When Roberto Goizueta died of cancer in 1997, at the age of 65, he was a billionaire. Not bad for a Cuban émigré who had come to the United States as a teenager. He was by no means the first immigrant to America to become a billionaire, but the others had made their fortunes by founding and building companies or taking them public. Goizueta made his as the CEO of Coca-Cola.
His timing was impeccable. In 1980 he became the chief executive of a company that owned no natural resources and had precious little physical capital. The talent economy had just come of age, and rewards for its key productive assets made an epochal shift—in his favor. His company was among the most valuable in the world for its iconic brand and the talent that built and maintained it. Goizueta epitomized that talent, and investors paid for it as never before.
A century ago natural resources were the most valuable assets: Standard Oil needed hydrocarbons, U.S. Steel needed iron ore and coal, the Great Atlantic & Pacific Tea Company needed real estate. As the 20th century progressed, America’s leading companies grew large and prosperous by spending increasing amounts of capital to acquire and exploit oil, mineral deposits, forests, water, and land. As recently as 50 years ago, 72% of the top 50 U.S. companies by market capitalization still owed their positions to the control and exploitation of natural resources.
To be sure, those companies needed lots of labor as they continued to grow — but mainly for routine-intensive jobs. Those jobs were largely fungible, and individual workers had little bargaining power; until they were enabled and motivated to unionize, suppliers of labor took a distant third place in the economic pecking order, behind natural resources and providers of capital.
The status quo began to change in 1960, with an extraordinary flowering of creative work that required substantial independent judgment and decision making. As the exhibit “The Rise of the Talent Economy” shows, creative positions accounted for a mere 16% of all jobs in 1960 (having grown by only three percentage points over the previous 50 years). That proportion doubled over the next 50 years, reaching 33% by 2010.
The top 50 market cap companies in 1963 included a relatively new breed of corporation, exemplified by IBM, which held the fourth spot. Natural resources played almost no role in IBM’s success, and although capital was not trivial, anybody at the company would have argued that its intensively creative employees — its scientists and engineers, its marketers and salespeople — were at the heart of its competitive advantage and drove its success in the marketplace. The same could be said for Eastman Kodak, Procter & Gamble, and Radio Corporation of America, all businesses whose success was built on talent.
By 2013 more than half the top 50 companies were talent-based, including three of the four biggest: Apple, Microsoft, and Google. (The other was ExxonMobil.) Only 10 owed their position on the list to the ownership of resources. Over the past 50 years the U.S. economy has shifted decisively from financing the exploitation of natural resources to making the most of human talent.
Through the 1970s the CEOs of large, publicly traded U.S. companies earned, on average, less than $1 million in total compensation (in current dollars) — not even a tenth of what they earn today. In fact, from 1960 to 1980 the providers of capital got an ever-improving deal from the chief executives of those companies, who earned 33% less per dollar of net company income in 1980 than they had in 1960. In that era the situation was similar across the talent classes, from professional to scientific to athletic to artistic.
After 1980, however, it seemingly became essential to motivate people financially to exercise their talent. Skilled leaders saw a major boost in income for two reasons:
It’s no surprise that talent got much richer after it was recognized as the linchpin asset in the modern economy. It’s also unsurprising that ordinary employees have long accepted this rebalancing of income—after all, it fits the American Dream, in which hard work and the cultivation of talent deserve rewards. People don’t mind your being rich if you made the money yourself; what they don’t like is your inheriting wealth. And the evidence is clear that the vast majority of Forbes billionaires are self-made. But the assumptions underlying that compliance are starting to change. People increasingly ask whether talent is overcompensated — and whether it’s quite the unalloyed good it has historically been made out to be.
Our basic grievance with today’s billionaires is that relatively little of the value they’ve created trickles down to the rest of us. Real wages for the 62% of the U.S. workforce classified as production and nonsupervisory workers have declined since the mid-1970s. The billionaires haven’t shared generously with investors either. Across the economy, the return on invested capital, which had been stable for the prior 10 years at about 5%, peaked in 1979 and has been on a steady decline ever since. It is currently below 2% and still dropping, as the minders of that capital, whether corporate executives or investment managers, extract ever more for their services.
