(FORTUNE Magazine) -- The setting: a private gathering that included several leading lights on Wall Street and the heads of some of America's biggest companies.

The topics of conversation: the extraordinary power of hedge funds, of course, and the unnerving liquidity of the markets.

But most of the talk - the most animated part - was about CEO pay.

"Executive compensation was out of control to start with, and now it's way out of control," one boss admitted.

Said another: "The problem is, we're living in a world where .220 hitters make $10 million, so look at what you have to pay when you finally find a .300 hitter."

Added a third: "It's not an excuse to say, 'Hey, the board gave it to me.' CEOs should be responsible too. That's leadership!"

There were modest proposals - "Can't we at least stop doing things like paying for perks like tax prep?" - and there was high anxiety - "My worry is that the more Americans perceive unfairness, the greater the risk government is going to impose a one-size-fits-all solution."

Then the most senior figure in the room summed it up. "We're not living in a world," he concluded, "where we can afford a lot of unnecessary ill will either between nations or within nations. That's why dealing with CEO pay and bad accounting is so important."

They hear you, America, loud and clear.

CEOs are concerned about the uproar over excessive executive compensation - backdating stock options to boost some bosses' pay, golden parachutes for world-class nonperformance, retirement packages that defy economic logic.

In fact, the outrage has grown so intense that the country's top CEOs are now vigorously debating the problem in private. What are they saying publicly? That's a different story.

When FORTUNE set out to find leaders prepared to talk for the record, only a handful of the nearly two dozen prominent executives we contacted would do so.

Two who did speak up, Home Depot's (Charts) Bob Nardelli and Pfizer's (Charts) Hank McKinnell, have taken some of the hardest pounding lately.

Nardelli has been hammered for accepting a pay package valued at $250 million even though his company's stock has declined slightly under his stewardship (and also for running a buttoned-lip, race-the-clock annual meeting in May that's destined for the Boneheaded PR Hall of Fame).

Still, the man was giving no ground when he met with FORTUNE in mid-June (though he did agree that the annual meeting was a mistake).

"We have an enterprise here that stands tall among corporations in America," Nardelli said. "The last thing you want to do is withdraw into a fetal position on some of this stuff."

He expressed gratitude for the "unwavering support" of his board and employees and deplored the fact that annual meetings have become "99% attack and antagonism."

"I've never seen such polarization in this country," he added. "Deal with the bad actors. Don't reward anyone who's done something inappropriate. But it's amazing to me how we broadbrush corporate leaders."

McKinnell, who is also head of the Business Roundtable, was even more assertive, dismissing critics who point to his $83 million lump-sum pension, his $16 million in total comp last year, and his stock's 42% decline since he took charge in 2001 as proof of pay for nonperformance.

While calling the overall debate "healthy," McKinnell questions the "agenda" of many "executive-compensation activists who try to inflame the issue of CEO pay."

Says he: "There's a much larger issue here; compensation is being used as part of a battle over control of the corporation itself."

In McKinnell's view, "an unholy alliance" of special interests - environmentalists, animal-rights activists, hedge funds - want to wrest decision-making control from boards and CEOs in pursuit of "their narrow interests," even though most shareholders "are pretty happy with the way companies today are being run."

McKinnell also says a scrubbing of pay numbers that the Roundtable commissioned found that "a lot of those big ratios everyone points to are just not supported by the data. CEOs are still very well paid, but they're not that well paid."

We're not picking on Nardelli and McKinnell. Both are very capable executives who've chalked up impressive business success.

Home Depot was running off the rails when Nardelli arrived; he has radically upgraded its systems while doubling sales, more than doubling earnings per share, boosting the dividend nearly 400%, and - a rarity these days - creating 100,000 net new jobs.

And Pfizer is, as McKinnell says, "the poster child for transparency." The 23-page report of its comp committee in the latest proxy - up from ten pages last year - meets stringent new SEC disclosure standards a year ahead of schedule.

While it's true both companies' shares have gone nowhere for years, that's also true of many blue chips such as IBM (Charts), GE (Charts), Cisco (Charts), and FORTUNE's parent, Time Warner (Charts) - all of whose CEOs are very well compensated.

We disagree with McKinnell's view that the recent efflorescence of shareholder activism is driven mainly by narrow interest groups: Pressure also comes from buttoned-down, big-money investors.

