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