Reversing Perverse Incentives

Depressed business investment prevents growth. There are two possible ways to change this. The first is to alter the way senior managers are remunerated. The second is leave the incentives unchanged but change their impact on investment. This chapter deals with the first. Bonus systems for companies could be changed by encouraging them to include productivity targets. Productivity is output divided by hours worked. Both these data are known to companies as output is broadly defined profits plus employment costs. Though known the information is seldom if ever published. The current failure to do so is both the result and the cause of misinformation, as analysts and financial journalists regularly confuse sales with output. The requirement to publish output and productivity data would on its own benefit the economy.

Deflation

The demonization of deflation has drawn attention away from the key problem of productivity. It arises from the two errors that deflation causes recessions and that investment responds to real interest rates. Deflation can be a symptom of inadequate demand but it can also occur when demand is strong. The fallacy depends on ignoring history and the importance of inflationary expectations. These were low in the late nineteenth century, allowing output to grow strongly while prices declined. Low expectations today have allowed stable prices to be combined with falling unemployment. But such expectations are very volatile. Should they rise a sharp increase in interest rates will be needed to prevent stagflation. This will be more dangerous today that it was on the previous occasion in 1982, as asset prices are now overvalued and were then cheap and debt levels were low.

Description of My Model

The volume of the capital stock is defined as the original cost at constant prices of all tangible capital that has not been scrapped. Due to the poor data available for the UK my calculations and testing have had to be limited to the US. The volume of labour is defined as civilian employment. Quality improvements for both labour and capital are defined as being part of TFP. TFP is under conditions of full employment and must therefore be measured over long time periods. All growth comes from TFP, changes in labour and NTVs. The change in the volume of capital less the change in the volume of labour equals the change in NTVs and the balance is that from changes in technology (TFP). NTV is exogenous in aggregate. The value of the capital stock, but not its volume, is mean-reverting.

The Problem of Income Inequality

Living standards change in line with GDP per head only if the distribution of incomes is unchanged. If incomes become less equally distributed the living standards of most people will fall even if GDP per head is stable. The Gini Coefficient is the most widely used indicator designed to measure the distribution of income. UK inequality, on this measure, has risen since 1977, stabilized since 1987, and fallen in recent years. In the US there has been a long-term increase in income inequality. Unless this US trend for increased income inequality halts, it is quite likely that even if GDP per head rises in the US, the living standard of the average voter will fall. The recent data suggest that changes in income inequality pose less of a threat to living standards in the UK then they do to those in the US.

Ageing Populations

The changes in demography, together with low investment and poor productivity, have been responsible for the whole of the decline in the trend growth rates of the UK and US economies. Living standards measured by GDP per person are given a boost when the population of working age grows faster than the total population. This favourable change in demography was the situation up to 2008. Until then living standards tended to improve faster than productivity. Since then the total population has been growing faster than the numbers of working age and living standards will now tend to grow less rapidly than productivity. The impact on prosperity has been sharp because we have moved from a favourable to an unfavourable situation.

Summary and Conclusions

Poor productivity poses the major threat to the UK and US economies. It should be but isn’t our main economic preoccupation. Growth does not depend solely on the rate at which technology improves. It can be raised by improvements in policy for which I have three suggestions. The first is to change either the perverse incentives of modern management remuneration, or their impact on the economy. The second is that companies should publish their output and the working hours of their employees. The third is to end the folly of allowing interest to be a deductible expense for corporation tax. The damage to the economy from the bonus culture is currently met with silence. This book aims to get the issue debated, so that the need will become self-evident and be accompanied by the new policies we need.

The Economic Consequences of Higher Investment

Increased investment is essential to restore growth, but this will require higher savings as well as higher investment. Subject to the limited amount of help likely from rising current account deficits, domestic savings will need to rise at the expense of consumption. This will be unpopular. Those who claim that high corporate cash holdings mean that additional investment can be financed without more savings are confusing stocks with flows. Equally at fault are those who think that additional public sector investment will be painless because interest rates are so low. Companies in the US are the only major sector which is a habitual buyer of equities. Additional corporate investment will lead to fewer buy-backs, lower share prices, and higher household savings. This will narrow the savings gap, but fiscal deficits are highly correlatated with corporate net savings, so rising taxes are likely to be needed if investment rises.

Misinformation Adds to the Risks for the Economy

The damage done by misinformation needs to be contained. Companies should publish their domestic and worldwide output. This should reduce the misstatement and thus volatility of published profits. US profits are habitually overstated, and this does relatively little harm, but periods of excessive overstatement lead to the risks in credit markets being under-appreciated and markets overpriced. Overstated RoEs encourage high hurdle rates, which reduces investment. The complacency about debt and asset prices is less prevalent today than it was before the financial crisis to which it made a major contribution. But restricting debt and asset prices is more difficult when there is bad information about asset values and credit risks. Misstated profits also contribute to asset bubbles and consequently to the magnitude of cyclical swings in the economy. Modern corporate accounting has contributed to this profit volatility.

The Legacy of the Financial Crisis

The reputation of liberal democracy has fallen not only internationally but even within the UK and the US, which on current policies risk a decline in living standards and an even worse outcome should more to populist policies be implemented. Weak growth followed the financial crisis but was not caused by it. Holding otherwise is an example of the ‘post hoc fallacy’. Weak growth was caused solely by adverse changes in demography and poor productivity. Addressing both economists and the wider audience of those concerned with our economic and political future, this chapter shows that the adverse changes in demography and productivity have causes which predate the financial crisis by many years. The financial crisis was due to poor theory which led central banks to ignore the risks of high asset prices and excess debt. Poor theory today inhibits policy makers from recognizing that bonus culture policy has stifled growth.

Management and Shareholder Interests

Objections to the bonus culture because it is unfair and morally unpleasant raise serious issues, but have diverted attention from its economic damage. Pay has also been misinterpreted as being an issue between management and shareholders. But shareholders are not damaged as, unlike the economy, they do not benefit from faster growth in GDP. This can be seen by comparing the growth rates of different countries and the returns that have accrued to shareholders. Shareholders are not a homogenous group. Those who are retired benefit from high share prices. Those saving for their retirement should like low prices so that they will have high returns on their savings, but few recognize their ‘real interests’ in this way. No group of shareholders likes, in practice, to have the prices of their shares decline.