Jim Manzi has an article up at The Atlantic Business where he talks about a recent article about how CEOs don’t matter as much as the conventional wisdom thinks in The Atlantic Magazine. Jim argues that the research presented isn’t impressive, and describes the article at TAS as an “argument that is presented against CEOs [that] is really an argument against markets setting prices.”
He writes this characteristically sharp paragraph:
There’s just no way out of the problem that what makes companies do well or badly is very, very complicated, and therefore isolating the impact of any one variable by lining up some descriptors for a few hundred companies and looking for patterns is like trying to grab liquid mercury. The only way to really isolate the causal impact of CEOs on performance would be to randomly change a subset of them while holding others out as controls, which of course will never happen. Even if we could do this, we would still have an almost insurmountable generalization problem: How would this vary by industry? Are some CEOs only good at turnarounds, independent of industry? Are CEOs secularly more valuable in some time periods than others? And so on.
To start, there are really two different questions here. One is “how much do CEOs matter?” The other is “How competitively set are CEO’s compensation packages?” The first is probably a fair amount. CEOs get final calls on mergers and acquisitions, and nothing can destroy a good company than a M&A gone bad. Since to study this part of it, you’d have to not only analyze what has happened but also what has not happened, what was prevented from happening, you are going to have a lot of problems right away.
The other question is more interesting. Our gut reaction should be that CEOs are overpaid compared to their productivity. One reason is that they are signals a company sends to the financial markets. It may be perfectly ok, or even pretty cool, if when someone compliments you on your jacket to say “oh this? I thrifted it. $10!” It is less cool if a board says to the bond market “Oh this CEO? We got him for cheap.” There’s always an incentive to bid over the average salary, and as such that should move market prices up.
There’s another argument where the CEO can appoint the people who compensate and monitor him. This has a long history of some really sharp research inside finance and business research, and I’m surprised The Atlantic author went to sociology for paper citations. Michael Weisbach’s Outside Directors and CEO Turnover (1988) is a good place to start, where he finds, quite conclusively in my opinion, that outsider-dominated boards do a better job of governance than insider dominated boards. This kicks off a whole wave of research in this vein.
But what about the specific point Jim brings up above? Can we isolate one variable and see how CEOs are compensated when it varies? Ask and ye shall receive! Are CEOs Rewarded for Luck? The Ones Without Principals are:
ABSTRACT: The contracting view of CEO pay assumes that pay is used by shareholders to solve an agency problem. Simple models of the contracting view predict that pay should not be tied to luck, where luck is dened as observable shocks to performance beyond the CEO’s control. Using several measures of luck, we find that CEO pay in fact responds as much to a lucky dollar as to a general dollar. A skimming model, where the CEO has captured the pay-setting process, is consistent with this fact. Because some complications to the contracting view could also generate pay for luck, we test for skimming directly by examining the effect of governance. Consistent with skimming, we find that better governed firms pay their CEO less for luck….
PAPER: Simple models of the contracting view generate one important prediction. Shareholders will not reward CEOs for observable luck. By luck, we mean changes in performance that are beyond the CEO’s control…
This paper starts by examining whether or not CEOs are in fact paid for luck using three measures of luck. First, we perform a case study of the oil industry where large movements in oil prices tend to affect firm performance on a regular basis. Second, we use changes in industry-specic exchange rate for firrms in the traded goods sector. Third, we use year-to-year differences in mean industry performance to proxy for the overall economic fortune of a sector. For all three measures, we find that CEO pay responds signicantly to luck. In fact, we find that CEO pay is as sensitive to a lucky dollar as to a general dollar. Moreover, these results hold as well for discretionary components of pay—salary and bonus—as they do for options grants.
These results are inconsistent with a simple contracting view. Motivated by practitioners such as Crystal , we propose an alternative, skimming, which can explain these results [Bertrand and Mullainathan 2000a]. The skimming view also begins with the separation of ownership and control, but it argues that this separation allows CEOs to gain effective control of the pay-setting process itself.
I love this paper. This paper looks at things that are random to CEO performance – oil prices for the oil industry, currency exchange-rates for exporters, and mean performance of an industry. The question is how much they should be compensated for luck, for things they have no control over. They shouldn’t. At all.
The important thing for this analysis, to answer Jim’s question, is whether or not the variable we are looking at is independent of the CEO’s performance. CEOs for oil companies don’t set oil prices. However when oil prices go up, they get paid more. And before you move to make a ‘human capital’ argument – that oil company CEOs are worth more when oil prices are high – there’s an asymmetry there. Oil company CEOs’ salaries do not go down the same way when oil prices drop. (The paper digs into this obvious criticism if you want to click through to the pdf above.)
The same goes for export industries who have profits tied heavily to exchange-rates. Exporters don’t set exchange-rates. Trust me, hedge funds across the US are trying to use complicated mechanisms to get a 5 basis point edge on exchange-rate movements; the CEO of an export company doesn’t have an edge here. Same effect. Even if you find the third measure, mean performance as proxy a little squishy (I can see that, though I’d disagree), the first two strike me as very reasonable ‘instruments’ for analyzing CEO performance.
And of course, the closer we look there the more it looks like CEOs are capable of skimming quite well from the people who have entrusted them to lead their company. Even more so if their monitors are chosen by the CEOs. It’s not an indictment, but it does go with our initial intuitions about how CEOs can capture the companies and boards they are supposed to be monitored by.