As a consequence, since the mid-1980s inequality has rapidly increased, with the top 1% of the income distribution taking in as much as 80% (estimates vary) of the growth in GDP over the past 30 years. Serious as this is, rising inequality is not the most ominous aspect of the situation. Our current system of rewarding talent not only doesn’t lead to greater overall value for society but actually makes the economy more volatile, with all but a fortunate few moving sideways or backward.
Evidence can be seen in the changing composition of the Forbes 400. Over the past 13 years the list’s number of hedge fund managers, by far the fastest-growing category, has skyrocketed from four to 31, second only to computer hardware and software entrepreneurs (39) in possessing the greatest fortunes in America. If the LBO fund managers on the list are included, it becomes clear that far and away the best method of getting rich in America now is to manage other people’s money and charge them 2&20. As Steven Kaplan, of the University of Chicago, and Joshua Rauh, of Stanford, pointed out in a recent paper, the top 25 hedge fund managers in 2010 raked in four times the earnings of all the CEOs of the Fortune 500 combined.
What are those 25 people doing?
Essentially, the business of a hedge fund is to trade. James Simons, the founder of Renaissance Technologies, ranks fourth on Institutional Investor’s Alpha list of top hedge fund earners for 2013, with $2.2 billion in compensation. He consistently earns at that level by using sophisticated algorithms and servers hardwired to the NYSE servers to take advantage of tiny arbitrage opportunities faster than anybody else. For Renaissance, five minutes is a long holding period for a share.
Modern market structures enable hedge funds to trade like this by borrowing stock in large amounts, which means they can take short positions as well as long ones. In fact, hedge fund managers don’t care whether companies in their portfolios do well or badly — they just want stock prices to be volatile. What’s more, they want volatility to be extreme: The more prices move, up or down, the greater the earning potential on their carried interest. They aren’t like their investment management predecessors, long-term investors who wanted companies to succeed.
But trading doesn’t directly create value for anyone other than the hedge funds. One trader’s gain is simply another trader’s loss. It’s nothing like building a company that gives the world a better product and generates employment. Of course, hedge fund aficionados argue that the funds help corporations offload interest-rate or exchange-rate risk, thus adding economic value to the world. It’s a nice rationalization, but a tiny fraction of the multitrillion-dollar industry could take care of the relatively modest task of hedging corporate financial asset risk. Besides, market volatility has increased dramatically as the hedge fund industry has grown, undermining any argument about the net risk-management benefit of hedge funds.
The shift from building value to trading value is worrisome, but the real problem for the economy is that hedge fund talent and executive talent both have an incentive to promote volatility, which works against the interests of capital and labor. Executive talent, as we saw earlier, is now rewarded primarily with stock-based compensation, which was supposed to align managers with the long-term interests of owners. But a stock price is nothing more than the shared expectations of investors as to a company’s future prospects. If expectations for performance rise, the stock price rises, and vice versa. Thus stock-based compensation motivates executives to focus on managing the expectations of market participants, not on enhancing the real performance of the company.
What’s more, because stock-based compensation is generally conferred annually at the prevailing stock price, managers have an interest in volatile expectations for their company. If expectations fall during the course of a given year, the options or deferred stock granted a year later will be priced low. To reap a big reward, all managers have to do is help expectations recover to the prior level.
That’s why the global financial crisis was not all bad for CEOs. Consider John Chambers, the CEO of Cisco Systems since 1995. Like Roberto Goizueta, Chambers became a billionaire by running a publicly traded company. But during his tenure Cisco shareholders have suffered through two bubbles and busts. The share price peaked at $80.06 in March 2000 and plummeted to $8.60 in October 2002. It worked its way into the $25 – $33 range for most of 2007 and reached $34.08 in November of that year. In the wake of the subsequent financial crisis it collapsed to $13.62 in March 2009, climbed to $27.57 in April 2010, fell to $13.73 in August 2011, and had recovered to $24.85 by the end of June 2014.
