(FORTUNE Magazine) – Sandy Weill, who got a pay package worth some $151 million for running Citigroup last year, was a Brooklyn teenager back in the summer of 1950, preparing to return to Peekskill Military Academy. Jack Welch, whose pay for managing GE last year totaled about $125 million, was caddying at a golf course near his home in Massachusetts, having completed his freshman year at Salem High School. In Chicago, Larry Ellison--2000 pay as Oracle's chief: $92 million--was an ordinary 6-year-old. There's no reason any of them would have given the least bit of attention to events in Washington that summer, let alone suspected that what was going on there would change their lives and the life of virtually every future American CEO.

But that's what happened. After weeks of horsetrading, Congress sent President Truman the Revenue Act of 1950, and on Sept. 23 he signed it into law. Buried deep within that bill was a section amending the tax code. And that change, scarcely remarked upon at the time, made it legal and practical for companies to pay employees with an interesting form of currency called the stock option.

Thus began the madness. If you want to understand America's out-of-control CEO pay machine--including Steve Jobs' recent $872 million options grant, by far the largest ever--start there. The machine is worth understanding because it has begun churning out dollar amounts so mammoth that even hardened professionals grope for words. "Outrageous in many cases and unrelated to services rendered," says Charles Elson, a director of three publicly held corporations who runs the University of Delaware's Center for Corporate Governance. "In many cases, outside the charts," says Joseph Bachelder, the New York lawyer who has probably negotiated more top CEO pay contracts than anyone else. "Grossly high--astronomical," says Richard Koppes, a well-known governance expert with the Jones Day Reavis & Pogue law firm. "I've generally worried these guys weren't getting paid enough," says Harvard Business School professor Michael Jensen, who has written some of the most influential work on CEO pay. "But now even I'm troubled."

What they and many others find so stunning are recent gargantuan pay packages unlike any seen before. Maybe you recall being shocked by the numbers of about a decade ago, when Time Warner's Steve Ross got a $75 million package, and Heinz's Anthony O'Reilly received four million options worth some $40 million. Such amounts marked the top end of the scale through the boom times of the mid-'90s. But suddenly, in recent years, pay has ballooned into nine-figure totals, almost defying comprehension. Consider:

--The No. 1 earners in each of the past five years got packages valued cumulatively at nearly $1.4 billion (see chart), or $274 million on average. Yet far from delivering the superb results investors might have expected from the world's highest-priced management, four of the five companies have been marginal to horrible performers. They are Walt Disney, Cendant, Computer Associates, and Apple Computer.

--Apple's Steve Jobs got last year's mightiest pay package, valued by FORTUNE at $381 million. (For the purposes of calculating his 2000 package, we have valued his monstrous options grant at one-third the exercise price of the shares optioned. And, of course, we've included the $90 million Gulfstream the Apple board gave him.) How big is that? The last time the public got furious over CEO pay was in 1992, when reports of huge numbers for 1991 sparked a flurry of reform efforts. Yet the 14 highest-paid CEOs then, including such legendary mega-earners as Coca-Cola's Roberto Goizueta, Philip Morris' Hamish Maxwell, GE's Welch, and ITT's Rand Araskog, together earned less than Steve Jobs did last year all by himself (even without the plane!). Yes, it's true that Jobs has paid himself only $1 a year since he returned to Apple as CEO in 1997. And, yes, he deserves to be rewarded--handsomely--for bringing Apple back from the dead. But still...

--Dell CEO Michael Dell received more than 38 million options from 1996 through 1998, though as the company's sole founder he already owned 353 million shares. Similarly, Oracle CEO Larry Ellison got a huge 20-million-share options grant, accounting for virtually all his pay last year, even though he already owned nearly 700 million company shares outright. What could possibly have been the point? "If they weren't already motivated enough to protect the owners' interests, then their shareholders are in worse trouble than they think," says shareholder activist Nell Minow.

The largest pay component in virtually all these cases is the stock option, which has mushroomed from modest use in the 1950s to a source of breathtaking CEO wealth today. A big reason for its runaway popularity is the insane way accounting authorities let companies treat options in financial statements--a way that's great for executives and awful for shareholders. (See "The Amazing Stock Option Sleight of Hand.")

More broadly, pay is out of control because many board compensation committees, which set CEO pay, aren't doing their job. Why not? That's always been a bit of a mystery, because the comp committee code of silence is sort of like the Mob's omerta, only stricter. Nonetheless, FORTUNE's Carol Loomis persuaded some high-powered comp committee members to tell, anonymously, what goes on behind those doors (see next article, "This Stuff Is Wrong"). The picture isn't pretty.

