Steven F. Schreiber, CFA
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Excessive Executive Compensation is Driving Economic Failure

The subject of executive compensation gets e verybody frustrated, because we all see the executives in our companies making millions of dollars while we struggle to pay for gas and groceries. But the problem runs deeper than our personal frustration...I credit corporate greed as the primary cause of many of the recent economic difficulties. Our economy needs consumption to grow. If people do not spend money, the economy cannot grow. We all hear how we need the excessively rich people to spend on luxury items to help grow the economy. I think this completely misleading and biased. Why? Because this is not optimizing consumption. If you made just enough money to pay the bills, you are going to spend every dime of your income immediately…100% consumption. If you make a hundred thousand dollars per month, you’re most likely going to put a big chunk of that money off to the side in an investment or savings account…not even close to 100% consumption.

When the average American is spending more than 100% of his income on day-to-day living (2005 marked the first year since the Great Depression that Americans spent more than they earned, and with the housing boom flowing into 2006, that trend will likely continue), you can rest assured that the top 1% of this country's earners are not spending even close to that percentage of their income. Much of the 20% of the country's total income that the top 1% of the workforce is earning is not going back into the economy as consumption dollars.

I am not saying that people should not be able to become rich. Capitalism does not work if people cannot get rich. What I am saying is that a person should become rich by creating something of value. It should be earned. When you create value you improve the conditions of others, and many people benefit. 1) Jobs are created 2) consumers gain a valuable product 3) the economy grows 4) the owners become rich from the profits. This is how Capitalism should work.

The catch is that Capitalism works best in efficient markets. There are certain areas that do not allow for efficiency, requiring outside (government) intervention. This is why we need government programs such as the military, infrastructure, and firefighting. I feel that the labor commodity is an inefficient market as well. I do not think that the government should intervene, as it does by supporting a military, etc., but I think that we need to push for a more efficient labor market. So how do we solve the problem of excessive compensation? We take steps to make the labor market more liquid and transparent. We find the barriers to efficiency and create products and services that break these barriers. So what are the barriers to labor market efficiency and how can we solve them?

One barrier is imperfect information. The job market is highly inefficient with pricing power heavily weighted toward employers. Salaries are set based on the lowest amount a candidate is willing to accept. Most people are not aware of average salaries for their position or what they should expect to aid in negotiations. More visibility will only provide tools for the labor market to negotiate with employers. More tools are becoming available, but they are still not widely used or applied because of the extreme confidentiality of employers. Employers are not willing to classify job openings to allow candidates to compare the position with average salaries.

Another inefficient process is the compensation setting for executives. Compensation is set by committees or consulting firms with severe conflicts of interest, when the market should be setting the compensation for executives as it does for lower-level positions.