Limiting CEO pay as a multiple of average employee salary can
solve most problems and make America stronger to lead the world

January 19, 2008

Sankarshan Acharya
Pro-Prosperity.Com and Citizens for Development

Economics Profession Does Not Guide
on CEO Compensation in Best National Interest

The U.S. Congress has scheduled a very important hearing with the ex-CEO of Merrill Lynch and the current CEO of Countrywide Finance.  The question that cannot be answered in such hearing is what the maximum CEO pay should be in the best national interest. 

The field of economics has no satisfactory answer to this question.[1] My rational inference based on decades of research is that the field of economics may have rendered only disservice to the long run welfare of mankind.  The real culprit is the current paradigm of maximization of individuals’ utilities of wealth, used to derive economic policies.  This paradigm induces or brainwashes even the smart people to behave myopically and to undertake actions that are detrimental to humanity in the long run.

A famous economist has said that every individual is dead in the long run and so what matters to him is the utility of his wealth during his life time.  But rules of governance derived from such myopic economic paradigm or thinking can make even the talented individuals ineffective, i.e., unable or unwilling to produce globally competitive goods, services or ideas.  Such paradigm leads to (a) wars by amassing mutually destructive weapons of mass extinction, (b) global warming, (c) depletion of ground water or pollution of surface water,  (d) exhaustion of nonrenewable resources like oil and minerals, and even (e) inability of a nation to generate net exports. 

What Constitute Optimal Governance?

  • Optimal rules of governance have to achieve national goals of unity, stability, universal prosperity and competitiveness

  • Optimal rules of governance must be so comprehensively articulated that vested interests-including the political party establishments, religious gurus, academic professors, government establishments or anyone else-cannot reject such rules without publicly exposing themselves as opponents of national goals.

  • Optimal rules for nations should lead to stability and prosperity of humanity.

CFD researches and freely disseminates optimal rules of governance. One such rule is limiting CEO pay as a multiple of average employee salary to solve most problems and make America stronger to lead the world.

The new paradigm to frame optimal rules of governance should be adopted on the basis of enhancing unity, stability and competitiveness to beget individual prosperity, to the extent feasible.[2] 

CEO Compensation in Best National Interest

How will the new paradigm of governance help set CEO wages?  A nation should not have a goal to enhance wages of only the CEOs.  The nation should not also remain indifferent to exponentially rising CEO pays, especially in faltering companies, when the employees’ wages remain stagnant.  A CEO who is brainwashed by the current paradigm of economics will continue to cannibalize or outsource jobs of his company to enhance his utility of wealth.  This is not in the best national interest because such CEO behavior can lead to social instability and disunity that are detrimental to national well being. 

The new paradigm of governance behooves the lawmakers to specify norms for CEO salaries to enhance the national goal of unity and stability.  Here is a norm:  the upper limit for a CEO’s salary is no more than ten times of the average employee wage.  Such a norm will induce the CEO to raise salaries of his employees.  The President of USA has a salary that is close to this norm. A maximum CEO compensation equal to a multiple (say ten times) of the average employee salary will immensely enhance national goals of unity, stability, prosperity and competitiveness:

  • The CEO will be motivated to enhance the average employee pay because only doing so will increase his own wages.  An increase in average employee salary due to inflation or rising company profitability will translate into a ten-fold increase in the compensation of the CEO.

  • The CEO will still be induced to eliminate unproductive workers to enhance the long-term strength of his enterprise and to boost the average pay of his employees.

  • He will be motivated by the necessity to keep his job long enough to earn pays till his normal retirement, leading to long-term viability and profitability of his company and strength of his employees.

  • The CEO will desist from the current pervasive tendency to retire early after (i) usurping hefty unsustainable short-term bonuses and (ii) enhancing own pay raises based on cooked up short-term boost in company profits due to reckless elimination of vulnerable productive workers to rehire them as consultants for a fraction of pays and more hours of work. 

