Regular readers will recall that I'm spending my Christmas break writing a review for the Texas Law Review of Lucian bebchuk and Jesse Fried's book Pay Without Performance: The Unfulfilled Promose of Executive Compensation. Their book is getting a lot of attention both in the press and the academy - and deservedly so, as they do a very good job as advocates of a so-called managerial power model of executive compensation.
Bebchuk and Fried forcefully contend that “managers have used their influence [over corporate boards of directors] to obtain higher compensation through arrangements that have substantially decoupled pay from performance." In other words, the executive compensation scandal is not the rapid growth of management pay in recent years, as too many glibly opine, but rather the failure of compensation schemes to award high pay only for top performance. They attribute this failure to management’s control over the board of directors. They claim that “directors have been influenced by management, sympathetic to executives, insufficiently motivated to bargain over compensation, or simply ineffectual in overseeing compensation.” As a result, executive pay has greatly exceeded the levels that would prevail if directors loyal to shareholder interests actually bargained with managers at arms-length.
In today's WSJ($), economist and blogger Tyler Cowen offers a very thoughtful review of Pay without Performance. Key observations:
Messrs. Bebchuk and Fried focus their criticisms on the "arm's length" model of hiring CEOs. According to such a model, a potential CEO and the company in search of an executive will strike a rational bargain, calculating costs and benefits on each side and picking the compensation scheme that will best serve the purposes of all concerned. Messrs. Bebchuk and Fried assemble an array of evidence to suggest that cozy deals between CEOs and their boards get in the way of this admirable rationality.
But the arm's-length model is not so easily defeated. Assume the worst -- that CEOs and boards are in cahoots. Outside capital still approaches this corrupt bundle from its own arm's-length point of view. If the problem were a big one, surely some firms would set up truly rational and fair executive-pay incentives to attract capital at a lower cost. And over time we would expect those firms to succeed in the marketplace. But there is no evidence of this happening. One would think that new firms would be in the best position to correct the inefficient status quo, but the data do not suggest that they are set up with more "rational" models of governance.
(Temporary nonsubscriber link here.) In other words, you would only buy Bebchuk and Fried's thesis as a complete explanation of what's going on with executive compensation if you have no faith in markets at all. When you see my review, you'll see that I've concluded that their model is but one of several complimentary rather than competing explanations for the observed pattern of executive compensation practices.
