Pay and the Pavarotti factor

Understanding the reasons why top pay has soared is crucial to next week's Greenbury report

The Greenbury committee on top people's pay is not due to report until next week, but already it is running into flak. It will call for considerably tougher controls on what senior executives are paid and on their length-of-service contracts; and there will be a special section attacking the pay ofprivatised utility heads, the issue which prompted the Government to encourange the setting up of the committee.

For many people, though, this will probably not be enough - as indeed the shadow chancellor, Gordon Brown, suggested yesterday. For some others, it may be too much: if a company wants to pay a top executive very well (but perhaps less than a top lawyer and much less than a pop star) then why should others protest?

But while executive pay is unquestionably a hot political issue, hardly anyone appreciates that it is also an economic issue. Why do companies pay their top people so much, when they seek to hold down all their other costs? The pat answer is that directors decide their own pay and they are greedy. Doubtless in some instances this is true, particularly in the couple of years before retirement - remember that in many pension schemes the pension is linked to final salary. It is also true that in the privatised utilities the same people in effect receive a windfall increase in their income, as the bodies shift from a public sector pay scale to a private sector one.

But in general companies pay their senior executives well because they worry that if they don't, the people will walk. And companies that find themselves in a mess because of an exodus of senior staff end up having to pay over the odds to re-recruit: the rate for the job plus danger money.

That does not explain, however, why top pay has risen so much in the past 15 years. There are at least three separate forces at work. First, the market for top managers has become an international one. Second, there was a structural change in demand for skills in the 1980s which affected pay differentials: the best were suddenly in much greater demand, while the average, sadly, often found themselves out of jobs altogether. Finally, management became more fragmented, with companies forced frequently to "out-source" managerial skills, that is, buy them in from consultants.

The first factor needs little expansion, except to point out that top British talent, to an even greater extent than continental Europeans and far more than the Japanese, has the potential to succeed in the US. Thus for example, the chairman of Ford, and the editors of the prestigious New Yorker magazine and American Vogue are Brits. US pay rates therefore have more of an impact on British ones than they do, say, on French or German.

The change in demand for skills is more puzzling, for while most people accept that something has changed, it is not at all clear why. The New York Federal Reserve Bank has been looking at this, and the graph (right) shows what has been happening. The general rule between 1940 and 1980 was that the more skilled you were, the greater the demand for your services, hence the straight line on the graph. Between 1980 and 1990, however, you had to be in the top 5 per cent of skills to find yourself in greater demand. In other words, just being, say, a university graduate is clearly not enough; you have to be a lawyer, or an MBA, too.

It is not even just skills; it is also a question of stars - let's call it the Pavarotti factor. Demand is strongest for the tiny proportion who have outstanding reputations in their field. It is worth paying that extra few thousand for the best barrister, the best analyst, or the best editor. If a film stars Hugh Grant, people, particularly now, will want to watch it; and the costs of signing up Grant are small in relation to the total cost of making the film. In exactly the same way, the additional costs of hiring a business or professional star are small in relation to the total wage bill.

There is no single, simple explanation for either the change in demand for skills, or the development of the Pavarotti factor. It has something to do with rising competitiveness in commercial life. It has something to do with greater job mobility and shorter professional careers. And it has something to do with wider social change, in that good people are less prepared than they were to "carry" mediocre ones. But even if the explanation is still fuzzy, it is an observable fact that something radical has happened.

The third change is outsourcing. Businesses have become so complicated and face such great strategic decisions that they cannot carry all the skills they need within their own management teams. Even giant firms like the big four banks or the oil companies find they have to employ consultants for managerial specialisms. Companies do not do this because they want to pay enormous fees or want to be told what to do by 28-year-olds. They do it partly because the price of failure is even greater, and partly because the skills needed for running a business in its existing form are very different from those needed, for example, to manage expansion into a different continent or develop a new line of business.

The effect is that many of the best young management graduates will not work for companies at all. The human resources department of one of the 10 largest firms in the world recently told me that it could no longer recruit the best graduates: they were going intomanagement consultancy or investment banking. It was terribly worried about this - rightly so. The problem was not just money; it was also that the company could not create sufficiently attractive jobs early in people's careers.

It is against this sort of commercial background that the Greenbury committee's recommendations should be seen. Of course there are abuses in the present system, and the Greenbury initiative is a step towards correcting those. But if the climate swings hard against top people's pay, the main effect, perversely, may be further to encourage even more high-fliers not to work for large companies at all. Instead, they will either pursue star status, or, if they want to be managers, go into consultancies - which would in turn lead to even more outsourcing. Or they will set up their own businesses, where no one can dictate how much they can be paid.