There's no simple explanation for the latest extraordinary pay figures. Today's roaring CEO pay machine is a giant device of many parts, built up over decades. Besides options, other important pieces have come from compensation consultants, economic developments, social trends, even government; indeed, the government's occasional attempts to restrain CEO pay have almost always had the opposite effect. What's so remarkable about the machine is that through all the ups and downs of business, the waxing and waning of corporate fortunes, it turns in only one direction--and faster all the time.

It wasn't always so. Through the '50s, the '60s, and part of the '70s, CEO pay actually grew more slowly than the pay of average workers. Most CEOs were publicly invisible and liked it that way. Adjusted for inflation, pay packages were much smaller than today's. They included options, though by modern standards the grants were pitiful; 20,000 shares were a big deal. Pay didn't seem tied particularly tightly to performance, yet stocks performed well: The S&P 500 advanced 11.3% a year on average in the low-inflation era from 1950 to 1964.

That golden age ended abruptly when stocks entered a long coma in 1964--and we soon began to see the early stirrings of today's opulent reward system. Since the market was going nowhere, options weren't paying off and substantial raises seemed hard to justify. So compensation consultants--yes, they were around back then--began cooking up the creative pay-enhancing gimmicks they have continued to devise ever since. Indeed, consultants play a critical role as the pay machine's expert mechanics. They understand every gear and sprocket and can always find a way to make the machine go faster. That's exactly what they do, in their utterly conflicted position--paid by management to advise management on how management should be paid.

The consultants' most inspired creation in the days of the stock market doldrums was a device called performance shares, which rewarded CEOs if they could increase earnings per share by a given amount in a given period--and never mind that EPS could be manipulated in a thousand unholy ways. What's important is the logic. You might have expected it to go like this: The stock isn't moving, so the CEO shouldn't be rewarded. But it was actually the opposite: The stock isn't moving, so we've got to find some other basis for rewarding the CEO. That difference, which persists to this day, is one of the keys to understanding megapay.

Another important element of today's CEO pay developed soon after. "An awful lot of CEOs should honor Curt Flood," says Michael Halloran of compensation firm SCA Consulting. Flood was the St. Louis Cardinals outfielder who in 1969 challenged the reserve clause in baseball players' contracts; though he lost his case in the Supreme Court, his quest inspired developments that made scores of players free agents by the late 1970s. Soon 20-year-old shortstops were making more than CEOs, and CEOs hated it. Surely they were worth more! And through that argument they started getting more. The counterargument--that athletes' pay, unlike CEOs', was determined in a brutally competitive open market--didn't get much airtime in the boardroom.

Meanwhile, in a radical shift, CEOs were becoming celebrities. As business became glamorized in the 1980s, CEOs realized that being famous was more fun than being invisible. Compensation consultants who were around at the time report a startling phenomenon: Instead of being embarrassed by their appearance near the top of published CEO pay rankings, many CEOs began to consider it a badge of honor. That societal change is another key part of today's CEO pay machine.

Though stock options have been available since 1950, today's options culture began in the bull market of the 1980s. This makes perfect sense, of course; since stocks essentially went nowhere from 1964 to 1982, options during that era didn't exactly make a CEO's heart beat faster. But once stocks took off, options suddenly became an excellent vehicle for getting rich, and companies began delivering them in truckloads.

Besides, corporate raiders like Boone Pickens were arguing, rightly, that most CEOs didn't have enough skin in the game--they didn't own enough company stock to care about increasing the share price. Institutional investors and shareholder activists were pressing the same case. It was a classic demonstration that you should be careful what you wish for. Companies quickly responded by handing the CEO tons more options and restricted shares. Trouble was, that came on top of already generous cash pay--so the CEO's interest wasn't really aligned with that of the shareholders. Besides, if the stock went down, the CEO wouldn't lose money the way shareholders did. He or she simply wouldn't exercise the options.

We pause a moment now to recognize a couple of CEOs for historically significant roles. Michael Eisner signed on as Walt Disney's chief in 1984 with a contract that changed the game for all who followed. Written by Graef S. Crystal--then America's preeminent compensation consultant, now one of the most vehement critics of CEO pay--the contract offered huge rewards if Eisner delivered great profits. Crystal advised Disney's board that the contract could make Eisner the highest-paid CEO ever. Understood, said the board. Eisner then performed as hoped for, and his pay--$57 million in 1989, for example--ratcheted the numbers up a giant notch. (That contract has long since expired, and last year Eisner got big pay for poor performance.)

Eisner's fellow trailblazer was Roberto Goizueta, Coca-Cola's chief from 1981 until his death in 1997. He turned Coke into a champion performer, and because he was paid heavily in options and restricted stock, he apparently became the first executive billionaire: the first person to amass assets worth more than $1 billion as a hired hand, without having founded or financed a business. After that, CEOs could never think about their pay in the same way again.

