The Milton Friedman Doctrine Is Wrong. Here’s How to Rethink the Corporation.

We won’t fix the problem until we address the nature of the corporation.

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By Susan Holmberg and Mark Schmitt

The compensation of American executives—CEOs and their “C-suite” colleagues—has long been a matter of controversy, especially recently, as the wages of average workers have stagnated and economic inequality has moved to the center of the national debate. Just about every spring, the season of corporate proxy votes, we see the rankings of the highest-paid CEOs, topped by men (they’re all men until number 21) like David Cote of Honeywell, who in 2013 took home $16 million in salary and bonus, and another $9 million in stock options.

Rarely, however, does the press coverage go beyond the moral symbolism of a new Gilded Age. Coverage of CEO pay usually fails to show that the scale of CEO pay packages—and the way CEOs are paid—comes at a cost. At the most basic level, the company is choosing to pay executives instead of doing other things—distributing revenues to shareholders, raising wages for workers, or reinvesting in the business. But the greater cost may be the risky behavior that very high pay encourages CEOs to engage in, especially when pay is tied to short-term corporate performance. CEO pay also plays a major role in the broader trend toward radical inequality—a trend that, evidence has shown, precipitates financial instability in turn.

CEO pay has been controversial in the United States for more than a century—for as long as corporate management has been a profession separate from ownership. In economic booms, CEO pay skyrockets and, after the inevitable bust, it attracts attention—as the million-dollar paychecks of executives such as W.R. Grace of Bethlehem Steel and Charles Mitchell of National City Bank drew notice in the 1930s. But the most recent debate focuses on the staggering, uninterrupted rise in CEO pay over the past three decades, following a long period of moderation in both executive pay and in overall economic inequality. Between 1940 and 1970, average CEO pay remained below $1 million (in 2000 dollars). According to the Economic Policy Institute (EPI), from 1978 to 2013, CEO pay at American firms rose a stunning 937 percent, compared with a mere 10.2 percent growth in worker compensation over the same period, all adjusted for inflation. In 2013, the average CEO pay at the top 350 U.S. companies was $15.2 million.

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Given the polarization and stalemate of current politics, one might expect CEO pay to be one of those issues, like tax loopholes, that the public occasionally gets upset about but the political system, which demonstrably tilts toward the interests of the wealthy, ignores or can’t resolve. But in fact, the cause of restraining CEO pay has had remarkable political success—measured by legislation passed and regulations enacted—since the 1930s, when CEO pay first became a contentious public issue.

The problem isn’t that the political system doesn’t want to deal with excessive CEO pay. There have been any number of formal efforts to rein in executive pay, involving a host of direct regulation and tax changes. But most of the specific efforts to reduce executive pay—through major policies such as a limit on the tax deductibility of high salaries, as well as more modest accounting and disclosure legislation—have fallen short. That’s because the story of skyrocketing executive pay is a story about our conception of the corporation and its responsibilities. And until we rethink our deepest assumptions about the corporation, we won’t be able to master the challenge of excessive CEO pay, or the inequality it generates. Is the CEO simply the agent of the company’s shareholders? Is the corporation’s only obligation to return short-term gains to shareholders? Or can we begin to think of the corporation in terms of the interests of all those who have a stake in its success—its customers, its community, and all of its employees? If we take the latter view, the challenge of CEO pay will become clearer and more manageable.

Decades of Modest Pay

It’s strange to imagine, but the position of corporate CEO is a relatively new one in the history of American business, and CEO pay has been controversial for most of that time. According to Harwell Wells of Temple University’s law school, who has written one of the only historical accounts of the CEO pay debate, before the “great merger movement” of the early twentieth century, all but a few companies were small and were run by managers who owned a sizeable portion of the business. At the beginning of the twentieth century, the face of industry was morphing from thousands of small manufacturing firms into fewer large corporations. As owners of these companies opted out of day-to-day management, employee-executives gradually took over their roles, and “management” became a profession. It didn’t take long for CEO pay to begin to climb—and for the American people to object.

There is very little information available about CEO pay prior to 1935, when the 1934 Securities Exchange Act implemented Form 10-K, the annual report companies are required to file with the Securities and Exchange Commission (SEC). One of the only surveys available tells us that, prior to World War I, the average salary of an executive at a large corporation was $9,958, or $220,000 in 2010 dollars, which would be paltry for most of today’s mid-management, let alone today’s high-level executives.