  • The CEO will have no incentive to outsource jobs because doing so will cut his own pay. He will outsource only if it leads to survival and competitiveness of his company.

  • The debate about taxing the rich at higher rates will no longer be needed.  A flat tax rate can be introduced to simplify the tax code and relieve the burden on the IRS.

  • Good incomes will accrue to the workers who are effective in producing globally competitive goods, services and ideas.

  • The uselessness of current GDP growth will give way to truthful governance to enhance prosperity for all. 

To protect the interest of shareholders of a company, a certain portion of the compensation of every employee including the CEO should include common shares to be vested only upon separation of an employee from the company.

An Example

Suppose that a nation consists of one CEO making $200000 per year and his two employees earning $100000 each per year.  The annual GDP is $400000 in this nation. 

Suppose then that the CEO eliminates the more productive worker to rehire him as a consultant for $20000 per year.  The CEO also borrows for the company $100000 from himself. This plan of cannibalization and increased funding will be supported by the less productive worker still employed, at least when this worker’s pay rises by, say, $10000. 

After restructuring, the CEO decides to take an increased salary of $300000 and the two employees get $20000 and $110000.  Such restructuring raises the size of national economy (total income 300000+20000+110000) to $430000 from $400000 or a growth in GDP of 7.5%.  The average employee salary falls to (110000+20000)/2 = $65000 or 35% and the CEO’s pay rises 50% to $300000.  The company’s indebtedness grows by $100000.  The company’s cash position improves by $70000: cost saving of $80000 through firing and rehiring of a productive worker plus new debt $100000 minus increased pays of $110000. 

Such unbridled CEO sophistry to raise his pays drives the effective workers to perpetual economic slavery with long hours of work.  Such sophistry is unfortunately camouflaged by raising GDP growth that the self-serving CEOs and ex-CEOs hoot as the strength of the U.S. economy.  But the country is becoming vulnerable in reality. The example illustrates that economic boom measured by GDP growth does not translate into prosperity of the vast majority that is supposed to rule in a democracy. The economic boom can be indeed be a bust for many working families.

Conclusion

A strong America that can enhance prosperity for all, achievable by the proposed CEO compensation rule, is obviously more desirable than a perpetually weakened, unstable, vulnerable and non-competitive nation characterized by economic bondage of the vast majority by a tiny fringe.  Only a strong America can lead the world.  Presidential candidate Hillary Clinton expresses her will to reform CEO compensation and financial markets. See the post script.



[1] Here is a paper by yours truly:  ``Maximizing the Market Value of a Firm to Choose Dynamic Policies for Managerial Hiring, Compensation, Firing and Tenuring.'' International Economic Review, May 1992.

[2] A more detailed discourse on this is available in a paper, “Utility of Wealth, Policy and Governance,” http://www.pro-prosperity.com/Research/UtilityWelfareDemocracy.pdf

For Clinton, Government as Economic Prod

http://www.nytimes.com/2008/01/21/us/politics/21clinton.html?pagewanted=2&hp

By DAVID LEONHARDT

Published: January 21, 2008

Senator Hillary Rodham Clinton said that if she became president, the federal government would take a more active role in the economy, to address what she called the excesses of the market and of the Bush administration.

In one of her most extensive interviews about how she would approach the economy, Mrs. Clinton laid out a view of economic policy that differed in some ways from that of her husband, Bill Clinton. Mr. Clinton campaigned on his centrist views, and as president, he championed deficit reduction and trade agreements.

Reflecting what her aides said were very different conditions today, Mrs. Clinton put her emphasis on issues like inequality and the role of institutions like government, rather than market forces, in addressing them.

She said that economic excesses — including executive-pay packages she characterized as often “offensive” and “wrong” and a tax code that had become “so far out of whack” in favoring the wealthy — were holding down middle-class living standards. Interviewed between campaign appearances in Los Angeles on Thursday, she said those problems were also keeping the United States economy from growing as quickly as it could.

