Are CEO's Overpaid?

To contact us Click HERE
Are CEO's Overpaid? I confess that my knee-jerk answer to this question is "YES"! But Steve Kaplan makes a strong case for a more nuanced answer in Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges," published in July as Chicago Booth working paper 12-42. Here's a sketch of some of  his arguments and graphs.

 First, just as a matter of getting the facts straight, CEO pay relative to household income did spike back in the go-go days of the dot-com boom in the late 1990s, but since then, it is relatively lower. Kaplan argues that there are two valid ways to measure executive pay. One measure looks at actual pay received, which he argues is useful for seeing whether top executives are paid for performance. The other measure looks at "estimated" pay, which is the amount that financial pay packages would have been expected to be worth at the time were granted. This calculation requires putting a value on stock options, restricted stock grants, and the like, and estimating what these were worth at the time the pay package was given. Kaplan argues that this measure is the appropriate one for looking at what corporate boards meant to do when they agreed on a compensation package.

Here's one figure showing actual average and median pay totals for S&P 500 CEOs from 1993 to 2010. Average pay is above median pay, which tells you that there are some very high-paid execs at the top pulling up the average.  Also, average CEO pay spikes when the stock market is high, as in 2000 and around 2006 an  2007. Median realized pay seems to have crept up over time. 
Here's a figure showing estimated pay--that is, the value of the pay packages when they were granted. But this time, instead of showing dollar amounts, this graph shows average and median CEO pay as a multiple of median household income. Average pay again spikes at the time of the dot-com boom. Kaplan emphasizes that estimated CEO pay is on average lower than in 2000 and that the median hasn't risen much. My eye is drawn to the fact that median pay for CEOs goes from something like 60 times median household income back in 1993 to about 170 times median household income by 2010.

An obvious question is whether these pay levels are distinctive for CEOs, or whether they are just one manifestation of widening income inequality across a range of highly-paid occupations. Kaplan makes a solid case that it is the latter. For example, here's a graph showing the average pay of the top 0.1% of the income distribution compared with the average pay of a large company CEO.Again, the story is that CEO pay really did spike in the 1990s, but by this measure, CEO pay relative to the top 0.1% is now back to the levels common in the the 1950s.

  

Kaplan also points out that the pay of those at the top of other highly-paid occupations has grown dramatically as well, like lawyers, athletes, and hedge fund managers. Here's a figure showing the pay of top hedge fund managers relative to that of CEOs in the last decade. Kaplan writes: "The top 25 hedge fund managers as a group regularly earn more than all 500 CEOs in the S&P 500. In other words, while public company CEOs are highly paid, other groups with similar backgrounds and talents have done at least equally well over the last fifteen years to twenty years. If one uses evidence of higher CEO pay as evidence of managerial power or capture, one must also explain why the other professional groups have had a similar or even higher growth in pay. A more natural interpretation is that the market for talent has driven a meaningful portion of the increase in pay at the top."   

Kaplan also compiles evidence that CEOs of companies with better stock market performance tend to be paid more than those with poor stock market performance, and that CEOs have shorter job tenures. He writes: Turnover levels since 1998 have been higher than in work that has studied previous periods. In any given year, one out of 6 Fortune 500 CEOs lose their jobs. This compares to one out of 10 in the 1970s. CEOs can expect to be CEOs for less time than in the past. If these declines in expected CEO tenures since 1998 are factored in, the effective decline in CEO pay since then is larger than reported above."And the CEO turnover is related to poor firm stock performance ..."

To me, Kaplan makes a couple of especially persuasive points: the run-up in CEO salaries was especially extreme during the 1990s, and less  so since then (depending on how you measure it); and the run-up in CEO salaries reflects the rise in inequality across a wider swath of professions. While I believe the arguments that job tenure can be shorter for the modern CEO, especially if a company isn't performing well, it seems to me that most former CEO's don't plummet too many percentiles down the income distribution in their next job, so my sympathy for them is rather limited on that point.

