We are hearing a lot about CEO salary caps in the coming bailout, so I have to visit once again the topic of salary, especially the misapprehensions people have about salary.

First, we often hear that a salary is "set" at some figure. The truth is, yes the company does offer a salary of such an amount, but they did not "set" it there, it is not an arbitrary amount. Salary is determined by two factors, what others are willing to pay for the same service, and what returns the company expects. If a CEO who will bring a certain amount of increased profits and reduced costs is priced on the market less than that amount, a company will offer him some figure between the market salary and the total revenue he is expected to bring. Usually it will be closer to the market price, but some companies will add a premium to ensure getting the best candidates. But the point is, the salary is not arbitrary, but based on objective factors.

Second, we often hear that salaries are "unfair", that a teacher is more important than a baseball player or actor, yet gets less money. And on an individual basis they may be right. But the problem is that salary is not based entirely on utility. Admittedly, each individual pays a service provider based on the utility he received, but a baseball player or actor can service more people. A baseball player may only provide an individual with $1 in utility over a year, while a teacher may provide $2000, but the teacher serves only 20 or 30 students, while the baseball player serves millions. So the teacher gets $50,000 while the baseball player gets $10 million. The fact that the teacher gets so much relative to the number of students, while upsetting to teachers, actually does show that we DO value teachers more highly, they just cannot reach as many people in a period of time as an actor or player.

Finally, and the one we hear most recently, is the idea that CEOs are paid unrealistically high salaries, that they get so much money yet produce nothing in return, and lead their companies into losses. It is an argument we often hear during bad economic times, when populist pundits agitate about CEO salaries and try to blame all economic problems on "corporate greed" rather than normal economic fluctuations or Washington's meddling, which is more often the case. Yet, popular as this argument is, it is wrong.

To begin, we do not know that the CEO lost any money. In bad times, even good companies lose money. Perhaps, were that multi-million dollar CEO not present, the company would have lost even more, justifying the salary that CEO drew because he put off even greater losses. Or perhaps he DID have a bad year, yet over the course of his employment, his wins are great enough to offset a few losses and still make him worth the money. It is a mistake to think about CEO performance in terms of discreet units of time. If you managed the Yankees and Babe Ruth struck out twice would you then fire him for being a "failure"? Then why do we judge a CEO based on a single year in a bad market? Or, in our current case, for getting involved in a problem that touched the entire market?

A second problem with the argument is highlighted by my Babe Ruth example. Sometimes even the best have an off day or two. And sometimes a CEO may not swiftly adjust to changes. However, if he truly is overvalued, then he will likely see his options shrink and eh will soon be unable to draw those kinds of salaries. So the system does self-correct, it just takes time, time for the CEO to prove himself no longer worthy of his salary, and time also for the contracts he holds to run out.

However, many argue that because companies can "often" pay too much for a CEO, we should limit their compensation. To return to baseball analogies, I have to ask, does the fact that a team paid too much for a free agent mean we should have salary caps? No, the lack of perfect foresight does not mean the government should get involved. The market corrects for this factor too. If a company makes one error, they pay for it in lost revenues. If they make it consistently, they continue to lose and either the company will find new methods to find and hire CEOs, or they will go out of business and better companies will take their place.

I could probably go on, but I think my point is clear. The high salary of CEOs is the outcome of the impact a single CEO can have, and the competition for the services of the best due to the huge boost they can bring. If the government is allowed to step in and try to "fix" that, they will only make companies likely to hire less skilled individuals and slow economic growth. They will also drive the best and brightest out of business management and into related fields without salary caps, where they can be paid what they are worth*.

The market runs well on its own, not perfectly, as no human venture is perfect, but well. And government interference does nothing to improve it, at best leaving things in the state they were originally, most often making them worse. So, pleas,e do not let appeals to class envy or "economic justice" blind you to the fact that CEO salaries are necessary and nothing like the arbitrary "gifts" populist demagogues would have you believe.

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* If the caps apply only to CEOs, we are likely to see fierce competitions for offices such as COO, CFO, CTO and others, as those who would normally become CEO drift into second-tier positions without salary caps. In reality a cap on only CEO salary would like turn the CEO into a figurehead and move real authority to subsidiary positions where no salary caps applied. (This is akin to the shift of power to the bureaucracy I predict term limits would bring.)