The Lake Wobegon effect was proposed some months ago as an explanation for Chief Executives' ever-increasing pay in the US. In Lake Wobegon (Garrison Keillor's fictitious town), all the children are above average.
The way it works is that all corporate boards want their executives to be above average. That cannot possibly be the case for everyone, but not to worry. Markets run on investor confidence and perception, so if a company gives its executives above average pay and bonuses, they will look above average, and this will make the company look strong. Hence an upward pay spiral.
Warren Buffett wrote in 2007: "CEO perks at one company are quickly copied elsewhere. “All the other kids have one” may seem a thought too juvenile to use as a rationale in the boardroom. But consultants employ precisely this argument, phrased more elegantly of course, when they make recommendations to comp committees."
Once the public has rumbled this, why don't companies get off the bandwagon and pay their executives a moderate reward for the job? Because, according to the analysis, a company that pays its executives moderately could be perceived as admitting that they are only average or below, which would harm its share price.
Taking this a bit further, it is argued that if lower-paid executives were in fact above average, they would have been poached by a company that is willing to pay more. So any executive that is lower-paid can't be above average.
But, I wonder to myself, as there are only so many banking jobs in existence, and if a lot of them are already occupied by average-or-below executives whose merits have been talked up by means of high pay, who are not going to be fired because that would involve the company admitting having been wrong, nor are they going to move in a hurry since they are already getting more pay than they merit, how do vacancies come up? Over to you, dear reader.
As I see it, the essential problem is that everyone involved in this process treats pay level as evidence of performance quality rather than looking at the actual performance itself. But looking at the actual performance is more complicated and difficult as well as presenting confidentiality problems, so most investors, I suppose, do not bother.
The Lake Wobegon effect has been blamed for the preposterous sums paid to some of the UK's top bankers who, it is now painfully obvious, were in fact worse than useless.
A similar thing happens in both branches of the English legal profession where lawyers with the chutzpah to demand silly money for their services often get it. This is then cited as evidence of brilliance.
It sounds a lot of nonsense doesn't it? Yet it is still happening.