The pay machine's newest pieces appeared in a flurry in the early 1990s. The forces of the previous decade--the bull market, the huge options grants, the Eisner-and-Goizueta effect--combined to produce a slew of mammoth pay packages. The public became furious--so furious that Washington had to act.

So in 1993 Congress created section 162(m) of the tax code, which prevents companies from taking a tax deduction for CEO salaries over $1 million a year; pay that varies on the basis of performance remains fully deductible. Compensation consultants agree that this change, far from restricting CEO pay, probably helped increase it. Many salaries that were below $1 million now rose to that level, since it was virtually government-endorsed.

Around the same time, the SEC required companies to report CEO pay in far greater detail, the better to inform shareholders. Ambitious CEOs now knew better than ever what their peers were getting--and could push for packages that were superior in every particular.

And with that, the main elements of today's megapay machine were in place. How does it work? Let's take a look:

1. A poorly performing company, under pressure from active investors, fires its CEO and seeks to bring in a highly touted outsider. The outsider has tons of options from his current employer that he'll forfeit if he leaves or joins a competitor. So the new employer has to make him whole by paying a massive signing bonus. Most egregious example: Conseco last year paid former GE Capital chief Gary Wendt a signing bonus of $45 million--cash--to forfeit his GE options and become CEO. (For more on Wendt, see Street Life.)

2. The ousted CEO was probably earning a lot--it's all public info--so the new guy argues, logically, that if the old CEO was getting so much for doing a lousy job, he, the presumed savior, should get a great deal more. He probably does, and the details are reported in the proxy statement.

3. The comp consultants duly enter that mammoth signing bonus and pay package into their databases, and the median pay in that industry jumps.

4. Every comp committee in that industry, when determining the chief's pay, is now looking at higher median levels. Since comp consultants report that virtually all committees believe their CEO ranks at the 75th percentile or above, they will almost certainly award packages that raise the median even further.

5. The typical underperforming CEO whose stock falls receives even more options and perhaps restricted stock. Inevitably, the publicly stated reason is that this gives him greater incentive to get the stock up. The actual logic is that since his old options are worthless--and because it would look profligate to take a tax hit by raising his salary above its current $1 million and a bonus increase would look terrible in light of recent poor performance--the only way to give him more money is to grant a big slug of new options at today's lower price, plus restricted stock, which will pay off no matter what.

6. Those mushrooming stock awards are cited by other comp committees as justification for handing lots more stock to their own CEOs.

7. When an underperformer finally gets canned, he leaves behind a formidable pay package, and the company may have to entice an outsider to give up his own giant package. Return to Step 1.

On and on this wondrous machine turns, cranking out bigger numbers with every revolution. Logical question: If all the machine's parts were installed by 1993, why is it only now that we're hearing such outrage over the results? Answer: The American public isn't angered by big pay. It's angered by perceived injustice. The last major outcry, in 1991 and 1992, arose from huge CEO pay at a time of recession and widespread layoffs. Pay kept right on rocketing after that, but when the economy got back on track and the stock markets caught fire, who cared? This time the backdrop is a dragging economy and a market collapse that hurt millions of people. Like the last crisis, this, too, shall pass.

And then what? Three facts combine to create the fuel that keeps the American CEO pay machine spinning at today's furious clip. First and most fundamental, the managers and directors, who control the corporation day by day, are not the owners, who bear the cost of what the managers and directors do. Shareholders may be incensed by their CEO's pay, but doing something about it is so cumbersome that it almost never happens. That separation of ownership from control, and the potential for mischief it creates, have been apparent for 70 years. We accept it because it's the price we pay for a system of broad-based capitalism that has enabled the funding of the world's largest and most successful enterprises.

Second, the American culture celebrates wealth and fame above almost all else. "Even if a CEO is worth it, should he take it?" asks Ken West of TIAA-CREF, America's largest private pension fund. In many countries a nine-figure pay package, and the attention it attracts, would be just too far outside social bounds. Not here.

Third, we're in a revolutionizing global economy where the difference between the right CEO and the wrong one is all the difference in the world. Many will fail. Demand for winners is huge, the supply small. In that environment the best CEOs will cost more than ever, and--who knows?--may be worth it.

Now, what are the odds that those facts will change anytime soon? Not good, it would seem. On the other hand, the chances that the economy will pick up and the public will feel better by next proxy season are excellent. That's why, despite this year's mind-blowing numbers and the outraged reaction they've provoked, a hard-headed realist would have to say that America's CEO pay machine looks well oiled and finely tuned, with a whole lot of life in it still.

REPORTER ASSOCIATES Ann Harrington, Paola Hjelt

FEEDBACK: gcolvin@fortunemail.com