January 16, 2020
(This post first appeared on my Patreon page.)
This is not an abstract philosophical question. Boeing forced out its CEO, Dennis Muilenburg last week. Muilenberg had played a major role in overseeing the development and production of the Boeing 737 Max, a plane which was recently involved in two major crashes, resulting in hundreds of deaths. Following these crashes, and the grounding of the plane in March, evidence has come out that Boeing did not take seriously many safety issues that were raised by people working on the plane.
Since Muilenberg was the person in charge for the last four and a half years, it is certainly understandable that the company would want to send the guy packing. Boeing had long been a company with a solid record of putting safety as a top priority. It no longer has that reputation, which is hugely important for a maker of civilian airplanes. While this was clearly not all Muilenberg’s fault, as CEO he has considerable responsibility.
All of this is pretty straightforward. The part of the story that many people may find jarring is that Muilenberg walked away with $62 million in pay and benefits when he left the company.
This is jarring because it would be pretty hard to argue that Muilenberg had done a good job running the company. He leaves it with a horrible reputation problem, for which it may take many years to recover.
But we know shareholders don’t care about reputation, they care about money in their pockets. They might be okay with handing Muilenberg $62 million if he made them a lot of money.
However, that doesn’t seem to be the case. Boeings stock did do quite well under Muilenberg, rising by just under 130 percent over the four and half years that he was at the helm. But the stock of Airbus, Boeing’s main global competitor, almost matched this performance, and that was without the assistance of the big cut in corporate taxes that Trump gave to U.S. corporations in 2017. In other words, there is little reason to think that Muilenberg did anything for shareholders that any other Boeing CEO would not have done.
According to the press statements about Muilenberg’s parting gift, this was money that Muilenberg was owed, not some sort of severance package. It would take a careful reading of his contract to determine whether this is completely true, but from an economic standpoint, it doesn’t really matter.
The people on Boeing’s board presumably are not stupid, and in any case, they hire lawyers to write contracts who should understand the law. They all know how to write a contract that says the CEO walks away with little or nothing if they have done major damage to the company in their tenure, sort of like custodians and dishwashers typically walk away with little or nothing when they get fired for messing up on the job. For some reason, Boeing’s board chose not to write a contract like this for its CEO.
This would just be a peculiar quirk if Boeing was the only company whose board didn’t seem to know how to write contracts, but in fact this seems to be the norm. To take another recent example, John Stumpf walked away with $130 million from Wells Fargo after he was caught in a major scandal where the bank issued phony accounts for hundreds of thousands of customers.
Going back another decade, Home Depot CEO, Robert Nardelli, got a $210 million severance package in 2007 even though the company’s stock price had been cut in half under his tenure. The stock price of Lowes, the company’s major competitor, went up 40 percent over the same period.
There are no shortages of examples where CEO pay doesn’t bear any relationship to the returns provides to shareholders. Corporate boards surely can write contracts that more closely tie CEO pay to the returns that they provide to shareholders, above someone just spinning their wheels in the CEO position. The fact that boards fail to tie CEO pay closely to value actually provided to shareholders strongly suggests that the boards are not working for shareholders, they are working for the CEOs.
For some reason, most progressives have been determined to say that CEOs get their outlandish pay for serving shareholders, in spite of evidence to the contrary. This matters if we are interested in bringing down CEO pay, both because shareholders can be powerful allies and also because it says a lot about the legitimacy of CEO pay.
If CEO pay is justified by the extraordinary returns they provide to shareholders, then the $10 million, $20 million, or even $30 million paychecks are a story of capitalism working as it is supposed to. In this story, CEOs are hugely productive people who manage to produce enormous benefits to shareholders, who should be happy to give back a fraction of their gains in CEO pay. (For this discussion, I’m ignoring the fact that the gains may be the result of breaking unions, making unsafe products, wrecking the environment, or other anti-social acts. I’m just focusing narrowly on returns to shareholders.)
But if the pay is not closely related to returns to shareholders, but rather the result of having their friends on corporate boards deciding how much they get paid, then it implies that these outlandish paychecks are not justified by the logic of the market. This is just flat out corruption.
And, the exorbitant pay of CEOs has an enormous spillover effect. If the CEO is getting $20 million, the other top executives are likely getting paychecks close to $10 million, even the third tier of corporate executives is likely earning $1-2 million a year. Imagine we were back in the world of fifty years ago when CEO pay was 20-30 times the pay of a typical worker. This would mean paychecks in the neighborhood of $2 to $3 million. In that world, the next echelon of the corporate hierarchy is likely earning not too much over $1 million, and the third tier is way back in the high six figures.
Exorbitant CEO pay also affects pay outside the corporate sector. It is common for the heads of major charities and universities presidents to earn well over $1 million a year. Other top executives can be earning at least in the high six figures, if not also crossing $1 million. These salaries would be radically lower if these top executives could not claim that they would be able to earn ten times as much in the private sector.
At the most basic level, the idea that the huge run-up in CEO pay over the last four decades is justified by the returns they produce for shareholders is undermined by the fact that returns have been relatively low by historical standards. They were high in the 1980s and 1990s, as there was a historic run-up in price to earnings ratios, but since then they have been relatively much lower than in the decades of the 1950s and 1960s.
This largely reflects the fact that when the price-to-earnings ratio is high, it is impossible to give shareholders the same percentage return on their investment. When the PE is 15 to 1, a 3 percent dividend is just 45 percent of earnings. However, when the PE is 30 to 1, a 3 percent dividend would be 90 percent of corporate earnings. The dividend yield, or its equivalent in buybacks, almost certainly has to fall when the PE rises.
Slower growth, now averaging close to 2.0 percent annually, (compared to 3-4 percent in prior decades) also means lower capital gains on average. To maintain historical stock yields, it would be necessary for PEs to fall in a period of slow growth.
A possible explanation for the rise in PEs is that share buybacks drive up the price-to-earnings ratios in a way that dividend payouts do not. (I hope to be able to test this later this year.) This would be completely irrational behavior by investors, but we have seen plenty of irrational behavior by big investors in recent decades, such as the stock and housing bubbles.
If paying out money as share buybacks does raise PEs, then it would create a scenario in which corporate management is effectively making money for itself and current shareholders, at the expense of future returns to shareholders. At a point in time, shareholders are presumably largely indifferent between getting their money in dividends or buybacks (tax considerations can make the latter more desirable), but a higher PE means returns will be lower for people buying stock in the future.
Anyhow, it is clear from the data that the last two decades have not been especially good ones for shareholders, which is consistent with the idea that they are being ripped off by top management. It is also the case that the vast majority of the upward redistribution of the last four decades has been from ordinary workers to high-end earners, not from labor to capital.
This means that if we want to reverse the upward redistribution we should be focusing on the high-end earners who got the money. CEOs should be among our prime targets, both for the money they directly receive and for the impact that their pay has on the wage distribution as whole.
It is unfortunate that few progressives seem interested in pursuing the evidence that CEOs are ripping off their companies. Part of this may be due to the usual difficulty that progressives have in dealing with new ideas, but part of it likely stems from their desire to lash out at the market rather than asking how the market can be structured to produce different outcomes.
It was not the market that led to a situation where mediocre CEOs can earn $20 million a year, it was a corrupt structure of corporate governance. The latter can be changed much more easily than eliminating the market economy.