Executive pay makes nobody poorer
- Ivo Vegter
- 20 Sep 2011 07:50 (South Africa)
Whenever the economy is in trouble, economic populists like to bash the rich. They challenge what they see as “excessive” pay earned by a few top executives.
The obvious emotion that such rhetoric taps into is envy. From time immemorial, the poor have blamed the rich for their predicament. And it has suited the politicians to tap into this instinctive emotion, to divert the blame from their own failures.
That's not to say the poor have only themselves to blame for their condition, of course. An economy is a large social network, of which a single person can only ever see a small part, let alone control it. However, there are many causes for poverty, and the exceptional wealth of a few is rarely among them.
For the sake of completeness, however, let's deal right up front with the scenarios where the rich really can be blamed. In a country that suffers under crony-capitalism or state-capitalism – that is, one in which government selectively licences favoured companies and protects them from competition, or actually owns those companies directly – it is clearly possible to exploit workers and customers alike. New competition that attracts disaffected staff or consumers cannot arise in such a market.
A country like South Africa has a large civil service, many state-owned companies, and protected cartels in many industries. Government contracts account for a quarter of the economy. In such an environment, it is downright dishonest for a politician to lament that executive pay is excessive in the private sector.
There are very many civil servants who earn massive pay packages. Even in small, poor towns, some municipality staff can earn well over a million rand a year, in addition to a raft of benefits like government pensions, housing subsidies and luxury German automobiles. This is indeed obscene, and it is doubly obscene for those same politicians and civil servants to turn around to assail the private sector for its supposedly excessive pay.
There are also very many corporate profiteers who live in the lap of luxury, paid for by government contracts. Such contracts, as I've documented in the case of the Gautrain, for example, are all too often structured heavily in favour of the gravy-train rider, while ordinary citizens take all the risks.
But let's ignore, for the sake of this argument, all the politicians and crony-capitalists who live in luxury on the taxpayer's dime, and look only at that small part of the private sector which is truly subject to market forces.
What determines the pay of a senior executive? It's exactly the same as with any other member of staff. Someone will be employed at whatever salary is sufficient to attract them, provided this is below the value that person can add to the company. Shareholders, after all, try to optimise the value versus cost trade-off in all they do. That's the basic principle of business. They aim to deploy their capital in such a way they they produce as much revenue as possible, while paying as little as possible to do so.
So if they agree to pay an executive several million a year, that decision reflects the considered judgement that this is the least they can pay for the value that the executive brings to the company.
If they could offer less, they would. When they can't, there are two options. Either it is evidence of a mismanaged company that will soon go out of business, or it recognises the fact that an executive who is paid less would deliver less or leave.
The workload and difficulty of an executive job is high, and it is far easier to take a less demanding job if you're going to be earning less anyway. The risks that directors and managers take, under the Company Act and a raft of other legislation that governs them, are substantial. People in top positions have very little job security. Whenever a company fails to meet investor expectations, executives are dumped like hot potatoes. Lower-level workers take far less risk, both legally and in terms of job security, even before they avail themselves of the extensive protections offered by labour legislation.
Ultimately, the decision to pay an executive a high salary in return for their service says that one way or another, this value would not have been delivered without them. Therefore, lower executive pay implies the company would perform worse. Therefore, it would create less profit that can be reinvested to grow the business, or be invested elsewhere in the economy for goods, services or new company formation. Therefore, the economy would create fewer jobs or reduce average wages, or both.
Just as with the argument about what I call Ginidiocy, as soon as one looks beyond populist, superficially intuitive notions about executive pay, one is forced to conclude that reducing it below the market rate will have exactly the opposite effect from what is intended. It will not leave more money available for workers. It will leave less money available for workers.
As I was writing this, I came across a column which David Carte wrote for Moneyweb. He made a similar argument, and cited a number of specific examples of executives who are paid a lot to add a lot of value, and who would probably cease doing so if they were paid less.
It is true that the business lobby makes placating noises, appearing to accept that executive pay is an issue of concern that ought to be looked at. Other than that they'd love to have an excuse to spend less on executives, business has little choice when faced with the power of politicians and unions. The coercive power to legislate and go on protected strikes are dangerous beasts to provoke.
However, that does not mean that the calls for reducing executive pay make any economic sense.
If executive pay is reduced, the people whose unique skills and experience can command those packages will start looking for greener pastures. And they will find them, not only in the rich world, but in other emerging markets that compete with South Africa. As the impact of this brain drain becomes felt throughout the economy, more people who fall on hard times and are able to leave will do so, in much the same way that middle- and working-class people from elsewhere in Africa seek opportunity in South Africa. They might love their countries, and hope to return one day, but in the mean time they are unable to prosper in economies that have lost their best and their brightest as a result of the corruption or the failed socialist policies of their political leaders.
At the start of this column I said that we'd all earn less than R4,000 if we were to distribute gross national income equally among South Africa's citizens. The exact figure is R3,772. However, this is only true as a matter of arithmetic. As a matter of economics, it wrongly assumes that our gross national income would remain the same if the rich were dragged down in an attempt to lift up the poor.
What would really happen is that our national income would shrink. In practice, most of us would earn nothing at all, because the innovators, the job creators, the risk-takers, the engineers, the project managers – in fact, all the people who are capable of delivering more than R3,772 worth of value for a month's work – will have ceased to produce that value. The rest of us would be competing for ever-fewer jobs at ever-lower wages.
No matter what the unions or the politicians say, the truth is simple. If executive jobs were not so richly rewarding for the few, the rest of us would be much poorer. DM
PS. The original version mistakenly referred to R4,000 per year in the introduction. The correct figure is, of course, R4,000 per month, as indicated later in the column. I regret the error.