Wednesday, June 17, 2009

Executive Pay

Lexington, Kentucky realtor Diana Nave suggested, “I think it is important for people to understand the spread between executives and workers and how far apart it has become.” Agreed. Let’s take a look.
A Little History
In 1940, executives (the three highest-paid officers in the 50 largest US companies) earned 56 times their average worker’s pay. In 1950, that ratio slipped to 34 times, and fell further in 1960 and 1970 to 27 and 25 times, respectively.
Then, in 1980, executive pay grew to 33 times their average worker, and in 1990, to 55 times, approximately equal to that of 1940. In the year 2000, executives were paid nearly 120 times that of their average worker.
So, what was the economic situation in 1940, how was it similar to 1990, and what happened between 1990 and 2000 that caused the average worker to lose so much ground?
The Great Depression may have improved to a recessionary status from 1938 to early 1940, but no economic recovery of significance could take place without government fiscal intervention. The recovery would have likely taken much longer if left to the private sector.
The US Gross National Product had passed the $100 billion mark in 1940, but was just 9 percent above the GNP level of 1929. It was the federal purchases of goods and services for national defense in the pre-war period - a rise from $1.2 billion in 1939 to $2.2 billion in 1940 - when the economy felt the rise in government spending that marked the end of an economically depressed era through the injection of government funds directly into the economy. While many credit the “New Deal,” evidence points more heavily toward defense spending.
After a protracted period of 14%+ unemployment, a combination of a “take any job” mentality, and a new, somewhat underpaid female workforce during the war exacerbated the CEO vs. average worker chasm during this decade, which was not again achieved until fifty years later in 1990.
After a protracted recession in the 1970’s, the 1980’s was a decade during which economic growth depended on a steady rise in consumer spending supported by both increasing debt and prices of stocks and homes. The present U.S. slump signals the end of that consumption-led growth, with an overbuilt housing market and an over employed consumption sector, from car dealers to malls. The question is whether our system can adapt to create new growth to fill the void left by embattled consumers.
The 1940s was a “boom” cycle due to government defense spending, and the 1990s, a “boom” cycle due to consumer spending. Neither was sustainable.
However, in the 1990s, a fundamental economic change took place – a “monetizing” of the financial asset growth – that largely rewarded the financing side of cash flow more than the operating side. Basically, there are three components of Cash Flow:
· Operating Activities, or producing revenue by operating the business at a profit
· Investing Activities, or buying and selling investments like property and equipment
· Financing Activities, or issuing/repaying long term debt (bonds) and issuing/buying back company stock.
As seen in both the Internet bubble in the 1990s and housing bubble in the 2000s, investors often were more highly rewarded for “flipping” their investments (or selling after owning them for a very short period) than for investing for the long-term. Both capital (stock and bond) and real estate investors saw a dramatic increase over the historic long term returns during these periods, and accepted and expected a continuation of those unsustainable returns.
Further, with the focus upon “short term” returns, management compensation became rooted in their ability to produce and sustain those returns by lessening their percentage of “salary” and increasing their percentage of “stock options” and the like, justified by their having the same stake in achieving profitability as their stock holders. Unfortunately, as seen by the collapse of the financial system, incenting management to achieve short-term profits over long-term viability can have disastrous consequences.
Now What?
It’s back to basics, now, for the capital and real estate markets. Real estate loans are again being made as they were for decades – 20% down, 30 year terms, with housing costs no more than 30% of gross income to borrowers with good credit. Stock prices are again reflecting management’s ability to turn a long term profit on the business more than their ability to buy back their own stock at a high return on investment. And executive pay is again reflected primarily in salary rather than stock options.
Are salary caps now appropriate? In my opinion, no. Any attempt to artificially cap prices, as was attempted in the 1970s, has ended in disaster. But, it has also not worked well to “let the market dictate,” as we are well aware now.
Companies must find a way to have the freedom to “bid” for talented people to run their businesses without undue interference, while recognizing that paying those talented people 120 times the salary of their average worker is a poor investment. It’s a complex problem that is fraught with both the tendency to over regulate and do nothing, both of which would be a terrible mistake.
And, while consumer consumption is severely mitigated by unemployment rates not seen since the 1980s, a return to conspicuous consumption seems, at least for the foreseeable future, passé. It is incumbent upon the US to convert the financial to the operating side of its future cash flow by innovating, i.e., producing new goods and services that address the needs of a global population in need of sustainable sources of food, housing and energy. As those businesses form, those who provide capital for their formation must demand a more horizontal business model that compensates innovators more closely to the level of their managers.
It’s a big job.

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