It was a pretty wild ride for the shareholders of record as of November 2007. Those who hung in through the end of June 2014 experienced a decline of 27% in their stock price and two 60% drops along the way. But it wasn’t so bad for Chambers. Those two big dips were handy for picking up attractively priced stock-based compensation—options in November 2009 at $23.40, and restricted stock units in September of 2010 through 2013 at $21.93, $16.29, $19.08, and $24.35. His $53 million in stock-based compensation from these five grants appreciated by about 18% through June 2014. If, instead of exposing shareholders to massive volatility, Chambers had overseen a steady decline from $34.08 to $24.85 during that period, his stock-based compensation would have lost about 20% of its value rather than gaining 18%.
The effect of modern stock-based compensation is to drive volatility, not appreciation. Of course, the providers of capital are constantly pressing executives to deliver better returns. What the executives do in response is fairly simple: They cut back on labor, the variable they can most easily squeeze in order to signal that they are addressing performance. Such creative destruction can be a good thing for the company and the economy — but it can also compromise the company’s long-term capabilities. And managers’ incentives to create large changes in the market’s expectations suggest that cuts in labor are more likely to be overdone than underdone.
Increasingly, therefore, jobs disappear and usually don’t return. Consequently, labor’s earnings have been suppressed and real wages have stopped growing. This has exacerbated income inequality in America, especially between the very rich and everyone else: The differential between 50th percentile incomes and 90th (or 99th, or 99.9th) percentile incomes has widened dramatically since 1980 and shows no signs of stabilizing, let alone narrowing. Meanwhile, the differential between 10th percentile and 50th percentile incomes has changed very little.
The income gap between creativity-intensive talent and routine-intensive labor is bad for social cohesion. The move from building value to trading value is bad for economic growth and performance. The increased stock market volatility is bad for retirement accounts and pension funds. So although it’s great that the proportion of creativity-intensive jobs is now nearly three times what it was a century ago, and terrific that the economy is so richly endowed with talent, that talent is being channeled into unproductive activities and egregious behaviors.
In a democratic capitalist country, it is not sustainable to leave the members of the largest voting bloc out of the economic equation. Think back to 1935, when the United States was still in the throes of the Great Depression. Real incomes were falling, and unemployment hovered around 25%. Employers had put pressure on wages both before the Depression and during it. Labor had no power whatsoever, and efforts to unionize were met with aggressive, even violent, countermeasures.
The Roosevelt administration passed sweeping pro-labor legislation — the National Labor Relations Act — that both facilitated unionization and instituted protections for the rights of unionized workers. It also established the National Labor Relations Board to ensure that corporations adhered strictly to the letter of the act. From 1935 to their historical peak, in 1954, unionization rates rose from 8.5% to 28.3% of U.S. workers, an unimaginably high level by today’s standards, and real wages for unionized employees rose faster than both nonunion wages and general economic growth.
Of course, the wages, benefits, and work-rule inflexibility for which labor successfully bargained priced it out of the market after 1960, especially as postwar Europe and Japan recovered. Also, corporations responded to labor’s demands by increasing mechanization, moving to “right to work” southern states, and beginning to source internationally. By 2000 unionization was back down close to 1935 levels. But all this rebalancing took time and arguably had a negative impact on overall growth.
It seems clear that the economy is heading toward another 1935 moment. It is hard to see the Occupy Wall Street and We Are the 99 Percent demonstrations as anything other than a shot across the bow. Zuccotti Park may have been cleared, but the sentiment hasn’t gone away. Unless the key players work together to correct what’s causing the current imbalance, the 99% will vote in a rebalancing that is radically in their favor, as they did before. Frankly, it’s surprising that they haven’t done so already. To avert that, three things have to happen:
Roberto Goizueta lived to see and benefited from talent’s rise to become the key asset in the modern economy. But he died before the positive aspects of this phenomenon began to give way to its dark side. The trend cannot proceed unabated in the United States without provoking a political reaction. Top executives, private equity managers, and pension funds can avoid such a reaction by showing the leadership of which they are fully capable and modifying their behavior to create a better mix of rewards for capital, labor, and talent.
Roger L. Martin was the dean of the Rotman School of Management at the University of Toronto from 1998 to 2013. His most recent book is Playing to Win: How Strategy Really Works (Harvard Business Review Press, 2013), written with A.G. Lafley.