In my last post on CEO pay, I pointed out that undeservedly high pay for executives would not be a problem on a truly free market, where CEO pay is undistorted by government intervention, as it is today. Nevertheless, there are real challenges in setting CEO pay, challenges that would exist even in a free market. But this is an argument for free markets and against regulating CEO pay. Here’s why.
The basic challenge a company faces when deciding on a CEO pay package is: How best to align management’s interests with those of shareholders? How can the company most successfully attract, retain, and motivate a CEO?
That’s not obvious. It requires a tremendous amount of thought and judgment. What should be the mix between base salary and incentive pay? What kinds of incentive should be offered–stock options, restricted stock options, stock appreciation rights? How should those incentives be structured–over what time frame and using which metrics? And what about a severance plan? What kind of plan will be necessary to attract the best candidate? And on and on. The mere fact some people make their living as executive-pay consultants illustrates how challenging the task is.
Moreover, a company must pay close attention to the internal mechanisms that affect executive pay: How should board members be selected? Who will make up the company’s executive compensation committee? Should there even be an executive compensation committee?
One of the virtues of a free market is precisely that it leaves people free to exercise their own judgment on such matters. If they make a mistake, their company is the one that suffers; if they succeed, others are free to learn from their example.
This is why a free market is sometimes said to unleash a “discovery process.” Only when individuals are free to try any number of different approaches to an undertaking can we see which ideas succeed and which fail, which ideas are good and which–however plausible they may seem in the boardroom or the laboratory–need to be scrapped.
Just look at the history of CEO pay. For decades, CEOs were basically salaried employees. But during the ’90s, stock options came into wide use, helping to more closely tie CEO pay to shareholder interests. Today, stock options are often only one element in a continually evolving set of compensation tools that are helping companies better reward their executives for performing well–and punish them for performing poorly.
If critics of executive compensation get their way, and the government starts dictating how to remunerate CEOs, what will happen to this kind of innovation? What will happen if, instead of leaving companies free to compete to find new and better ways to tie pay to performance, regulators saddle them with a one-size-fits-all “solution”? One thing is for sure: if that happens, we will all pay the price.
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