Tag Archives: economy

Still waiting.

Posted on December 18, 2012 | Leave a comment

Progress is to the UK economy as words have been to my blog. Lacking. News on economic fundamentals, and the associated policy discourse, have consistently underwhelmed. Government concern remains fixed on the same, narrow goal of fiscal consolidation, with inadequate regard of how this consolidation is achieved. 2012 bears evidence to the claim that this concern is misdirected and that the derivative economic strategy is self-defeating. December has born witness to yet another downgrade in UK growth prospects and the rise of measured government debt has only been slowed by the inclusion of projected departmental underspends and the proceeds from the 4G license sales to projections. This post is a summary piece on the the state of the UK recovery and outlines the economics behind why the policies pursued to date have been unhelpful (at best).

The economy, ….

The underlying picture remains much as it has been for the past two years: one of persistent weakness. Fifty shades of grey minus anything remotely stimulating if you will. The economy performed less strongly in 2012 than anticipated. The OBR cut its growth forecast to predict a 0.1% fall in output this year, followed by growth of 1.2% in 2013. Output is thus at roughly the same level as 2 years ago, 4% below that in 2008. This recession by now far exceeds the “Great Depression” in length. The graph below from the NIESR illustrates the point nicely.

It is unclear whether below par growth this year derives from “cyclical” (temporary) or “structural” (permanent) weaknesses. Cyclical weakness sits on the “demand side” of the economy– people and businesses just aren’t buying enough stuff–, whilst structural weakness is more pernicious and difficult to tackle, the result of a “supply side” contraction — we can’t make as much stuff. The two are related as cyclical weaknesses can be locked into structural ones via a process called “hysteresis” — see this post for more. There is disagreement as to how much of our current troubles to attribute to one or the other but, regardless, the OBR now forecasts systematically weaker economic growth for the coming years than it previously predicted in March.

Difficulties (understatement) in the Eurozone have continued to depress net exports and confidence. However, our lacklustre performance is by no means implied by the economic woes that plague Europe and other Western countries. Growth in the US and Germany has consistently dominated that achieved on these shores, and the UK pales in comparison to a host of countries in any ranking of capital investment.

And what of the lauded deficit reduction strategy? Despite (because of?) Plan A(usterity), good news isn’t forthcoming in this domain either. The size of the of the public finance hole is of a similar magnitude to that of 2011. However, even this underwhelming achievement is sullied by the knowledge that without the inclusion of funds from the one-off 4G licensing auction and the predicted “underspends” by certain government departments, the funding shortfall facing the government would have grown this year.

… stupid.

In his Autumn statement, Osborne upped the dosage of existing prescriptions to cure the UK economy and added a few new measures to the mix. However, don’t expect a return to health soon. Policy remains inadequate and misdirected. There continues to be insufficient concern about the ends that sustainable public finances are supposed to advance. This has contributed to a lack of attention surrounding the composition of the policy mix conjured up on order to coax fiscal sustainability back to UK shores.

Just to remind ourselves, what is a budget deficit? When people talk about the deficit they are referring to the gap between what’s coming into the government coffers through taxes/other revenue sources (call this amount “T”) and what’s being spent (amount “G”).

Budget deficit = G – T

We care about the size of the budget deficit because of the impact that unsustainable public finances have on the economic prosperity of a country and the wellbeing of its citizens. It is not of value in and of itself to pursue low government borrowing (see this post for more on the cost of a deficit). Therefore, the obsession with fiscal consolidation is misguided and has resulted in a misdirected, overly narrow economic strategy. The size of the budget deficit is not the most salient economic ill plaguing the UK at present. If financial markets were overly concerned with the sustainability of the UK fiscal position, we would see interest rates rising with market risk. We have not witnessed this, the opposite in fact, suggesting that indebtedness is not the primary concern in financial markets (see this piece by Adam Posen, former MPC member, for more evidence on why reducing the debt should not be the top priority right now).

A blinding focus simply on the extent of the debt reduction required, without much regard to the how’s and why’s, has promoted a self-defeating economic strategy. The experience of the last 12 months is testament to this. Given that what we actually care about is general prosperity and wellbeing, we should aim for a deficit reduction strategy that protects these ends as far as possible. This demands a detailed analysis of the composition of spending and taxation changes, rather than just a pure focus on levels. This is because the austerity-growth dichotomy often presented in the media and by politicians is a false one. By reallocating government resources to activities with a high “fiscal multiplier” (to be explained!), growth can be supported whilst the budget deficit is reduced.

The Fiscal Multiplier

What does it mean to reallocate spending to activities with a “high multiplier”? The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by £1. This additional £1 then represents income for someone that can be spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c²+ c³ + …

Therefore, there can be a more than proportionate increase in demand for an increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. The introduction above was clearly overly simplified; there is not one fiscal multiplier but a set of them associated with different government programmes. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. To illustrate, imagine a balanced budget policy, that simply takes income from one group in society and transfers it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. This helps to highlight that through redesigning the austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated, and output protected, without a need to increase the debt burden.