Convinced that an executive salary would never inspire managers to feel the same stake in their company that owners inherently have, American Tobacco and U.S. Steel were among the first companies, in the 1910s, to institute “performance pay” in the form of bonuses for senior executives, who received a percentage of annual profits in addition to their base salary. By 1928, a survey of 100 industrial companies showed that 64 percent of executives received a bonus, typically in the form of cash linked to the firm’s annual profits. The same survey found that for those executives, bonuses constituted 42 percent of average total compensation. Incidentally, while it’s impossible to do any real comparison with the available data, there does seem to be a noticeable jump in pay after bonuses were introduced. The 1928 survey of industrial firms reports that the median annual compensation for executives was $69,728, or $892,000 in 2010 dollars—four times the pre-World War I numbers.

How the Explosion in CEO Pay Happened

The most comprehensive historical analysis of CEO pay numbers, by Carola Frydman and Raven Saks Molloy, indicates that average pay remained below $1 million (in 2000 dollars) from 1936 to the mid-1970s—despite the fact that there was a lot of company growth during that time span. It even fell in the 1940s: sharply during World War II, and more gradually in the later part of the decade, which, according to Frydman and Saks Molloy, was “the last notable decrease in the past 70 years.” From the early 1950s to the mid-1970s, the inflation-adjusted value of executive pay increased very gradually, averaging less than 1 percent growth a year. Growth in pay picked up speed starting in the mid-1970s and continued until the recent financial crisis, with the most significant increase happening in the 1990s, when annual growth rates topped 10 percent. According to EPI, between 1978 and 2012, CEO pay rose about 875 percent.

Starting in 1930, a handful of shareholder lawsuits put the issue of executive pay on the front pages, culminating in Congress’s “Pecora hearings” on the securities industry. The hearings revealed that Charles E. Mitchell of National City Bank (now Citibank), who was blamed for fueling the speculation that led to the Crash of 1929, took home more than $1 million a year leading up to the crash, a revelation that inflamed shareholders and the American public and prompted the federal government to begin to institute reforms, starting in the early 1930s with the Securities Act and the Securities Exchange Act.

The New Deal response to the Pecora revelations centered on disclosure, which was already a major component of the nascent structure of corporate reform and Wall Street regulation. As previously noted, the 10-K form on which we find chief executive salaries to this day was created in the Securities Exchange Act of 1934. Soon after, in 1938, the SEC required shareholder proxies to report compensation of the corporation’s top three executives. Since the New Deal, the SEC has, among other regulations, instituted a variety of disclosure rules, including a 2009 rule requiring some companies to disclose what they pay for compensation consulting. And it has recently proposed a strong disclosure rule—mandated by the Wall Street Reform and Consumer Protection Act of 2010, better known as the Dodd-Frank bill—on the CEO-worker pay gap.

Another avenue to target executive pay has been through the tax code. Tax provisions specifically addressing executive pay date back to 1950, when restricted stock grants were given preferential treatment. And overall changes to tax rates have likely had a significant effect on executive pay. Thomas Piketty has suggested that a major cause of the sharp rise in inequality beginning in the late 1980s was the tax reform of 1986, which reduced individual rates and closed corporate loopholes, making it more lucrative for executives to take money as salary than to leave it in the company.

But it wasn’t until the beginning of the 1990s that the current effort to use the tax code to target executive compensation directly took hold. Compensation expert Graef Crystal’s 1991 book, In Search of Excess: The Overcompensation of American Executives, became a best-seller, but more important was a single reader: then-presidential candidate Bill Clinton. CEO pay became a core issue of Clinton’s 1992 campaign, during which he pledged to eliminate corporate tax deductions for executive pay in excess of $1 million a year. In the 1993 budget legislation, this policy became part of the U.S. tax code, known as Section 162(m). But it came with a few qualifiers. The most significant was the exception for executive pay based on specific corporate performance goals, called “performance pay.”

The IRS offered a technical definition for performance pay but, to corporations’ collective glee, allowed a lot of room for interpretation, so companies quickly began moving executive pay from salaries to mainly stock options and restricted stock grants. If you look at a standard proxy statement, you’ll notice that most companies say outright what sections of their executive compensation packages are designed to avoid being taxed.

After In Search of Excess and Section 162(m), CEO pay continued to skyrocket, now at an even faster pace. Using the performance-pay loophole, during the longest sustained run-up in stock prices since the 1920s, the spike was driven by short-term measures of earnings or stock performance.

The Value of a CEO

Aside from the occasional anomaly, where pay clearly doesn’t align with performance (as in, for example, the case of JPMorgan Chase’s Jamie Dimon, who recently announced 10,000 potential layoffs by the end of 2014 despite his $20 million in pay last year), one might ask what is so wrong with high CEO pay. Especially when it’s linked to profits or stock performance, haven’t executives earned this compensation?

