Capitalism isn't perfect. Because business, like science, is about excellence and not fairness some people are going to make more money than other people. Some are going to be better at marketing and some are even going to cheat.
A professor in chemical engineering with no private sector experience has figured out how to redo capitalism so it works great - in a numerical model.
Venkat Venkatasubramanian of Purdue University says CEOs in 35 of the top Fortune 500 companies were overpaid by about 129 times their 'ideal salaries' in 2008 - that must mean mean 465 CEOs, or 93%, were paid just fine. One thing he left out of his analysis is that professors won't go to jail if their models are wrong but legislation passed in the wake of Global Crossing and Enron scandals makes sure that a CEO who signs a piece of paper that turns out to be fraudulent, or even incorrect, will go to jail, making it less appealling to run a public company and driving costs up to balance out those risks.
The ratio of CEO pay to the lowest employee salary has gone up from about 40-to-1 in the 1970s to as high as 344-to-1 in recent years in the United States while the ratio has remained around 20-to-1 in Europe and 11-to-1 in Japan, he said.
Using his analysis method, Venkatasubramanian estimated that the 2008 salaries of the top 35 CEOs in the United States were about 129 times their ideal fair salaries. CEOs in the Standard&Poor's 500 averaged about 50 times their fair pay, which raised questions in his mind about the efficiency of the free market to properly determine fair CEO pay. Yes, the free market should not be a free market.
Why would a chemical engineer be concerned with economics and CEO salaries anyway?
"You might ask why a chemical engineer is concerned with economics and CEO salaries. Well, it turns out that the same concepts and mathematics used to solve problems in statistical thermodynamics and information theory also can be applied to economic issues, such as the determination of fair CEO salaries."
Not exactly. We had a whole housing collapse because statisticians and information theorists rolled dice that couldn't account for the independence of human thinking.
Can entropy determine whether or not a CEO will work at a public company, with its multi-million dollars in added costs and risks of jail time, versus working at a private company where none of that applies?
Venkatasubramanian says it can, mostly by changing the definition - he identified entropy as a measure of "fairness" in economic systems, which revealed a connection to him between statistical thermodynamics, information theory and economics.
"As we all know, fairness is a fundamental economic principle that lies at the foundation of the free and efficient market system," he said. "It is so vital to the proper functioning of the markets that we have regulations and watchdog agencies that break up and punish unfair practices such as monopolies, collusion and insider trading. Thus, it is eminently reasonable, indeed reassuring, to find that maximizing fairness, or maximizing entropy, is the condition for achieving economic equilibrium."
On the contrary, there is nothing in anything Adam Smith wrote about fairness in the free market. Evolution is not fair, economics is not fair. Only gravity is fair and only then if you're not very large or very small. He is confusing preventing of insider trading as being the same as fairness in the free market.
Using his new hypothesis, the ideal pay distribution is determined to be "lognormal," a particular way of characterizing data patterns in probability and statistics. He calls it the economic equivalent of the Boltzmann distribution for ideal gases, which describes how the gas molecules are distributed at various energy levels. "One may view our result as an 'economic law' in the statistical thermodynamics sense. The free market will 'discover' and obey this economic law if allowed to function freely and efficiently without collusion-like practices or other unfair interferences."
So what is the result? Fair pay for an average S&P 500 CEO should ideally be in the range of 8 to 16 times the lowest employee salary, Venkatasubramanian said. And at one time it was - namely when Congress did not mandate you will go to jail if a subordinate in a billion dollar company makes a mistake or lies and you sign it.
"It's interesting to note that Warren Buffett, CEO of Berkshire Hathaway and an outspoken critic of executive pay excesses, drew an annual salary of $200,000 in 2008," Venkatasubramanian said. "This makes his pay ratio 8-to-1, assuming a minimum employee salary of $25,000 per year, which fits the ideal benchmark estimate for fair CEO pay almost exactly. Mr. Buffett's instincts about fairness seem to be amazingly accurate. The top pay set by Mr. Feinberg for the AIG executives is almost exactly the amount recommended by the new theory."
Buffett also owns $42 billion in Berkshire Hathaway stock, making a salary less important. Most CEOs are granted salary and options because they are not wealthy, just competent. Berkshire Hathaway also does not produce a product or sell anything that could come under scrutiny by shareholders. Their only complaint can be if Berkshire Hathaway does not increase in value, hardly a jail term offense.
Venkatasubramanian may not agree with the salaries of sports athletes either, where the ratio of highest player to lowest is over 100:1 but outside the pristine world of numerical models, where companies want the best people, the free market he claims to extol does not obey arbitrary limits.
Article: Venkat Venkatasubramanian, 'What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions', Entropy 2009, 11(4), 766-781; doi:10.3390/e11040766
Comments
It was deregulation and refusal of government to enforce laws that led to the high salaries, and other reckless actions.
I suggest to the readers that there were a great many qualified people who would have been willing to take the management jobs with vastly lower pay.
Considering the high prices that were paid, the performance standard was really poor.