In this paper, Kaplan doesn't seek to address the deeper question of why the pay for those at the very top, CEOs included, has risen so dramatically.  While the demand for skills at the very top of the income distribution is surely part of the answer, I find it hard to believe that these rewards for skill increased so sharply in the 1990s--just coincidentally during a stock market boom. It seems likely to me that
  cozy institutional arrangements for many of those at the very top of the income distribution--CEOs, hedge fund managers, lawyers, and athletes and entertainers--also plays an important role.  

Distribution of Taxes in 2009: CBO

[Ljava.lang.String;@1e3a1db8

Current Account Imbalances

.lang.String;@67295fd7

Other Air Pollutants: Soot and Methane

To contact us Click HERE
It sometimes seems to me that the arguments over carbon emissions and the risk of climate change have crowded out attention to other environmental issues--including other types of air pollution. Thus, I was intrigued to see the article by Drew Shindell called "Beyond CO2: The Other Agents of Influence," in the most recent issue of Resources magazine from Resources for the Future. Shindell focuses on the benefits of reducing soot (more formally known as "black carbon") and methane emissions (which are a precursor to more ozone in the atmosphere), and identifies which emissions to go after. He is reporting the results of a study with a larger group of authors appeared here in the January, 13, 2012, issue of Science magazine. I'll quote from both articles here.


The starting point for this group was to note: "Tropospheric ozone and black carbon (BC) are the only two agents known to cause both warming and degraded air quality." Thus, "an international team of researchers, including experts from the Stockholm Environment Institute, the Joint Research Centre of the European Commission, the U.S. Environmental Protection Agency, and others" looked at  400 different policies for potentially reducing these emissions.

Here's a capsule overview of the effects of soot and methane from the Resources article: 

"When the dark particles of black carbon absorb sunlight, either in the air or when they accumulate on snow and ice and reduce their reflectivity, they increase radiative forcing (a pollutant’s effect on the balance of incoming and outgoing energy in the atmosphere, and the concept behind global warming), and thus cause warming. They can also be inhaled deeply into human lungs, where they cause cardiovascular disease and lung cancer.

"Methane has a more limited effect than black carbon on human health, but it can lead to premature death from the ozone it helps form. That ozone is also bad for plants, so methane also reduces crop yields. It is a potent greenhouse gas as well, with much greater potential to cause global warming per ton emitted than CO2. But its short atmospheric lifetime—less than 10 years, versus centuries or longer for CO2—means that the climate responds quickly and dramatically to reductions. CO2 emissions, in contrast, affect the climate for centuries, but plausible reductions will hardly affect global temperatures before 2040."

The group looked at costs and benefits to whittle down the 400 measures and eventually selected 14 of them. "Of the 14 measures selected, 7 target methane emissions (from coal mining, oil and gas production, long-distance gas transmission, municipal waste and landfills, wastewater, livestock manure, and rice paddies). The other 7 controls target black carbon emissions from incomplete combustion and include both technical measures (for diesel vehicles, biomass stoves, brick kilns, and coke ovens) and regulatory measures (for agricultural waste burning, high-emitting vehicles, and domestic cooking and heating)."

 The potential gains from the policies that they advocate are shown in this table from Science. The first column of the table shows gains from reducing methane, the second shows gains from the technical fixes for soot emissions and the third shows gains from regulatory measures for reducing soot emissions. The first few rows are physical effects: in particular, you can see that methane the emissions have a bigger effect on crops, but soot emissions have a much larger effect on lives saved. The remaining rows then put monetary values on the reduction in emissions. 



The Science article sums up: "We identified 14 measures targeting methane and BC [black carbon]
emissions that reduce projected global mean warming ~0.5°C by 2050. This strategy avoids 0.7 to 4.7 million annual premature deaths from outdoor air pollution and increases annual crop yields by 30 to 135 million metric tons due to ozone reductions in 2030 and beyond."  Indeed, a "combination of measures to control black carbon, methane, and CO2 could keep global mean warming at less than 2ºC (relative to the preindustrial era) during the next 60 years—something that reducing the emissions of any one agent cannot achieve by itself."