Indeed, that is what the economic theory of marginal productivity—which holds that any worker is paid based on what he or she adds to the firm’s income—would suggest. Harvard economist N. Gregory Mankiw has argued that “the most natural explanation of high CEO pay is that the value of a good CEO is extraordinarily high.”

But this is the most tautological of economic ideas. The theory requires very strict assumptions that are found nowhere in the real world, and it cannot be put to the test, because it is impossible to measure the performance of a CEO in terms of his or her marginal contribution to a firm, particularly when success is the function of an entire team. And when “pay for performance” is based on the company’s stock price, it is really “pay for luck,” because more of the share price performance that CEOs are paid for is driven by broader macroeconomic factors, particularly economic upswings, than anything the executives did. But when the economy declines, and the share price goes down with it, executives are usually not penalized. Marginal productivity theory seems to move in only one direction.

The foundation of “pay for performance” is “agency theory” or “shareholder primacy.” The intellectual godfather of shareholder primacy is Milton Friedman, who wrote in 1970 that “a corporate executive is an employee of the owners of the business [i.e., the shareholders]. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible,” without breaking the law or cheating people. At a time when CEO pay was less than 40 times what the typical worker earned (the multiple is now more than 350), Michael C. Jensen and William H. Meckling codified Friedman’s argument with their seminal 1976 article, “Theory of the Firm.” The purpose of corporate governance, they argued, is about finding ways to align the incentives of shareholders (whom they referred to as “principals”) and executives (“agents” of the shareholder-owners). This theory has enraptured economics departments and business and law schools for decades and profoundly shaped how corporate officers, shareholders, taxpayers, policy-makers, and even most Americans think about the roles and responsibilities of corporations.

Though shareholder primacy has never been challenged in a serious way, a bit of heresy did happen at the 2013 annual meeting of the Allied Social Science Associations, where mostly neoclassical economists converge to present their research, graduate students scramble for tenure-track jobs, and what should be debatable ideas like marginal productivity theory are taken as pillars of research. That year, a French financial economist named Jean-Charles Rochet gave the keynote address, in which he skewered the very foundation of pay for performance. Cornell Law School professor Lynn Stout calls it the “shareholder value myth”—the idea that corporations exist for shareholders and no one else. Rochet told the conference: “Everyone knows that corporations are not just cash machines for their shareholders, but that they also provide goods and services for their consumers, as well as jobs and incomes for their employees. Everyone, that is, except most economists.”

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Rochet was, if anything, being too kind. While economists are certainly to blame for presenting an ideology as a natural law, shareholder primacy has also infiltrated the consciousness of most politicians and journalists and has been transmitted in our classrooms, to the extent that today, most of the American public has come to take this myth for granted.

The idea that there are other corporate stakeholders besides shareholders—the stakeholder framework—is not a new one. But it’s gained traction recently as a result of Rochet’s speech, Stout’s 2012 book, The Shareholder Value Myth, and the emergence of new corporate forms like benefit corporations, which promise to be accountable and transparent about their impact on the environment and surrounding communities, and often aspire to a “double bottom line” of private and public value. A high-profile union-recognition battle at a Volkswagen plant in Chattanooga earlier this year, in which the company not only didn’t challenge the union but actually invited the vote, brought new attention to the German corporate model, based on “works councils” that include labor in decision-making, and a much broader vision of the corporation’s obligations.

At the heart of almost every effort to curb CEO pay have been the assumptions of marginal productivity and shareholder primacy. There is no silver bullet to slow the growth of CEO pay. It requires all the tools in our toolbox—the tax code, disclosure and accounting rules, and so forth. But none of those will be fully effective without rethinking the very purpose of the corporation, a question that is too often outside the scope of debate.

The True Costs of High CEO Pay

Before we go any further, we should consider how CEO pay is determined. In theory—and this is what corporations would like us to believe—compensation packages for CEOs are determined by independent boards of directors, by compensation committees made up of members of the board, and sometimes by compensation consultants, who make pay recommendations based on their analysis of the market.