In a previous real estate and banking crisis, administered by the same family of politicians 18 years earlier, about 400 financial managers were sentenced to 2 years of prison, and actually spent about 60 days under low security or house arrest, for defrauding the public of 110 billion dollars in tax money and swindling countless private investors of their life savings.
In dollars per hour the penalty didn't really fit the crime. That's why we had another crisis of larger size and cost.
So with a 700 billion swindle and still counting, in the current crisis., how any people have been charged with a crime? One self employed person went to prison for 150 years, and a second person has been charged with a serious offense.
Considering that hundreds of traders on wall street went unpunished for making transactions on the exchange floor every day, that would have been prosecuted as felonies if done on the public street outside, the evidence does not support the claims about the risk and reward of corporate management.
A law named Sarbanes Oxley put managers under new obligations, but those managers quickly put the risk onto their subordinates, who are now required to sign a statement every quarter that everything has been closely examined, and there are no financial irregularities.
Sometime I do that type of work, and a remedy is automatically applied whenever a Sarbanes Oxley test fails to meet the standard. So the manager is in no risk at all.
When you look at how the crisis developed, for about 6 years wall street made easy money available to banks with no restrictions. Then the credit was cut off by the same people in a period of 2 months. It isn't a case of wall street versus the banks. All of the managers in both groups follow the same politics, belong to then same organizations, and share the same opinions about finance and economics.
A very old tradition in American economics is called the business cycle. It is a way that market traders gouge the public by driving prices too high one time and too low another time. It is a type of treason that does as much damage to our country as any military campaign could do.
The public is better informed now than in previous generations. Nearly everyone saw the crisis coming years in advance. People with cash to spare put it into savings and left it there. Other people with no spare cash ran up debts with the expectation that the government would have to intervene in the crisis that was coming.
Crisis in an election year is a very bad idea. That is not part of the tradition. A long standing custom says the crisis should have ended late in 2007 two months after the credit was cut off. It didn't work that way.
To end the crisis there should be something called capitulation, during the which the public gives up and sells off their investments for pennies on the dollar. That is the only way the market makers who create the crisis can cover their short sales and make a profit.
The market panicked as did the government, but the public didn't panic. So the crisis continued into the election year.
Now we find scholarly deficient articles with bad science published in distressed magazines for a declining circulation, offered as a really lame excuse to a totally outraged public, that doesn't read that magazine.
In the mean time a lot of public time and money was spent on remedies that cost a lot and take a long time to work, while the fundamental problem is not fixed and the public is not fooled.
The problem began on Wall Street and will end there, when regulations that cost nothing and work quickly are enforced to give investors confidence in the economy.
A business cycle is driven by buying on credit one time and selling short another time. Those things might be useful at times, with regulations, but have been destructive in the deregulated market.
When the market is down sharply below a moving average, short selling should be prohibited. Other times credit buying should be prohibited when the market is sharply up above a moving average.
The people who have record amounts of cash put away in savings would make investments, and we could have economic growth without recessions.
What we have now is an SEC with actions that are timid, weak and slow.
The public is not fooled, and socialism is on the rise over seas.
Amateur Astronomer (not verified) | 11/04/09 | 22:01 PM
What nonsense!
The fact that someone even has the audacity to refer to the free market after the taxpayer bailouts of the financial industry speaks volumes in itself. The "free market" can only refer to individuals and NOT corporations and governments. There can be no fair competition when governments are involved in subsidizing local industries or in providing bailouts, or legislative protections, or manipulating currencies. Let's dispel this myth once and for all.
The mere fact of the laws affecting corporations grants them privileges that the ordinary citizen cannot enjoy. Freedom from personal liability as well as the ability to leverage thousands of employees and yet be treated as a singular individual from a legal perspective makes the machinations of corporations anything but fair. Corporations exist in the legal fantasy land where an individual can actually be responsible for killing others and yet have no personal responsibility or liability.
If genetics were as tightly controlled as the money supply then one could argue that evolution should be fair, since it is no longer operating without intervention. Similarly, economics is no longer the means by which people trade, but it represents a financial infrastructure that has been invented and manipulated by human societies. To put it in the same category as evolution is disingenuous.
So the rationale is that these guys should be paid dramatically higher salaries because they're responsible for what they report? Please spare me the "poor CEO" rhetoric. These are the same guys that managed to take a booming market and because of greed and stupidity, run it into the ground.
No, we had a housing market collapse because financial companies were fabricating loan qualifications just to get people into houses. It wasn't done because of government pressure or altruism. It was done for the simple reason that the paper was constantly being sold, and everyone was profiting on the transaction. The stupidity was in the presumption that no one would ever question whether the paper had value any longer.
It has become chic to criticize the consumer for not being more vigilante and for accepting these financial traps, but if we're going to praise businesses then let's also hold them responsible for offering such irresponsible transactions. The truth is that without the consumer buying (mindlessly in many cases), the economic growth in this country would have been paltry. It is largely due to the consumer spending that these same "brilliant" business people were able to make the money they did. God knows it wasn't because of their intrinsic abilities.
The free market is a fantasy. It has never existed on a large scale and will never exist. To keep bringing it up as some magical solution to everything that ails us is simply a failure to understand how economics really works.