But we agree that most CEOs work very hard at extremely demanding jobs and deserve to be paid well. The best deserve to be paid really, really well.

Finally, we agree, as McKinnell says, that "nobody has any idea what the right level should be." The last thing we need is for government or a concerned collective of citizens to make that decision rather than boards of directors.

That said, put us squarely in the camp that has no doubt that the system by which McKinnell, Nardelli, and their fellow CEOs collect enormous pay packages remains deeply dysfunctional and overly generous, despite extensive recent reform efforts.

Too many incentives are wrong - most do less than they should to align managers with the interests of long-term owners by setting high hurdles and insisting execs keep skin in the game.

Too many companies continue to pay the top brass a king's ransom merely for doing decently - or for seriously screwing up.

How bad are things? Here's one wise man's assessment: "About half of American industry has grossly unfair compensation systems where the top executives are paid too much," says Charlie Munger, Warren Buffett's partner at Berkshire Hathaway.

Florida governor Jeb Bush - a pro-market conservative - is even more blunt. Out-of-control compensation, he believes, is "a threat to capitalism."

Says Bush: "Large rewards for great results can still be attacked, but they're very defensible. But if the rewards for CEOs and their teams become extraordinarily high with no link to performance - and shareholders are left holding the bag - then it undermines people's confidence in capitalism itself."

The governor, whose $120 billion Florida pension fund is the fifth-largest in the country, is hardly the only appalled "owner." Some 90% of institutional investors think top execs are "dramatically" overpaid, according to a Watson Wyatt survey last fall.

In fact, ill will over excessive compensation is fast turning into a giant political problem for corporate America.

In a Bloomberg poll in March, more than 80% of Americans - evenly divided between the well-off and those making under $100,000-a-year - agreed most CEOs are paid "too much."

The commentariat on both the left and the right is foaming.

"In the time of the French Revolution," wrote conservative Bill O'Reilly of Fox News about the golden goodbye Exxon (Charts) handed its outgoing leader, "Lee Raymond and his $400 million pension would be running one step ahead of the guillotine." (Actually, Bill, only $98 million of that princely sum was the pension, but we take your point.)

What's different about the fire this time is that it is singeing respected CEOs like Nardelli, Raymond, and in the biggest brushfire yet, UnitedHealth (Charts) CEO William McGuire.

McGuire has long been hailed as proof that nothing is wrong with paying outlandish sums for outrageous overperformance - in his case a 40-fold increase in total return over fifteen years. ("I don't think we could have anticipated the shares [would reach] this level five years ago," McGuire has said in rejecting the "perceived problem" of his excessive comp.)

In March, the Wall Street Journal raised questions about possible options backdating at UnitedHealth (a practice that, while permissible under certain circumstances, can amount to outright theft of shareholder assets.

No wrongdoing has so far been established, but the company, the SEC, and government prosecutors are all still investigating. Even so, the stock is down 22%, a drop that has lowered the value of McGuire's trove of in-the-money options from $1.6 billion in December to a still hefty $1 billion today.

Meanwhile, the number of U.S. companies under investigation for possible options backdating has climbed from just a handful in early May - back when a Houston jury was about to slam the jailhouse door on the poster boys for 1990s corporate excess, Enron's Jeff Skilling and Ken Lay - to some 50 at last count.

No wonder politicians from both parties have gone from ventilating about gas prices to expressing outrage over CEO pay.

No wonder SEC chairman Chris Cox is pushing ahead with the toughest set of pay disclosure rules in more than a decade.

And no wonder most top executives, in response, have curled up into a "fetal position," in Bob Nardelli's phrase.

One highlight of the hearings that Congressman Barney Frank (D-Massachusetts) held on this issue in late May came when compensation consultant Fred Cook stepped forward to defend his clients at the Business Roundtable - not to mention justify his industry's handiwork.

The standard methodology for calculating the pay gap is deeply flawed, Cook argued. Use medians, not averages, compare executive pay with all workers' (white-collar as well as blue-collar), and most important, ignore actual realized annual gains from options grants and instead substitute Black-Scholes valuations.

All are reasonable points. But what is the bottom line of this festival of prestidigitation? The median CEO-to-worker pay ratio in 2004, announced Cook, falls from a commonly cited figure of more than 400 to 1 to ... a mere 187 to 1!