But Lucian Bebchuk and Jesse Fried, in their 2004 book Pay Without Performance, argued that this procedure is a comforting fiction. They wrote that skyrocketing executive pay is the blatant result of CEOs’ power over decisions within U.S. firms, including compensation. Being on a corporate board is a great gig. It offers personal and professional connections, prestige, company perks, and, of course, money. In 2013, the average compensation for a board member at an S&P 500 company—usually a part-time position—was $251,000. It only stands to reason that board members don’t want to rock the CEO’s boat. While directors are elected by shareholders, the key is to be nominated to a directorship, because nominees to directorships are almost never voted down. Bebchuk and Fried showed that CEOs typically have considerable influence over the nominating process and can exert their power to block or put forward nominations, so directors have a sense that they were brought in by the CEO. Beyond elections, CEOs can use their control over the company’s resources to legally (and sometimes illegally) bribe board members with company perks, such as air travel, as well as monetary payment.

Usually the CEO pay debate pivots on the public’s distaste for extreme inequality. While Thomas Piketty has recently provided us an impressive historical account of how capital accumulation increases inequality, Joseph Stiglitz, in his 2012 book The Price of Inequality, and former Labor Secretary Robert Reich’s recent documentary Inequality for All have moved the conversation by broadening our grasp of how economic inequality, including between CEOs and the typical worker, harms our society. What we haven’t talked about enough is how the assumptions and incentives driving CEO pay, which primarily encourage executives to raise the price of the company’s stock, can damage the economy by encouraging companies to take on excessive risk, rewarding fraudulent behavior and curtailing real investment and innovation.

A successful business leader or entrepreneur needs to be willing to evaluate and take risks. Starting a business, moving into new markets, and developing new products all come with great risks—of losing profits, shutting down departments, even closing a company’s doors. One of the main arguments for high CEO pay is that it compensates executives for being exceptionally calculating risk-takers. Yet there is plenty of evidence that shows us that when CEOs are paid with stock—either options or grants—it can enable executives to become very wealthy very quickly without bearing much risk at all. This creates the financial motivation for CEOs to make shortsighted and very high-risk decisions in order to boost their company’s stock prices, which will ultimately line their own pockets. The effects of this behavior, particularly with CEOs in the financial industry, can be measured in higher share-price volatility (meaning large swings in share prices) and in bank failures, such as those of 2008 and 2009, which had profound consequences for the broader financial and economic system.

More troubling about the ways in which CEOs are paid is that incentives can easily move from risky behavior toward outright fraud, including misrepresenting the company’s finances and illegal stock-options backdating. The backdating of stock options became a scandal in the late 2000s. By retroactively changing the date when a stock option was granted, typically to an earlier date when the share price was lower, companies can change the baseline by which performance was measured, making it look better than it was, in order to pump up executive pay. At its peak, this was not a rare practice: A study led by Bebchuk showed that between the mid-1990s and mid-2000s, 12 percent of the firms in the sample backdated options for their CEO, boosting total compensation by around 20 percent. Many studies demonstrate that firms found committing fraud have greater stock option-based compensation, suggesting that the greater the incentive for CEOs to maximize the company’s stock price, the greater the incentive the CEO has to engage in fraudulent activities to accomplish this objective.

CEO pay that is ultimately based on the stock price invites another easy trick to show performance: stock buybacks. The problem, according to economist William Lazonick, co-director of the UMass Center for Industrial Competitiveness, is that funds for stock buybacks come at the expense of other priorities. By choosing to buy back publicly held shares, executives can push up the price of the stock without actually investing in the company’s capital, research and development, or workers.

Lazonick’s research provides many examples. For several decades after World War II, IBM had a lifetime employment policy, which was the norm for that era. In the mid-1990s, IBM shifted gears from manufacturing to software and services, and global employment dropped from 374,000 to 220,000. A leader in the U.S. offshoring movement, IBM announced in 2011 a strategic plan for the years until 2015, the main objective of which is to raise their earnings per share from $13.44 to $20 by increasing “operating leverage” (i.e., layoffs) and buybacks. IBM bought back $107 billion of its stock between 2003 and 2012, $13.9 billion in 2013 alone, and $8.2 billion in the first quarter of 2014. All these financial moves have had the effect of boosting “performance pay” for executives without the slightest improvement in the company’s revenues, market share, or profits.

Performance pay, on the model encouraged by the 1993 reform, has been tested. What we’ve learned is that it rewards not performance, but shortsightedness, excessive risk, and even fraud, and that the consequences go well beyond radical inequality to include the kind of crisis that nearly took down the economy in 2008, abrupt layoffs and plant closings to meet shareholder expectations, corners cut on products that risk consumer safety (as seen at General Motors), and desperate attempts to evade the costs of environmental and workplace safety regulation.