“If you go back and look at our history, we were most successful when we had that balance between an effective, vigorous government and a dynamic, appropriately regulated market,” Mrs. Clinton said. “And we have systematically diminished the role and the responsibility of our government, and we have watched our market become imbalanced.”

She added: “I want to get back to the appropriate balance of power between government and the market.”

In the last two weeks, Mrs. Clinton has devoted most of her public remarks to the economy, and she won the New Hampshire primary and the Nevada caucus largely because of support from households making less than $50,000 a year, according to polls conducted by Edison/Mitofsky.

Mrs. Clinton’s approach to the economy would have three main components. She would roll back the Bush tax cuts for households with incomes over $250,000 while creating more tax breaks below that threshold; impose closer scrutiny on financial markets, including the investments being made by foreign governments in the United States; and raise spending on job-creating projects like the development of alternative energy.

“We’ve done it in previous generations,” she said, alluding to large-scale public projects like the interstate highway system and the space program. “We can create millions of good new jobs. But we’ve got to have a plan, and we’ve got to make investments.”

Using blunt and at times populist language in the interview, Mrs. Clinton, Democrat of New York, tried to steer a course between the often business-friendly themes embraced by her husband and the straight populism that John Edwards, the former senator from North Carolina, has used in his presidential campaign this year. Senator Barack Obama, Mrs. Clinton’s main rival for the Democratic nomination, has also begun using more of her kitchen-table language in recent days.

Although the two Clintons share similar views on a wide range of economic issues, she has long been more skeptical about the benefits of freer trade and other aspects of a free-market economy. While he peppered his 1992 campaign speeches with both populism and calls for personal responsibility — including welfare reform — she talks less about irresponsibility among individuals and more about irresponsibility in corporate America and the government.

Perhaps the bigger difference, though, is that Mr. Clinton was running for president when the federal budget deficit was much larger than it is now and the United States seemed to be falling behind Western Europe and Japan in economic competitiveness. Mrs. Clinton is running when the economy has grown at a healthy clip for six years but incomes for most Americans have barely outpaced inflation.

Republicans say that her tax increases on the affluent and her spending proposals would increase the deficit, but Mrs. Clinton’s advisers respond that she, like her husband, is a fiscal conservative. They add that reducing the deficit is no longer sufficient, because today’s problems have less to do with the size of the economic pie than the way it is divided.

“Inequality is growing,” Mrs. Clinton said. “The middle class is stalled. The American dream is premised on a growing economy where people are in a meritocracy and, if they’re willing to work hard, they will realize the fruits of their labor.”

Mrs. Clinton, whose campaign initiated the interview, can speak in both fine detail and sweeping historical terms about the economy — almost as would a policy adviser, which she essentially was for a long time. When talking about the middle class, she divides the decades since World War II into two periods, using the same cutoff point that many economists do.

In the first period, from 1946 to 1973, the pay of most workers rose steadily. The income of the median family — the one earning less than half of all other families and more than half of all others — more than doubled during those years, to almost $50,000, in inflation-adjusted terms, according to Census Bureau data analyzed by the Economic Policy Institute, a liberal group in Washington.

Since 1973, the income of the median family has grown only about 25 percent.

During the earlier period, Mrs. Clinton said, the share of workers in labor unions grew, allowing workers to win raises and benefits that they can rarely win on their own. Marginal tax rates on the affluent were “confiscatory” by today’s standards, she said. (In the early 1970s, the top rate, which applied to income above $1 million in today’s terms, was 70 percent; the top rate now is 35 percent.)

Jobs once paid enough that only one parent in many families needed to work, saving them from expenses like day care. And not only did the federal government invest in public goods like the highway system, but companies also invested more in communities than they do today. In Rochester, for example, Kodak helped build hospitals and schools.

“You had a corporate ethos, that, because of the more self-contained American economy, was really focused on community,” Mrs. Clinton said. “There was a sense of multiple obligations. It wasn’t just to one’s shareholders. It was also to one’s employees, to one’s community.”

Mrs. Clinton mentioned technological change, which has eliminated the need for many blue-collar jobs, as well as global trade, which studies suggest may be holding down the wages of some Americans.