Guys, trust us. This is not a road you want to go down.

What connects popular anger against CEOs as the new robber barons to more technical arguments over how best to yoke pay to performance?

This simple truth: Despite its great strengths, this country is up against huge challenges.

Faced with rising global competition, soaring benefit costs, and lousy demographics (too many retirees, too few new workers), large employers in every industry are walking away from or renegotiating the old postwar social contract over health benefits and pensions - just as most companies long ago stopped guaranteeing lifetime employment.

Nor, unless we're eager to see a lot more GMs (Charts), Bethlehem Steels, and Delphis (Charts) down the road, can society expect them to do anything else.

In making these hard but necessary decisions, however, it sure helps if leaders maintain the moral high ground. And splitting hairs over a 187-to-1 pay ratio doesn't get them anywhere near the mountaintop.

Unlike the lucky crowd at the top of the income scale - hedge fund managers, media superstars, lawyers, strategy consultants, rock stars, sports heroes, and, yes, CEOs - a majority of Americans haven't been reaping the rewards of globalization.

Even as benefits shrivel, real median wages have stagnated since 2000, while real median family incomes have fallen four years running. Americans don't mind income inequality, as Harvard University's Benjamin Friedman points out in a sweeping new book, The Moral Consequences of Economic Growth.

Throughout U.S. history, he writes, "the central question is not the poverty of the most disadvantaged, not the success of the most privileged. It is the economic well-being of the broad majority of the nation's citizenry."

So when all income levels prosper, as they did in the mid- to late 1990s, few mind if the rich get richer.

When the vast middle falls behind, suddenly you get today's ugly politics: hysterical attacks on illegal immigrants at the low end, and at the high end, mounting assaults on greedy executives and feckless boards.

What's at stake, in short, is nothing less than the public trust essential to a thriving free-market economy.

"There's a right amount for CEOs to get paid, and it could very well be lower than it is today," GE CEO Jeff Immelt replied when asked about executive comp last winter at the Washington, D.C., Economic Club.

"I don't know. I wish the debate would end, though, for one reason ... it's crowding out important debates on education, innovation, technology, globalization, competitiveness, that are really what you want this whole thing to be about."

What will make a difference? Better disclosure should help.

The SEC first passed a rule making companies put information on stock grants into proxies in 1992, the last time the country got so worked up about CEO pay.

Since then, a lot of executive compensation - surprise! - has shifted into areas where disclosure was optional: deferred-comp plans and special executive retirement schemes.

"When you discover what's been left out, you get very angry," says John Wilcox, head of governance at TIAA-CREF. "The new regime should finally ensure everybody knows everything."

But for a sobering reminder of how behavior always trumps process - and why it's been impossible so far to bring this ugly era to a close - consider this: In June 2002, Goldman Sachs (Charts) chairman Hank Paulson (now about to become Treasury Secretary) gave a much heralded speech laying out "an agenda for change" to restore investor confidence.

As a good team player, Paulson admitted that his ideas, many of which have since become standard practice, were hardly original and concluded by crediting the thinking of three leaders: the heads of the Business Roundtable, the New York Stock Exchange, and the Financial Services Forum.

What's become of those leaders? Franklin Raines was forced to resign as head of Fannie Mae (Charts) in December 2004 after collecting $90 million while Fannie was committing huge accounting errors that have wiped out $11 billion in restated earnings.

Dick Grasso was pushed out as head of the NYSE amid a furor over his nearly $200 million pay package and accusations of an egregious lack of disclosure.

And Phil Purcell was sent packing from Morgan Stanley (Charts) last summer after earning $22 million in his final year as boss, plus $43 million in severance, for delivering a 25% decline in the firm's stock price since 2001. Ouch.

It's time for more walk and less talk. As Charlie Munger puts it, "The CEO has an absolute duty to be an exemplar for the civilization." Munger isn't the only leader with that old-fashioned view.

At big-box retailer Best Buy (Charts), 33-year company veteran Brad Anderson decided he was making plenty when he became CEO in 2002.

Because he also wanted to shake up the company's strategy, he decided to hand over his annual option grants to the frontline troops - which he's done for three years now and plans to continue doing until he steps down.

Says Anderson: "I thought it would help internally to be indicative to my people that I was thinking about more than myself."

CEO volunteerism, however admirable, will only get us so far. The real action has to come at an even higher level: the board.