From Shareholders to Stakeholders

There is an alternative. If Rochet, Stout, and others are right that a corporation has obligations beyond delivering short-term gains to the shareholders of the moment, then surely that alternative view of the corporation can provide a sounder foundation for thinking about CEO pay. CEOs should be rewarded for productivity and performance, yes, but success should be measured in terms that reflect the interests of all the stakeholders in a corporation, and the corporation’s own health.

The stakeholder corporation is not a new idea. The term stakeholder has been in circulation since the 1960s to characterize the key groups of people that support an organization. R. Edward Freeman brought it into the management world in 1984, when he published Strategic Management. The book proposed that effective management consists of balancing the interests of all the corporation’s stakeholders, including employees, customers, and communities:

Simply put, a stakeholder is any group or individual who can affect, or is affected by, the achievement of a corporation’s purpose. Stakeholders include employees, customers, suppliers, stockholders, banks, environmentalists, government, and other groups who can help or hurt the corporation. The stakeholder concept provides a new way of thinking about strategic management—that is, how a corporation can and should set and implement direction. By paying attention to strategic management, executives can begin to put their corporations back on the road to success.

The concept of the stakeholder corporation has percolated since Freeman’s book, and interest in this model has slowly begun to take root, particularly since the failed United Auto Workers vote at the Volkswagen plant in Chattanooga.

German corporations like VW are far friendlier than their U.S. counterparts to worker rights and “co-determination.” [See “The Church of Labor,” Issue #22.]Works councils, or Betriebsrat, are essentially “shop floor” organizations that represent workers and institute labor law at the local level. The works council is what the Germans proposed in Chattanooga but, after a drawn-out public battle, workers at the plant rejected the idea by voting against unionization, which was opposed by the state’s Republican politicians, but not by the company.

The stakeholder corporation is not only a brilliant model, as the German economic success, especially in manufacturing, shows—it is also the key to the unresolved problem of CEO pay. Shareholder primacy is now so self-evidently flawed that we should be emboldened to think of a range of options—through policy, corporate norms, and culture—for changing CEO pay practices. The irony, as Cornell’s Stout points out, is that broadening the scope of corporate stakeholders would benefit many shareholders as well, because “long-term shareholders fear corporate myopia.”

Imagine what becomes possible when we start to understand that executives and managers are not strictly beholden to shareholders—who hold their shares for an average of four months—and share prices. When executives and directors are free to consider a range of stakeholders—workers, suppliers, creditors, customers, shareholders, and the community in which they’re based—in managing a company, it inherently changes their time horizon from the next quarter to the next decade or quarter-century and beyond, because most of these stakeholders have deeper investments in the company.

The next steps in controlling CEO pay fall into two categories. The first should involve reconsidering and reversing the failed practices that were the result of shareholder primacy. The second would begin to advance the vision of the stakeholder corporation.

The most obvious priority is to close the performance-pay loophole and stop subsidizing pay practices that encourage CEOs to behave like financial speculators. Last year, Democratic Senators Richard Blumenthal and Jack Reed, with Congressman Lloyd Doggett of Texas, introduced the Stop Subsidizing Multimillion Dollar Corporate Bonuses Act, which would cap the deductibility of compensation at $1 million, as Clinton had originally proposed, regardless of the form that compensation takes. The legislation also broadens the range of Section 162(m) by applying it not just to public companies but to all companies that file quarterly reports with the SEC. It would also no longer be limited to CEOs and the three highest-paid executives in a company; it would apply to any employee earning more than $1 million.

UMass’s Lazonick proposes stronger regulation of stock buybacks. The current SEC rule, he argues, “has given top executives license to use buybacks to manipulate the market.” He also suggests that the SEC rescind its current rule and “conduct a Special Study, on the scale of its 1963 study of securities markets that resulted in the creation of NASDAQ, of the possible damage that open-market repurchases have done to the U.S. economy over the past three decades.”

One small and familiar step, endorsed even by shareholder-primacy advocates, would be to move toward more independent boards of directors by reducing the power of the CEO in the nominating committee. Another option, still based on traditional assumptions, would be for companies to pay their executives for performance only after the fact, with performance measured by what Edward D. Hess of the University of Virginia’s Darden Business School and author of the 2000 book Smart Growth calls “authentic earnings.” Hess identifies “non-authentic earnings” as “numbers manufactured creatively by accountants and investment bankers.” Authentic earnings, based solely on real transactions with real customers, provide a broader and more accurate picture of a company’s productive capacity, engagement with new markets, and technological innovation than share price. Hess also challenges the idea that corporate success should expect earnings growth to be continuous and linear. Successful companies might not always be growing. It would be complex, but not impossible, to structure tax incentives for CEO pay based on the measures Hess identifies.