But when discussing the causes of the middle-class wage slowdown, she tends to focus not on market-based changes, like technology and trade, but on institutions, like unions and the government.

Her first priority, she said, would be changing the tax code. She has proposed tax credits for college tuition, retirement savings, health care and alternative energy use, most of which would go to lower- and middle-income families. She would also raise the top marginal rate to 39.6 percent, its level for much of her husband’s administration. Increasing high-end tax rates would bring in $52 billion a year, her campaign says, and help pay for some of her other proposals.

“It’s shocking that there is such a continuing political pressure to lower tax rates on the wealthy, when so much of what we look back on now with nostalgia and pride,” she said, referring to the decades immediately after World War II, “was at a time when those who were well off were paying a significantly higher percentage of their income.”

She said she would also use the White House bully pulpit to inveigh against the current level of executive pay. Though it is difficult to reduce such pay with new laws, she said, she wants to consider proposals that law school and business school professors have made along these lines.

“We have this class now of professional corporate managers who are not the creators of the corporation — they very rarely had anything to do with starting the business or building it up,” she said. “And then they come in and they believe their No. 1 obligation is to secure the biggest possible pay package at the expense at everybody else.”

On this subject, she sounds very much like Mr. Edwards, yet, unlike him, she has still received considerable support from top executives. She has been endorsed by John J. Mack, the chief executive of Morgan Stanley; Peter Chernin, president of the News Corporation; and Lloyd C. Blankfein, the chief executive of Goldman Sachs, who received a $67.9 million bonus last year.

David Bonior, Mr. Edwards’s campaign manager, said her support from Wall Street suggested that she would be as friendly to corporate America as her husband was.

Still, if Mrs. Clinton is elected, she might bring the toughest regulatory scrutiny of any president in a generation. Mr. Clinton nudged the Democratic Party toward a more laissez-faire economic policy, and President Bush has gone considerably further in this direction.

“I just believe strongly that we are in great need of a total overhaul,” she said, arguing that the Bush administration has outsourced too many functions and damaged the federal government’s competence.

Last March, when many officials in the administration and at the Federal Reserve were saying that the housing slump would not be too severe, she warned in a speech about “trouble signs below the horizon” with subprime mortgages. She has suggested that she would have been more willing to crack down on some lending practices than the current administration has.

But perhaps the most telling example of her approach is how she would try to clean up the mortgage problems. She has called for a 90-day halt to foreclosures on homes with subprime mortgages and a five-year freeze in the interest rates on all subprime mortgages, many of which are scheduled to jump.

The proposal would most likely reduce the number of coming foreclosures. But it would also potentially reward real estate speculators and others who took out mortgages they could not afford. In the process, it could raise interest rates for everyone else, economists say, by forcing banks to rewrite the terms of loans retroactively and to lose money on some.

Her plan goes significantly further than Mr. Obama’s. She decided, in effect, that the downsides of rewarding irresponsible borrowing was outweighed by the benefits of reducing foreclosures.

She said she could “understand totally” the frustration of people who did not take out such loans and now wonder why the government would help those who did. “What I’m trying to do,” she said, “is practically stabilize the patient so we can begin to try to cure this mess that everybody got us into.”

If she were to win the Democratic nomination and the general election, she would most likely take office at a similar economic moment as her husband, with the economy struggling to emerge from a downturn. In 1993 — with Mrs. Clinton playing a role that Bob Woodward later described as “de facto chief of staff” — Mr. Clinton pushed through an economic plan without a single Republican vote.

Many analysts say that plan played a role in the Democrats’ loss of Congress the next year, but it is also widely credited with helping lay the groundwork for the 1990s boom. Mrs. Clinton suggested that she would be willing to take a similar approach in 2009.

“You try to find common ground, insofar as possible. But if you really believe, you have to manage the economy,” she said. “You have to stake a lot of your presidency on it. Because at the beginning is when you’re strongest.”