Warren Buffett has long believed, as he told FORTUNE, that "the only cure for better corporate governance is if the small number of very large institutional investors start acting like true owners and pressure managers and boards to do the same."

In the models of how capitalism works in public companies with widely distributed ownership, directors stand at the pinnacle of power.

While the CEO runs the company day to day, directors hire, supervise and, if needed, fire the CEO. That's the theory.

In practice, for most of the postwar era, the CEO ran the show; directors were little more than boardroom decoration - "like the parsley on fish," as an ex-CEO of U.S. Steel (Charts) described them.

In the wake of the post - Enron/WorldCom reforms, power has been shifting back to boards - but perhaps not fast enough.

In a true Pogo moment ("We have met the enemy and he is us"), 75% of outside directors agreed in a PricewaterhouseCoopers poll last fall that "U.S. company boards are having trouble controlling the size of CEO compensation."

To stiffen individual directors' spines, especially those on comp committees, a growing number of pension funds, mutual funds, and other institutional investors - the folks who control on behalf of you and me most of the shares of America's biggest companies - have decided to direct their throw weight to the issue of "majority" voting.

Here's how it works. Typically in the past, companies would put up a slate of directors, and shareholders could vote "yes" or "withhold."

One "yes" sufficed to get you reelected. Now owners are increasingly backing resolutions requiring that directors need to get more "yes" votes than "withholds."

In 2004, according to the Institute for Shareholder Services, there were 12 such proposals, and they got about 12% of the votes. The number has swelled this proxy season to 143 proposals.

Thirty-three have garnered over 50%, often at companies where CEO pay was an issue - UnitedHealth, Home Depot, Exxon, GM (okay, more than pay was at issue there).

"We were in those votes," says Jeb Bush, as in most cases were the folks at TIAA-CREF ($380 billion under management), Calpers ($202 billion), and others - and for the same reason.

Says Coleman Stipanovich, who runs Florida's pension fund: "Get the right people on the boards, and this is going to take care of itself."

Wouldn't that be nice? The truth is that fixing this mess will be plenty hard.

Many of the worst aspects of today's executive pay - insufficiently high incentive hurdles, "golden hellos" that ensure constant streams of stock far into the future, obscene severance deals - all get baked into employment contracts long before CEOs and boards really get to know each other.

By the time they fall out of love, it's too late. And it's not valid to insist, as some critics do, that market forces play no role in this process.

Bob Nardelli got such a sweet deal at Home Depot in part because he was among the hottest would-be leaders in the land six years ago.

"Nothing offends more than executives being paid for failure," says investment fund superstar Eddie Lampert, who now owns Sears and Kmart (Charts).

"But you'd never hire somebody in the first place if you thought they were going to fail. The key is to strike a fair and reasonable balance at the outset."

In those negotiations, Lampert notes, "there's no substitute for having board members act and think like owners - and ideally be owners."

Speaking of thought exercises, here's one more. "Can you recall a single instance where a CEO has walked because the board refused to pay him enough?" asks a money manager with $3 billion in long-term assets.

No, we can't. (But if we've missed one, volunteers are standing by to take your calls.) In real markets, some negotiations just don't work out. When that starts happening, then you'll know we really are getting somewhere on CEO pay.

Rik Kirkland, a former managing editor of FORTUNE, is writing a book on capitalism for Random House.

Lee Raymond

$405 Million

That's the 2005 comp, lump-sum pension, and current value of various stock grants with which Exxon's chief rides into retirement.

Bob Nardelli

$250 Million

The total value of the package Home Depot has paid him so far. He's collected about 30%. The rest varies with the stock price.

William McGuire

$1 Billion

UnitedHealth's CEO holds a ton of options. Alleged accounting flaws have hit the stock. But his potential reward (above) remains rich.

Hank McKinnell

$99 Million

Pfizer's CEO took heat for a hefty pension built up over many years (present value: $83 million). He earned $16 million in 2005.

Franklin Raines

$90 Million

Fannie Mae's boss made that from 1998 to 2003. But auditors now say the earnings his comp was based on were overstated by $11 billion.

Phil Purcell

$66 Million

Morgan Stanley's stock fell 25% in the past five years. Pushed out last year, he collected this amount in severance plus 2004 pay.

Reporter Associate Doris Burke contributed to this article.