But it’s necessary to go well beyond these steps, which don’t challenge the assumptions that led to the 1993 reform. Yes, we need to reform corporate boards, but let’s do it by following the successful German model and creating a place for workers at the board table. Employee board-level representation is a core part of Germany’s corporate “dual structure”: a management board for day-to-day functions and a supervisory board for more high-level decisions, akin to U.S. boards. Depending on a company’s number of employees, up to half of the supervisory board members are employee representatives rather than shareholders.

And yes, we need to redefine performance pay, but let’s reward companies and CEOs that not only keep executive pay down but increase the well-being of all those connected to the corporation. One smart, still-theoretical proposal would adjust the corporate tax rate based on the ratio of CEO pay to the average pay for workers in the company. At the moment, this is difficult to implement, or even to study, because the data on average pay is invisible or unreliable. In some cases, it should include employees of firms, often offshore, that contract solely with the parent company, and it might have to be adjusted based on industry sector—for example, a firm like Apple, where the average employee might be an engineer, will look much better than a firm like Costco, even though Costco pays very well for its sector. But the reporting provision of Dodd-Frank, if implemented effectively, could provide the data needed to develop a policy that would push against inequality in both directions.

Beyond policy efforts, we need to change our cultural understanding of what corporations are for. It’s highly ironic that one of the most articulate critiques of shareholder primary was delivered by one of its most grandiose beneficiaries: Jack Welch of General Electric. After years as one of the best-paid celebrity CEOs, and after taking a retirement package worth $417 million, including tax-free perks such as club memberships and the use of private aircraft, Welch told the Financial Times in 2009 that the doctrine of shareholder primacy was “the dumbest idea in the world,” and added: “Shareholder value is a result, not a strategy…your main constituencies are your employees, your customers, and your products. Managers and investors should not set share price increases as their overarching goal…. Short-term profits should be allied with an increase in the long-term value of a company.” A few days later, Welch backtracked, but his words make a biting case against the doctrine on which he built his career and reputation.

When even Jack Welch can see that Milton Friedman’s doctrine was no eternal rule, but one economist’s theory with no basis in law, then business schools, economics departments, and financial journalists should be able to do the same. If they can train students, including future CEOs, how to think creatively about the challenges corporations face in building viable businesses that meet their obligations to all their stakeholders, then even if CEOs continue to be well-paid professionals—although not at today’s stratospheric levels—at least they will be paid for helping their companies and communities become better off.

2016 June 9

Originally published here.

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  • Robyn Ryan

    Economics, like religion, is based on theories, not science.

    • Robyn perhaps you should rethink your faith in Science …… Economics is based on theories, which are based on observations. Do not put too much “faith” is science, since a lot of science is also based on theories, which are based on observations. Note that in 1946 most scientist did not believe in the “BIG BANG” theory, by 1966 most did, and now in 2016 some science are saying the “Big Bang” theory is not correct …. Sounds a lot like economics! In fact look at any science book that is 100 years old, and see how many of their theories are still valid today.

      • John M Legge

        Mainstream economic theories are not based on observations and observations do not confirm these economic theories. See Daniel Kahneman
        100 year old science books offered a pretty good description of observed reality; to the extent that they have needed updating, it is the basis of increasingly precise observations, not fundamental misconceptions.

  • tomjlowe

    Dean Baker points out that the right to incorporate is in itself a very valuable right granted by society to private individuals on the optimistic premise that such an arrangement benefits society as a whole. There is nothing wrong with requiring them to fulfill their end of the implied contract to serve the common good.

  • Jeff ….. Perhaps this is new to you but Shareholders are people, with all the problem of people. Also, companies are very concern about their employees, and their customers. And their reputations …. In fact they are very concern about that, since a lot of their profits are based on customers repeat business. The real issue is how some customer/people teat businesses.

    • fairleft

      Many shareholders are not people, actually, and nearly all Shareholders hold their shares purely as investments, often as short-term investments. When companies are oligopolies or duopolies, and that is how most of the U.S. economy is organized, they are not very concerned with their customers or their reputations. They are primarily concerned with their rate of profit, especially quarterly profit, and they know their customers have in effect nowhere else to go. The short-termism cripples economies. It can be cured by government intervention that forces or at least strongly incentivizes a reasonably long term perspective.

  • John M Legge

    Application of principal-agent theory to corporate management is a false step made possible by the orthodox economists static equilibrium view of the world.