The authors also find that the benefits of such policies far outweigh the costs. "Benefits of methane emissions reductions are valued at $700 to $5000 per metric ton, which is well above typical marginal abatement costs (less than $250)." For soot, "improved efficiencies lead to a net cost savings for the brick kiln and clean-burning stove BC measures. These account for ~50% of the BC measures’ impact. The regulatory measures on high-emitting vehicles and banning of agricultural waste burning, which require primarily political rather than economic investment, account for another 25%. Hence, the bulk of the BC measures could probably be implemented with costs substantially less than the benefits given the large valuation of the health impacts."

The policy agenda for soot and methane is daunting in practical and political terms. For example, it requires measures that affect rice paddies, fossil fuel production and transmission, animal manure, brick kilns, diesel stoves, indoor cooking, and other areas. The agenda is worldwide, and those who receive the benefits will often not align well with those who are likely to end up footing the costs. The Resources article points out that an international coalition involving Canada, Sweden, Mexico, Ghana, Bangladesh, the United States, and the United Nations Environment Programme has embarked on a program to reduce  black carbon and methane emissions. The Climate and Clean Air Coalition to Reduce Short-Lived Climate Pollutants is just getting underway.

Interviewing Darrell Duffie on Financial Economics

To contact us Click HERE
The June 2012 issue of the Region, from the Federal Reserve Bank of Minneapolis, has an insightful interview of Darrell Duffie by Douglas Clement. It's worth reading the whole thing, but here are a few of the highlights that caught my eye. Except where noted, all quotations are from Duffie.

_____________________________

Developing a theory of inattentive investors and market volatility

"In the ideal world, we’d all be sitting at our terminals watching for every possible price distortion caused by demands for immediacy. We’d all jump in like piranhas to grab that, we’d drive out those price distortions and we’d have very efficient markets. But in the real world, you know, we all have other things to do, whether it’s teaching or interviewing economists or whatever, and we’re not paying attention.

"So we do rely on providers of immediacy, and we should expect that prices are going to be inefficient in the short run and more volatile than they would be in a perfectly efficient market, but in a natural way. I have been studying markets displaying that kind of price behavior to determine in part how much inattention there is or how much search is necessary to find a suitable counterparty for your trade."

As a vivid example of how even professional investors aren't always attentive, a footnote to the interview relates one of Duffie's anecdotes on this subject: "In his American Finance Association presidential address, Duffie refers to a Wall Street Journal article (Feb. 19, 2010) that reported, “Investors took time out from trading to watch [Tiger] Woods apologize for his marital infidelity. ...New York Stock Exchange  volume fell to about 1 million shares, the lowest level of the day at the time in the minute Woods began a televised speech. ...Trading shot to about 6 million when the speech ended.”

_______________________________________

Reducing the need for future government guarantees on investments at money market mutual funds

In September 2008, one of the events that created panic in financial markets was when a money market, the Reserve Primary Fund, seemed likely to announce that it had lost money. Investors pulled $300-$400 billion out of money market funds in two weeks, until the government guaranteed the value of your principal in these funds. What might be enacted so that money market mutual funds don't face runs in the future? Duffie explains:

"One of those proposals is to put some backing behind the money market funds so that a claim to a one-dollar share isn’t backed only by one dollar’s worth of assets; it’s backed by a dollar and a few pennies per share, or something like that. So, if those assets were to decline in value, there would still be a cushion, and there wouldn’t be such a rush to redeem shares because it would be unlikely that cushion would be depleted. That’s one way to treat this problem.

"A second way to reduce this problem is to stop using a book accounting valuation of the fund assets that allows these shares to trade at one dollar apiece even if the market value of the assets is less than that. ...  That’s called a variable net asset value approach, which has gotten additional support recently. Some participants in the industry who had previously said that a variable net asset value is a complete nonstarter have now said we could deal with that. ... 

