Exorbitant Wages – A Justification

Adam Smith, the most highly respected spokesman for free market capitalism, in “The Wealth of Nations” written in the late 1700s, puts forth his rationale behind the variations in the price of labor. He breaks the causes for these variations into five major parts with each in turn having some detail and further explanations. The five major categories are:
1. “Agreeableness or disagreeableness of the employments”
a. “Ease or hardship”
b. “Cleanliness or dirtyness”
c. “Honourableness or dishonourableness”
i. “Honour makes a great part of the reward of all honouurable professions.”
1. “In point of pecuniary gain, they are generally under-recompensated.”
ii. “Disgrace has the contrary effect.”
1. “The most detestable of all employments, that of a public executioner, is, in proportion to the quantity of work done, better paid than any common trade whatever.”

2. “The easiness or cheapness, or the difficulty and expense of learning them”

3. “The constancy or inconstancy of employment”

4. “The small or great trust which must be reposed in those who exercise them”

a. “We trust our health to the physician; our fortunes and sometimes our life and reputation to the lawyer and attorney.”

5. “The probability or improbability of success in them”
a. In some professions there is a great probability that the training will lead to employment of that skill
b. In others, however, there is a low probability. Adam Smith cites the example where only one in twenty educated in the law wind up working as lawyers and feels that their wages would reflect not only their education, but the education of the twenty that did not make it.

I suspect there are many arguments for variations in wages based on free market principles. I would like to see if and how the principles laid out by Adam Smith can be applied to high pay of professional athletes, Wall Street traders and the huge increase in compensation for CEOs.

One can apply the 5th principal to professional athletes. The probability of making a living at a sport is in the thousands to one range, so the cost of preparing the 1,000 that don’t make it can be added to the salaries of the ones who do. That along with the 3rd principle, where a professional athlete has a limited time he/she can practice their trade, certainly supports a large wage.

How about Wall Street traders, let’s compare them to “rocket scientists”. They both need advanced degrees, the trader an MBA and the rocket scientist a PHD. The education of the scientist is more expensive. Though they may think so, I don’t believe the traders are any smarter. So what is the reason there is about a factor of ten between their wages? The job demands a lot of time and travel and thus a stress on family life but that may account for about a factor of two. Using Adam Smith’s analysis, could it be that the trader’s job lacks honor? The rocket scientist builds rockets and at the end of the day can have the satisfaction of looking up into the sky and seeing his work among the stars. What has the trader accomplished? He has convinced someone to sell something for less than it is worth and someone else to buy something for more than it is worth enriching himself in the process. The larger the spread in values, and the greater the number of transactions, the greater is their personal success reflected in their wages. This may be too harsh a commentary and I know the arguments that they are a critical cog in the free market engine and the creators of wealth etc. but if not training, intelligence or skill that justify the factor of ten difference, than what?

I would like to propose that the same argument applies to the great increase in compensation of CEOs in multinational public companies in recent times. With the increase in institutional investors, the role of the CEO has changed. An ever-growing portion of investors in businesses is comprised of mutual funds, pension funds and endowments. These institutional investors have no interest in anything but short-term gains in value. The enterprise is seen only as a number they want to see grow. They are in and out and look at an enterprise very one-dimensionally. (I heard today on CNBC that 70% of trades on the stock market involve the investor getting in and out in a few seconds. That doesn’t sound right to me but it was on TV so it must be factual. Hmmm!) Private investors, though also interested in the short-term gain, sometimes are willing to take a longer-term view and consider factors beyond just numbers. For example, many sports teams are owned for ego with no real intent on financial gain. The same can be said for investors in movie productions; they want their names to be affiliated with the publicity and to be able to rub elbows with celebrities. Large family holdings in public companies often have the family name tied to the long-term success of the enterprise and some relationships with the workers. Business ownership can also be used to express the political ideology of key investors.

A CEO in these circumstances needs to balance the drive for profit (or in the case of sports teams, minimize loss) with other factors important to the owners. Many of these have underlying noble aspects to them. Their skill often includes balancing the profit with the respectful treatment of employees, vendors and customers. With the short term, one-dimensional task of enriching the institutional stockholders and their traders, most of the noble aspects of the job go away. The main job of the CEO’s becomes their ability to demonstrate short-term gains often at the expense of long time employees, walking a fine ethical line and convincing the market of the great worth of the enterprise. The output of the enterprise becomes irrelevant except to the extent that it many affect the short-term value. They are applauded for being able to make “hard” decisions usually about other peoples lives. In that sense they could be compared somewhat to Adam Smith’s example of the executioner. (Jack Welsh, former CEO of GE was nicknamed Neutron Jack because of his reputation for going into a newly acquired enterprise and decimating their staff.) In this king of setting individuals like Dennis Kazlowsky of Tyco (now in jail) and Ken Lay of Enron become the stars.

The job of CEO requires intelligence and along with intelligence, given a level of experience, comes wisdom. The new CEOs need to leave wisdom at the doorsteps and rearrange their sense of values, and in the process lose much of the sense of “honor” that they might otherwise have gained. I don’t accept the argument that, with globalization and ever changing technologies, the job of the current CEO requires greater skill. Information and the ability to interpret and disseminate it is a key to leading an organization and with today’s computer systems, there is more and better information more readily available. I also have heard discussion that with companies primarily held by institutions, there is no entrepreneurial ownership and the large wages are an attempt to have the CEO “act” as if they were owners. I don’t buy that because they are administrators working on behalf of someone else no matter how much you pay them. The wages do not alter the relationship. I might accept the argument that the job now has taken on a theatrical element and as is the case of movie stars, this justifies a large compensation. Or it may just be the degradation of honor.

If it is honor, there may be some light at the end of the tunnel. I heard Jack Welsh on CNBC last year. He said that the MBA textbook may need to be revised and other stakeholders in an enterprise, the employees and customers may need to be considered not only as a means to maximizing returns to the stockholders but as beneficiaries of the enterprise in their own right. Also there is a new management “buzz word” emerging, “shared value”. Mark Kramer and Michael Porter wrote an article for the Harvard Business Review on the subject and are consulting major corporations on the concept. “Shared value” is a recognition that there are activities an organization can participate in that are not directly aimed at the bottom line but have as a primary focus some social good which actually result in financial advantage to the organization. An example they cite is that of a large candy company that relies heavily on cocoa grown in Africa. By helping the community where it is farmed and thus contributing to its stability, it is ensuring a continuing supply of a commodity that is not only rare, but crucial to their success.

I fundamentally have no issue with very high compensation. My interest in this topic stems from concern about the negative impact on our society of the widening gap between the rich and poor. Being an optimist, I am hopeful that going forward, in time a sense of honor will be restored to the position of CEO and other senior executives and its lack will not need to be compensated for by exorbitant salaries. As to the Wall Street traders, I don’t hold out as much optimism. (In “The Essays of Warren Buffett: Lessons for Corporate America”, Lawrence Cunningham writes that 20% of corporate annual earnings of $700 Billion, goes to various traders who “recently describe themselves variously as hedge fund and private equity firms”). That’s $140B! I don’t see where there ever has been nor can there be much satisfaction in a job of making someone else rich so these jobs will need to be paid well. In fact a primary attribute required of someone entering this profession is a strong drive to amass great personal wealth above all else. From the standpoint of reducing the gap, the answer probably is to take away the great tax advantage they have bought with effective lobbying.