    A short excerpt from Economics versus Reality:

    “In the rush to eliminate X-inefficiency by the provision of what economists describe as appropriate incentives, the cost to the economy as a whole of supporting the lifestyles of top management has grown by at least one and possibly two orders of magnitude: by some estimates senior management remuneration is now consuming 10 percent of corporate profits in the United States. Similar effects are probably occurring in the rest of the English-speaking world; but only in the United States is transparency taken to the point that the necessary data to form a conclusion is readily and freely available.
    “Companies are formed by entrepreneurs who raise cash for expansion by selling shares in the prospective profits to investors. The company, as an incorporated person, is not really owned by anybody; but it is called into existence to further the entrepreneur’s ambitions, not those of the shareholders. The attempt to solve the X-inefficiency problem by the application of principal-agent theory has led to an explosion in the salaries and other benefits enjoyed by senior corporate managers and an even more cautious approach to productive investment by the corporations that they manage.”
    The suggestion in this article that over-paying chief executives encourages risk taking is dubious: the focus on quarterly earnings discourages investment in innovation, since the return on innovation generally takes more than three months to arrive. The nearest thing to risk taking is increasing leverage by share buybacks funded by debt.

  • Duncan Cairncross

    There is another very serious problem with sky high CEO pay

    Sensible people work until they have enough plus a margin for a rainy day and to leave to the family.
    Once they have that they are “satisfied” – and don’t need to put major effort into that part of their lives
    Given that being a CEO is a difficult ball aching job that takes you away from your family

    Why do they continue to do it do it?
    The present CEO’s are “insatiable” they literally cannot be filled
    This is a well-known type of mental illness
    A “satiable” person would take the salary for a short time and leave
    What has happened is the “sane” and “satiable” people in those type of positions leave
    Leaving behind the “insatiable” and “insane” people

    The old saying is
    “Pay peanuts and get monkeys”
    We should add
    “Pay millions and get loonies”

  • Adrian Byram

    High CEO pay certainly contributes to overall economic inequality, but it is hardly the major factor. Even if all 500 of the Fortune 500 CEOs are highly overpaid, that’s only 500 folks.
    To address inequality one has to look beyond CEOs — investment bankers, hedge fund execs, entrepreneurs, sports and entertainment stars, and most importantly, wealthy investors. There are far more of these people, and their average annual net gains would make most CEOs envious.


    Harari in Sapiens (one of Bill Gates Top 5 Books of the Summer) makes a compelling argument that any financial / monetary system is based on trust and the general acceptance of legal, ethical, and practical fictions that enable mass cooperation. If the, perhaps intentionally, convoluted Friedman justification for excessive CEO to employee pay multiples is exposed as unjust and impractical to the 99%, what then, is preventing the increasingly alienated 99% from grabbing pitchforks? Only a few possess the imagination, skill, and courage to advance entirely different economic paradigms, as did Kelso, who proposed a new social contract for the legal fiction we call the corporation. Kelso’s procedure for linking the financing of capital formation to trusts that benefit all stakeholders as corporate loans are repaid through future profits has been creatively applied to enable the 99% to become stakeholders in future growth without taking anything from existing owners. What is the objection?

  • Anthony Sperryn

    I tend to think that change is best achieved by a series of little steps, each of which might be considered incontrovertible and beneficial, rather than by full-frontal dispute.

    It seems to me that going, to some extent, with the grain of capitalism (though not the full-blooded far right version) could be preferable.

    I have long been suggesting that, if you give the boss-man, CEOs etc fancy bonuses of shares and cash incentive payments, everyone in the firm might get the same, pro rata to their basic pay. From the cleaners upwards, and no nonsense about so-called self-employed part-time workers being excluded.

    Have you got someone who could develop this theme? It would, of course, require legislation, which ought not to be too difficult to enact in a democratic society.

  • Jenn Egan

    Whoa, a lot of information….we must not forget, and I say this knowing that our CEO’s are grossly overpaid…we must however attract the best of the best to these roles. Point to ponder.

  • mikegale

    Thought provoking and interesting.

    Thought Experiment: If you believe that the problems discussed here are caused by the legislative framework, how would you voluntarily organise to avoid them.

  • George McKee

    The authors’ hearts are in the right place, but they are not thinking in evolutionary terms. The evolutionary perspective on shareholder value would try to identify a measure of “fitness” for the organization, and ask how it is maximized by the organization’s properties and operations. If CEO pay and market cap are the measures by which corporations are judged for potential fitness, then perhaps those measures are not the proper ones.