"A third proposal, which has since come to the fore, is a redemption gate: If you have $100 million invested in a money market fund, you may take out only, say, $95 million at one go. There will be a holdback. If you have redeemed shares during a period of days before there are losses to the fund’s assets, the losses could be taken out of your holdback. That would give you some pause before trying to be the first out of the gate. In any case, it would make it harder for the money market fund to crash and fail from a liquidity run. ...

"The SEC has a serious issue about which of these, if any, to adopt. And it’s getting some push-back not only from the industry, but even from some commissioners of the SEC. They are concerned—and I agree with them—that these measures might make money market funds sufficiently unattractive to investors that those investors would stop using them and use something else. That alternative might be better or might be worse; we don’t know. It’s an experiment that some are concerned we should not run. ...  I feel sympathy for the  SEC. It has a tough decision to make."

___________________________________

Addressing instability in the repo market with a public utility for tri-party clearing

The market for repurchase agreements ("the repo market") was one of the financial markets that seized up during the financial crisis in late 2008 and early 2009. Repo agreements are very short-term borrowing, often overnight. But as a result, those using such agreements often want to borrow during the day, as well. The financing for intraday trading is done by "tri-party clearing banks," and essentially all of the tri-party deals in the U.S. are handled by two banks: JPMorgan Chase and Bank of New York Mellon.

"JPMorgan Chase and Bank of New York Mellon handle essentially all U.S. tri-party deals. As part of this, they provide the credit to the dealer banks during the day. Toward the end of the day, a game of musical chairs would take place over which securities would be allocated as collateral to new repurchase agreements for the next day. All of those collateral allocations would get set up and then, at the end of the day, the switch would be hit and we’d have a new set of overnight repurchase agreements. The next day, the process would repeat.

This was not satisfactory, as revealed during the financial crisis when two of the large dealer banks, Bear Stearns and Lehman, were having difficulty convincing cash investors to line up and lend more money each successive day. The clearing banks became more risk averse about offering intraday credit. ...  [T]he amounts of these intraday loans from the clearing banks at that time exceeded $200 billion apiece for some of these dealers. Now they’re still over $100 billion apiece. That’s a lot of money. ..."

"The tri-party clearing banks are highly connected, and we simply could not survive the failure of probably either of those two large clearing banks without an extreme dislocation in financial markets, with consequential macroeconomic losses. So if you take, for example, the Bank of New York Mellon, it really is too interconnected to fail, at the moment. And that’s not a good situation. We should try to arrange for these tri-party clearing services to be provided by a dedicated utility, a regulated monopoly, with a regulated rate of return that’s high enough to allow them to invest in the automation that I described earlier."

________________________________________

What financial plumbing should we be working on now, so that the chance of a future financial crisis is reduced?

"And there has been a lot of progress made, but I do feel that we’re looking at years of work to improve the plumbing, the infrastructure. And what I mean by that are institutional features of how our financial markets work that can’t be adjusted in the short run by discretionary behavior. They’re just there or they’re not. It’s a pipe that exists or it’s a pipe that’s not there. And if those pipes are too small or too fragile and therefore break, the ability of the financial system to serve its function in the macroeconomy—to provide ultimate borrowers with cash from ultimate lenders, to transfer risk through the financial system from those least equipped to bear it to those most equipped to bear it, to get capital to corporations—those basic functions which allow and promote economic growth could be harmed if that plumbing is broken.

"If not well designed, the plumbing can get broken in any kind of financial crisis if the shocks are big enough. It doesn’t matter if it’s a subprime mortgage crisis or a eurozone sovereign debt crisis. If you get a big pulse of risk that has to go through the financial system and it can’t make it through one of these pipes or valves without breaking it, then the financial system will no longer function as it’s supposed to and we’ll have recession or possibly worse."

