Why CEO pay continues to rise and rise

A century ago, JP Morgan said that the pay of the top worker in a company should not exceed that of the average production worker by more than 10 times. In America, in 1980, that differential was 40 times. By 1990, it had moved to 85 times. Today, it is more than 400. Even after the dotcom bubble burst, wiping out around US$8 trillion in shareholder value, and lay-offs spread through corporate America, CEO pay continued to rise. Why was this so?

The reason for this is what social scientists call the “Lake Wobegon Effect” (after the Garrison Keillor novel, Lake Wobegon Days, about a town where all the children are above average). Here’s how it works in the context of CEO pay:

When a vacancy comes up for a top post, the compensation committee, set up by the board to determine how much the CEO should be paid, asks its pay consultant to come up with an appropriate figure. The pay consultant cites a figure which is the average pay for that post. The compensation committee, because it has to act under the premise that its candidate is above average, has to pay above that figure. And as it does so, the industry average rises, ensuring that the pay consultant will cite a higher figure next time. The average, thus, is a watermark that continues rising regardless of the state of the economy or the stock market. And the self-sustaining feedback loop moves faster as the turnover of CEOs rises, as it has been doing in the last few years.

Thus, CEO pay functions in an entirely different sphere from the economy, and has virtually nothing to do with how a company may be doing or how the rest of management gets paid. You might think that this could be arrested if strong boards, with high standards of corporate governance, put their feet down and pay only what they deems reasonable. But this would only work if it happened across the board, simultaneously, and that is hardly likely. Also, as this Guardian report by Polly Toynbee indicates, non-executive board member’s renumerations have also been zooming madly in recent times, on a self-sustaining feedback loop of their own.

I am a fervent supporter of capitalism, free markets and globalisation. Such spiralling and disjointed CEO pay undermines capitalism, though, just as America’s farm tariffs, for example, undermine their rhetoric on free trade. No system works without checks and balances – as Toynbee sums it up, “Capitalism is the only system that works - but it only works when properly regulated by a benign state. And that must include controlling dysfunctional pay distortions at the top and bottom that corrupt society and demolish the government's hopes for social justice.”