In the latest installment of his series “Breaking Through the Jobless Recovery,” economist William Lazonick explores how excessive executive pay weakens our economy.
Focusing on shareholder return is a very bad way for companies to govern the allocation of their resources. Public shareholders simply trade outstanding stock, but taxpayers and workers make risky investments in the innovation process and should be able to lay claim to a fair share of the returns. Yet since the 1980s, top executives of major US business corporations have invoked the flawed obsession with maximizing shareholder value to justify the exclusion of taxpayers and workers from sharing profits. Instead, they have been intent on increasing not only cash dividends -- the traditional way of distributing value to shareholders -- but also stock buybacks, which are used to manipulate their company's stock price. So shareholder return has become the measure of success of the publicly traded corporation.
This kind of financialized corporate behavior contributes to both the government deficit, as corporations look for every opportunity to avoid paying taxes, and income inequality, as corporations favor payouts to shareholders over investment in innovation and job creation. Ultimately, by neglecting investment in the productive capabilities of the labor force, the corporate pursuit of shareholder return undermines the ability of a rich country like the United States to maintain its standard of living.
So why do they do it?
All you have to do is look at how US corporate executives are paid. According to AFL-CIO Executive Paywatch, the ratio of the average pay of CEOs of 200 large US corporations to the pay of the average full-time US worker was 42:1 in 1980, 107:1 in 1990, 525:1 in 2000, and 343:1 in 2010. Over the past two decades, gains from exercising stock options have been by far the most important component in the outsized pay of top corporate executives. The average annual compensation in 2009 dollars of the 100 highest paid corporate executives named in company proxy statements was $20.6 million in 1992-1995, of which 63% came from exercising options; $77.8 million in 1998-2001, with 79% from options; and $61.8 million in 2004-2007, with 73% from options. For the top 500 in executive pay, average annual real compensation increased from $9.0 million in 1992-1995 with 51% from options to $29.5 million in 1998-2001 with 72% from options to $27.2 million in 2004-2007 with 60% from options (see my paper, "The Explosion of Executive Pay and the Erosion of American Prosperity").
But doesn't stock-based compensation of executives reflect the real productivity gains of their companies, translated into higher stock prices? Answer: no. Most of the gains from exercising stock options are the result of stock-price speculation and manipulation. The price yields on S&P 500 stocks averaged 13% per annum in the 1980s, and 15% per annum in the 1990s, rates of increase that far outstripped productivity growth in even the most dynamic sectors of the US economy. Especially in the Internet boom of the last half of the 1990s, stock-market speculation drove up stock prices -- and executive pay. In the 2000s, however, stock-price yields averaged minus 2% per annum, with considerable volatility. A massive manipulation of stock prices through stock buybacks pushed the S&P 500 Index even higher in 2007 than it had been at the zenith of the speculative boom in 2000 -- again to the great benefit of the stock-based pay packages of the corporate executives who made these resource-allocation decisions.
The problem is that in the United States, the practice has been to grant executives stock options that are unindexed to the productive performance of their company. If the stock price soars as a result of speculation, such as it did in the late 1990s, then executive pay explodes. If the stock price is manipulated through a multiplication of stock buybacks, as occurred especially in 2003-2007, executive pay rises as well. With a system that permits top corporate executives to be rewarded by stock-market speculation and manipulation, what need do they have for innovation and job creation?
The "Say-on-Pay" provision of the Dodd-Frank, sanctioned by the Securities and Exchange Commission in January 2011, has given public shareholders the right to express their opinion to corporate management on issues related to executive compensation. According to a report from Institutional Shareholder Services, during Say-on-Pay's first months in operation, stock-market investors endorsed over 90% of company board executive pay proposals. In my view, the impact of "Say-on-Pay" will be to encourage corporate boards and executives to disgorge even more cash flow to shareholders, with all its negative effects on the health of the US economy.
A case in point that I have analyzed in an article in The Globalist is an agreement on the conditions that, under Say-on-Pay, General Electric (GE) shareholders placed on the stock options of GE CEO Jeffrey Immelt. One of the conditions is that Immelt only gets to exercise some of his options if, over the next four years, GE generates at least $55 billion in cash from operations from its industrial businesses, as distinct from its financial arm, GE Capital Services. This provision creates the impression that GE's shareholders want Immelt to invest in real productive assets. Indeed, upon being named chair of President Obama's Council on Jobs and Competitiveness, Immelt declared that "there is nothing inevitable about America 's declining manufacturing competitiveness if we work together to reverse it."
Really? Over the past four years GE generated almost $73 billion in cash from its industrial operations. In effect, therefore, armed with Say-on-Pay, GE's shareholders are willing to reward CEO Immelt if he oversees a 25% reduction in GE's industrial businesses. So much for working together to reverse the nation's declining manufacturing competitiveness.
The only effective counter to the explosion of executive pay and the erosion of American prosperity will be a social movement of people, as taxpayers and workers. It's time to demand that US business corporations be governed according to the principles of innovative enterprise, and not by the anti-innovation principle of maximizing shareholder value.
William Lazonick is director of the UMass Center for Industrial Competitiveness and president of The Academic-Industry Research Network. His book, Sustainable Prosperity in the New Economy? Business Organization and High-Tech Employment in the United States (Upjohn Institute 2009) was awarded the 2010 Schumpeter Prize.