    Holmberg & Schmitt imply that fitness includes customer and employee values. It doesn’t take an SEC study and burdensome governance structures like German employee works councils to allow natural selection to do its magic. All that is needed is expose these measures more effectively, and the free market should do the rest. Show that satisfied customers and well-treated employees increase corporate fitness, and make reporting of customer satisfaction and employee well-being in a standard format mandatory for public companies. Investment funds that maximize the long term discounted return for their holdings will take advantage of the market distortions that those measures will expose, and take their profits. The rest of the markets will soon follow.

  • Kris

    Of course there is a silver bullet: pass laws limiting the ratio of CEO to average worker pay. This was in force in Sweden for decades. I’m not necessarily saying this is the best – or the worst – way to address the problem, merely pointing out that the author’s arguments accept the box within which they’re being limited.

  • A good leader with a good team can make all the difference!

    Pay for performance does not need to be bad either. It should be tied to the interests of the share- and the stakeholders by taking a sustainable, company survival-ensuring, adaptive long-term perspective.

    Some family-owned and directed companies manage to do it after all and show some mechanisms for instituting and implementing such pay for performance. The solution for hired managers without ownership stake is to link pay to effective short, medium and long term performance by basing parts of yearly pay on different time horizons by short, medium and long term vesting periods.

  • No More Neos

    Friedman espoused neoliberalism, the “new” “freedom” of unfettered capitalism. There’s a reason all of this deregulation has been destroying countries and the environment over the past 4 decades. This is what actually trickles down into society – lawless behavior.

    Neoliberalism refers to the “new” “freedom” of deregulated, unchecked capitalism that was promoted in the 70’s by economist Milton Friedman, who was a devout follower of Fredrich Von Hayek, the Austrian economist and father of neoliberal ideology. (Austria, btw, was the #1 exporter of Nazis.)

    “I long ago formed a view of capitalism that regards it as similar to fire. It is a powerful force which can warm our home and cook our food. In short, it can be very useful, maybe even essential, but ONLY if it is kept tightly controlled.

    Fire has no conscience, it only wants to be fed, and it always demands more. Before one brings fire into their home, one builds a fire-proof containment vessel. When designing this fire-box, we do not let ‘fire’ decide how thick to build the steel walls or how tightly the gaskets fit. ‘Fire’ does not even get a vote.

    We have given in to the demands of ‘fire’. We have sacrificed all the furniture. We have allowed fire to escape the box and become the master. The house is burning down, the roof is gone, the walls are burnt almost to the substructure and our very foundation is at risk.

    Viewed in this manner, everyone, whether or not they are totally anti-‘fire’, can understand the urgency of getting the damn thing back in the box.”

    • Veralidaine

      Deregulation? In what universe?

  • No More Neos

    Great article, but it misses the unchained elephant in the room! The problem isn’t so much about how profits are being distributed, but what the parameters of profit-making should be. Neoliberalism and its wildfire consumption of the planet must finally end.

    Former World Bank Staffer Explains How Neoliberalism Is Destroying The World

    More destructive than bombs, money has become the weapon of choice for the global elite, for the hidden hand of finance can plunder and conquer entire nations, assimilate whole cultures, exploit resources and rape the earth while forcing billions into poverty, all with the surprising stealth of pen-strokes and business contracts.

    Neoliberalism is the economic and political philosophic driving force in the world today. It suggests that human progress is the result of competition, best expressed by an extremist version of unfettered capitalism, where privatization of profits and socialization of losses are acceptable ethics, regardless of human and environmental costs incurred along the way.

    Neoliberalism is the killer plague of the 21st century. Neoliberalism is economic fascism. It is a criminal doctrine. Globalized neoliberalism privatizes public goods for private profit. Neoliberalism led by Washington with the shameful complicity of Europe has in the last fifteen years killed between 12 and 15 million people by wars, famine, deprived health services… forced refugees. Today a small world elite of corporate and Wall Street CEOs and selected politicians call the shots. ~ Peter Koenig

  • The Neoliberal Status-quo Economics has built great Industrialized Developed Countries like the US, Japan, Germany; however, with the ongoing globalization and the high productivity, the China’s Industrialization and the Internet the pro supply forces controlling the world forever have evolved into pro-demand, equilibrium such that the best example is the increasing inequality, accumulating Debt, the high Unemployment, Underemployment; so the Orthodox Economics has become obsolete, underperforming; the shady business of large corporations employ less than a % globally but takes about 70% of the revenue and therefore any system must deleverage such disadvantages to prompt Market Development, save Earth from pollution of increasing poverty. Only China has succeeded in reducing such poverty by targeted flexible economics, indeed!