue personal vendettas. Corporate money is donated to charities, not because this benefits the shareholders, but because the CEO gets to be photographed accepting an award from Angelina Jolie. Employees are overcompensated because he wants people to like him, or undercompensated because he wants to show the union delegate who's boss. It's a mess.

Unlike unions, though, it really isn't possible to run a company without having a CEO. Someone has to be in charge, because the rest of us are too busy watching back episodes of The Wire on our new Blu-Ray players. That leaves us with the thorny question of how to protect shareholders--and the economy--from the bumbling predations of the managers they hire.

Stock options were supposed to solve that problem. And to some extent, they did. CEO pay may be offensive, but not as offensive as the empire-building indolence of career corporate bureaucrats that characterized mid-century business--and by the 1970s had rendered "Made in America" synonymous with "overpriced junk". But stock options turn out to have problems. Most notably, they are not actually the same thing as holding stock. Options are all upside, no downside; an out of the money option is just as worthless when the stock is at $45 as it is when the stock hits $1 and the NASDAQ starts to threaten delisting. So managers have an incentive to take more risk than is really wise, because just keeping the company plodding along doesn't do them any good. Better to take a long shot flyer on cornering the fur-bearing trout market, which stands at least some chance of making a fortune for the CEO who seals the deal. Stock options also focus executives on hitting short-term earnings targets that will make their options profitable, rather than building long-term value for the company. And they're not as transparent as cash compensation--they're harder to value, and psychologically, a lot of shareholders just don't treat them as real money. Which they are: every time an option is cashed in, the increased supply dilutes the value of their own shares, which is just the same as taking cash out of the company's bank account and handing it to him. Either way, the shares you own are now worth slightly less.

We've fixed some of the accounting problems that led to the most egregious abuses of the late 1990s, but as the options backdating scandals showed, our nation's executives are ever willing to put their shoulders to the grindstone and their noses to the wheel and find some way to shake a little more money out of shareholders' pockets. And, as the Enron and Worldcom executives demonstrate, a few of them are willing to do so by wildly, nay suicidally, inflating earnings statements. I have no idea what to do about this, other than punish 'em when they're caught. It's easy to cry regulation--but if history is any guide, regulation generally serves to entrench the managers, not protect the shareholders.