Some of the preventive financial plumbing that Duffie emphasizes would include (in the words of the interviewer): "broadening access to liquidity in emergencies to lender-of-last-resort facilities," "engaging in a deep forensic analysis of prime brokerage weakness during the Lehman collapse, "
"tri-party repo markets," "wholesale lenders that might gain prominence if money market funds are reformed and therefore shrink," "cross-jurisdictional supervision of CCPs [central clearing parties]," and "including foreign exchange derivatives in swap requirements."

Bringing the plumbing up to code in an older house is no fun at all, and bringing the economy's financial plumbing up to code is not much fun, either. But having the plumbing break under when stressful but predictable events occur is even less fun.

Underfunded State Promises for Retirement Benefits

To contact us Click HERE
The Pew Center on the States has published "The Widening Gap Update" about the shortfalls between what state pension funds have promised and the actual funds on hand. The report also includes some useful information on the extent to which states are prefunding their health care plans for retirees. The report makes for grim reading--and even so, it's probably over-optimistic.

The headline number is $1.38 trillion: "In fiscal year 2010, the gap between states’ assets and their obligations for public sector retirement benefits was $1.38 trillion, up nearly 9 percent from fiscal year 2009. Of that figure, $757 billion was for pension promises, and $627 billion was for retiree
health care."

Some states are doing better than others on funding pension benefits:  Wisconsin is 100% funded; Illinois and Rhode Island are less than 50% funded. Overall, 11 states are more than 90% funded, but  32 states are less than 80% funded.


In general, states are doing much less on pre-funding retiree health benefits. Only Alaska and Arizona have funded more than half of their retiree health benefits. Overall, only 7 states have funded more than 25% of the health care benefits they have promised to retirees.

Many states have negotiated unrealistic promises, and those promises are unlikely to be kept in full. Indeed, Pew calculates that from 2009-2011, 43 states changed their pension plans to hold down future costs."The most common actions included asking employees to contribute a larger amount toward their pension benefits; increasing the age and years of service required before retiring; limiting the annual cost-of-living (COLA) increase; and changing the formula used to calculate benefits to provide a smaller pension check."

These changes mostly affect current employees who have not yet retired, but not always. "Since 2010, 10 states—Arizona, Colorado, Florida, Maine, Minnesota, New Jersey, Oklahoma, Rhode Island, South Dakota, and Washington—have frozen, eliminated, or trimmed their annual COLA
increase for current retirees."

Pew also counts 11 states that altered their policies on retiree health benefits from 2009-2011.  Some examples include extending the time that a worker must be a state employee before qualifying for such benefits (Delaware), increasing employee contributions for retiree health benefits (New Jersey), and capping the subsidy for retiree health benefits (New Hampshire).

A shortfall of $1.38 trillion is obviously enormous, but it also substantially understates the size of the gap. To figure out whether states have set enough money aside for future payments, it's necessary to make some assumption about what return will be earned by the money that has been set aside. Most states assume an average return of 8% per year--which seems pretty optimistic, and lets the states get away with putting much less money aside in the present. A more realistic rate of return would make state pension plans look perhaps one-third less well-funded. Here's Pew: 

"The pension ratings are based on a state’s projected investment rate of return, which for most states is 8 percent. States factor in their expected investment gains when they estimate how much they need to set aside. The Governmental Accounting Standards Board (GASB) is considering new rules that would prompt many states to use a lower rate of return to estimate their bill coming due, which would increase the liabilities states acknowledge. If these rules are adopted, as expected, retirement plan funding ratios would drop, increasing reported pension plan shortfalls. The Center for Retirement
Research at Boston College analyzed a database of state and local plans and found that if the new rules had been in effect in 2010, those plans’ funding levels would have dropped from 77 percent funded to 53 percent."

