After overseeing one of the most profitable years in firm history, Goldman Sachs CEO Henry M. Paulson Jr. received a total compensation package of approximately $39 million for the fiscal year 2005, up from a mere $30 million in 2004. To put that into perspective, Mr. Paulson’s compensation was more than 900 times the median wage of the American worker. That’s one of the many ‘comparisons’ used by armchair economists getting hot and bothered over exorbitant executive pay in corporate America.

The median CEO compensation in 2004 was $14 million, up 25% from the year before. According to one estimate, the top five executives in a typical public company netted a total of 10 percent of the company’s total earnings in 2003.

The natural reaction among observers upon hearing these numbers is shock and anger: how can top executives appropriate such huge shares of company revenues when the economy has been largely stagnant and the middle class is being squeezed by higher prices and static incomes? In light of Enron, WorldCom, and other book-cooking scandals where the top brass illegally lined their pockets through under-the-table dealings, we are especially likely to ascribe even legal payoffs to the most malignant forms of backroom cronyism and greed. But before we blindly jump to this conclusion, we must at least consider the possibility that this level of executive compensation simply reflects the free market’s valuation of executives for their contributions.

In order to examine whether executive compensation is truly as grossly inflated as is commonly believed, we must first decompose the term “compensation” and realize that execs aren’t just receiving the value of their quoted compensation as cold hard cash from the company coffers. Compensation typically consists of some mixture of an annual salary and bonuses (this is the cold hard cash), stock options that accrue value in lockstep with the company’s stock performance, interest-free loans, miscellaneous perks (private jets, limousines, and personal sushi chefs), and health care plans that make Howard Dean jealous. When we read stories of CEOs cashing in for over $100 million at once, this is typically because they exercise the stock options they had been accruing over the course of many years rather than simply making off with the corporate bank account.

There is actually a more intellectually sophisticated argument defending this seemingly exorbitant executive compensation than Gordon Gecko’s “Greed is good! Greed is Right! Greed works! Greed will save the USA!” The argument holds that the same market forces that determine salaries for gas station attendants, middle-managers and investment bankers set the going rates for top talent in the labor market for executives. Economic theory says people are paid what they are worth to their employers. Does this hold for the rising stars of management at Fortune 100 companies? That depends on the market’s ability to accurately and objectively value top executive talent.

Accurately and objectively are clearly the loaded words in this condition. Is Mr. Paulson’s $39 million really an accurate estimate of his contribution to the firm or was he simply riding its success to the benefit of his already well-padded wallet? A simple initial market analysis might say that because companies are willing to fork over this level of compensation, they must believe they will recoup the costs in the form of better company performance under talented leadership.

This idea that executive compensation is closely linked to the leaders’ performance gains support from the way recent cuts in executive pay mirror the declines in companies’ profitability. About a third of the top U.S. companies now tie CEO compensation directly to stock price targets, and this link has led to declines in total payoffs as stocks have been largely stagnant. The drawback to this analysis is that stock performance can only serve as a proxy for the true value of an executive’s leadership. A mediocre CEO of a pharmaceutical company who happens to be in the driver’s seat when his company discovers the cure for cancer still stands to gain millions of dollars through no fault of his own.

Even if we assume that stock prices are a decent gauge of executive leadership and companies are theoretically capable of using stock targets to craft compensation plans that accurately reflect the value the execs are adding, we are still left to consider whether the corporate structure and culture we have now is capable of deciding appropriate compensation objectively. Many boards of directors for major U.S. companies are composed largely of executives from other companies. This opens the door for the possibility of backroom deals where favorable compensation packages are worked out in the old boys’ network of corporate leadership. Even if this does not occur explicitly in very many cases, the idea that executives are setting the appropriate level of compensation for other executives is somewhat perverse.

Despite these problems with the market-driven approach to explaining executive compensation, it is still logical to infer that the starting point for a company’s decision of how much to pay its top management is based on maximizing the return to the firm. Boardroom backslapping, good old cronyism, and an inability to truly gauge the value of an exec’s contribution might all figure into the inflation of executive compensation, but it still must have some basis in the management leadership’s ability to deliver results.