Arecent Time magazine poll found that 71% of Americans who responded want the government to place limits on the executive compensation at firms that received bailout money. Yet accomplishing this task selectively is impossible to do.
The government did appoint a czar of executive compensation for these corporations, but he approved a $7-million salary/$3.5-million bonus plan for the head of AIG, 80% of which is now owned by taxpayers. Few workers, executives included, would agree to work for less than the going rate. Executives are simply used to earning millions of dollars, and there is little that either the czar or shareholders can do about it unless Congress limits all executive compensation. But the chance of such legislation passing is slim.
Why is limiting executive compensation so difficult? Because executives have a seemingly unassailable argument -- market forces -- that University of Chicago professor Steven Kaplan defended in an October debate: "Market forces govern CEO compensation. CEOs are paid what they are worth."
Of course, market forces are cited not only to justify outsized compensation for executives but also poverty wages for workers. Textbooks claim that minimum wage laws and union wages create unemployment. Just what are these market forces, and should we let them determine executive compensation and wages?
When British economists David Ricardo and Adam Smith examined this question 200 years ago, they concluded that what a person earns is determined not by what the person has produced but by that person's bargaining power. Why? Because production is typically carried out by teams of workers, managers and machines, and the contribution of each member cannot be separated from that of the rest. A driver and a bus, for example, generate $100,000 of income a year. The driver is paid $25,000. Is this because the driver had transported 10 of the passengers without the bus while the bus had transported 30 of the passengers without the driver? The driver's pay is so small only because the driver is so weak at the bargaining table.
It was Smith who explained that the bargaining power of each party is determined by the laws that the government passes and the way that it enforces them, and that, as a rule, the government sides with employers against employees. He was particularly concerned with anti-unionization laws. Had he witnessed the largesse that boards of directors are permitted to offer executives, and the government's behavior toward executives in the current crisis, he probably would have added that the government also sides with executives against shareholders and taxpayers.
Despite the logic of Ricardo and Smith's explanation that it is power, not productivity, that determines what people earn, the notion that people earn what they "deserve" persists. It dates to the Haymarket riot of 1886 in Chicago -- in which police and labor protesters clashed and several policemen and demonstrators were killed -- and the labor unrest that followed. Concerned about this unrest, John Bates Clark, a Columbia University professor, warned in an 1899 book: "The indictment that hangs over society is that of 'exploiting labor.' If this charge were proved, every right-minded man should become a socialist."
It was thus with a clear political agenda that Clark took it upon himself to prove that the charge of exploitation of workers was dead wrong. Clark's "proof" was to ignore the fact that production is carried out by teams and that individual contributions cannot be measured. He simply declared that the contribution of each individual worker and each machine could be measured, and that the earnings of either workers and executives or machines are simply the values of these contributions.
In this view, if the government were to raise wages by law, employers would have no choice but to fire workers, because no employer can pay out more than the worker puts in. And if the government were to set limits on executive compensation, the bright and the talented would choose to work less or limit the level of their performance.
Evidence that Clark's theory is wrong -- that production is carried out by teams and that astronomical compensation is not a requirement for good performance -- can be found everywhere. In 1941, Wassily Leontief, a Nobel Prize-winning economist, tried to alert economists to the fallacy of Clark's theory. But Leontief, like Ricardo and Smith, was ignored. And Clark's tale that earnings are determined by productivity alone is still being taught around the globe.