U.S. Human Capital: Gains Flatten Out

To contact us Click HERE
Some years ago I found myself giving a talk at a university in South Africa, where I discovered that I had apparently been typecast in the role of Defender of Capitalist and Colonialist Oppression. A commonly heard claim in the room was that the U.S. had a high standard of living mainly because it oppressed South Africa, and countries like South Africa. I found myself trying to explain the long-run roots of economic growth: growth of human capital, physical capital, and technology, operating in a market-oriented environment. I pointed out that in modern South Africa, the average adult at present had about 5-6 years of schooling. In the United States, there had been widespread primary schooling back in the mid-19th century, a "high school" movement that spread education further in the early 20th century, and the a burst of college enrollments after World War II. I pointed out that other countries during the last couple of centuries, including Japan and the East Asian "tigers" and China, all built their economic growth on base of expanded mass education. My point was not to deny that buying commodities cheaply has benefited the U.S. and other high-income economies, but to point out that economic growth and the resulting standard of living have roots so much deeper and broader than cheap commodities.

But the notion of a healthy and growing U.S. economy built on steadily rising levels of education is getting to be a few decades out of date. In the July 2012 issue of the Journal of Economic Literature, Daron Acemoglu and David Autor have a lengthy book review called, "What Does Human Capital Do? A Review of Goldin and Katz’s The Race between Education and Technology." (The  JEL is not freely available on-line, but many in academia will have access through their library.) The review makes a number of useful and sometimes subtle points about the interactions between education, skill, wages, inequality, and growth. Here, I'll just focus on their basic point about educational attainment in the United States.

High school graduate rates in the U.S. levelled out rose sharply in the first part of the 20th century, but levelled out several decades ago. They write: "Figure 7, which plots high school completion rates at age 35 by birth cohort for U.S. residents born between 1930 and 1975, shows that the secular trend increase in overall high school graduation rates prevailing since at least 1890 ... sharply decelerated
starting with the 1948 birth cohort and then plateaued with the 1952 birth cohort. It showed no trend improvement over the subsequent three decades."




College graduation rates have risen a bit in recent decades, but the increased is completely due to gains in college graduation rates by women. Acemoglu and Autor write: "Figure 8, which
similarly plots college completion rates at age 35 by birth cohort, reveals an equally discouraging inter-cohort trend in college completions. The aggregate college graduate rate peaked with the 1951 birth cohort and did not begin to rise again until the 1966 birth cohort completed college.
Despite the surge in the college [wage] premium ... there has not been a robust supply response
among recent cohorts."


These two figures also break down the overall rate (blue line) into a rate for males (red line) and females (green line). For men, high school graduation rates are lower for men born in the 1970s than they were for men born in the 1950s. For men, college graduation rates have rebounded a bit, but still haven't returned to the level for men born around 1950.

These graphs measure the quantity of people graduating, but there is little reason to believe that the quality of graduates is improving, either. Acemoglu and Autor: "[T]he United States is also lagging
behind in terms of school quality, particularly in K–12. Goldin and Katz are careful to note that AP calculus students in the United States compare favorably with the advanced mathematics students in almost any country, while the average U.S. student lags behind the average student in most OECD countries in math and science. This quality deficiency is almost as worrying as the lack of
progress in the high school and college graduation margin."


When I was arguing about comparative human capital trends in front of a university audience in South Africa, little was really at stake but debating points. But for the U.S. economy as a whole, the fact that educational achievement levels have flattened out in terms of quantity and quality, so that the U.S. is now falling behind in international comparisons, poses and enormous risk both for the distribution of gains across the U.S. economy and for long-term U.S. growth prospects.
 
For a couple of earlier posts on how other countries are outstripping the U.S. in college attendance, see my May 23, 2012, post here and my July 19, 2011 post here.  For a discussion of the causes of rising wage inequality that draws heavily on the Goldin-Katz argument, see my July 18, 2011, post here.  (Full disclosure: One of the authors of the JEL article, David Autor, is the editor of the Journal of Economic Perspectives, and thus he is my boss.)