The Autumn statement flirted with this principle by earmarking funds for capital spending and investment. These are potentially “high multiplier” activities given the employment and productive projects they facilitate. However, the scale of proposed new capital spending is insufficient. £5bn over the next two years. An amount that, at best, is expected to add 0.1% to GDP. Not exactly pushing the boat out… Secondly, and more importantly, the funding source for the proposed investments has the potential to undermine their (already small) impact. Cuts to welfare and tax credits will be used to fund these measures. However, such cuts will have a significant negative impact on demand in the economy given that they fall on those at the lower end of the income distribution. Such households tend to have a high marginal propensity to consume and little way of smoothing their spending. Therefore, the policy is largely funded by those who’s incomes the government should really be trying to protect if it is to be true to a multiplier guided philosophy. (Note that this is before any equity based arguments are even considered.)

A new voice

“For last year’s words belong to last year’s language

And next year’s words await another voice.

And to make an end is to make a beginning.”

— T. S. Eliot

In the next few weeks, I will write a number of more targeted posts on specific policy proposals and Eurozone developments. However, hopefully this post will have equipped you with some background knowledge on the economy and convinced you that a significant shift in economic strategy and dialogue is required in the UK. The singular focus on austerity has been self-defeating and has contributed to the prolonging the country’s economic woes. We’re long overdue a change in vision and vocabulary. The Autumn statement highlighted some appreciation of the arguments laid out here. In 2013, the government must go further to nurse the economy back to health.

Understanding Eurozone Imbalances II: Talking TARGET

Posted on March 11, 2012 | 3 comments

More time is only good if it’s used for something. The success of the Greek debt swap this week staved off chaos but is not a solution to Europe’s problems or a signal that an end to the crisis is in sight. Recent weeks have seen a growing awareness of the accumulation of imbalances in Europe’s central payment system, TARGET. These imbalances are yet another reflection of the fundamental asymmetries at heart of Eurozone crisis and are analogous to build ups that destroyed the Bretton Woods system.

The commentary and debate on TARGET is currently overly technical. This post explains and analyses the nature and origin of these imbalances, and asks what they mean for the Eurozone (for some background on the link between budget and current account deficits see here and the crisis in general here, here and here!).

What are TARGET imbalances?

TARGET is an acronym standing for Trans-European Automated Real-Time Gross Settlement Express Transfer. Fog lifted?! It’s basically a system through which commercial (‘normal’) banks in one Eurozone country make payments to commercial banks in other Eurozone countries. Importantly, TARGET balances can be interpreted as a measure of the accumulated deficits and surpluses in each Eurozone country’s balance of payments with other Eurozone countries, reflecting the amount of ‘extra’ money circulating in a country over that created inside the country by it’s own national central bank.

Until mid 2007, TARGET balances netted out at zero; there were no deep asymmetries in financial flows within the Eurozone. This is no longer the case. Prompted by the financial crisis, imbalances in the TARGET system have ballooned. This is shown in the graph below, taken from Sinn and Wollmershaeuser (2011) (GIPS refers to Greece, Ireland, Portugal and Spain).

TARGET imbalances have gone under the radar because they do not show up on the ECB’s balance sheet. However, this is not to say they are inconsequential. Researchers have commented on the similarities in the imbalances captured by the TARGET balances and those that destroyed the Bretton Woods system. Therefore, understanding what these balances reflect, how they have arisen and how to fix them is of crucial importance.

Something for Nothing

Let’s build up how these imbalances have arisen in stages. To understand the full story, we need to look at how payments are made between banks. When customers make transfers between commercial banks, in effect, it is actually central bank money, or ‘base money’, that actually flows between them.

Consider a Greek factory owner wanting to buy a new machine. If she buys from a vendor within Greece, funds need to be transferred between bank accounts within the same country. To affect the transfer, base money is taken out of the central bank account of the purchaser’s bank and put on the central bank account of the vendor’s bank. The purchaser’s bank then charges the checking account of our factory owner, and the vendor’s bank credits the vendor’s account with the payment amount.

If our factory owner instead buys from a machine vendor in another country, say Germany, a similar procedure occurs but payments now flow via the Target system of the European Central Bank (ECB). When the Greek National Central Bank (NCB) debits the account of the commercial bank of our Greek factory owner, it takes money out of the Greek economy and sends a payment order to the Bundesbank. In so doing, it acquires a liability to the ECB. On the other side, the Bundesbank creates new money and transfers it to the German producer’s commercial bank, acquiring a claim on the ECB.

Target balances reflect these liabilities and claims on the ECB. Until 2007, payments between countries cancelled out as they flowed in both directions. This is despite the huge asymmetries in intra-Eurozone trade because importing countries paid for their imports with foreign money received from asset sales to exporting countries. Thus, private capital flows financed trade flows. Target imbalances have arisen because trade and asset flows no longer net out at zero, causing a build up in claims and liabilities. A Target deficit represents a net outflow of money to pay for an inflow of goods, and a Target surplus can be thought of as an accumulation in a stock of ‘outside money’ within a country.

Look like loans….

Target balances are best thought of as loans given that they reflect the fact that economic goods are moving between countries without movements of goods or other assets in return. They represent real claims and liabilities on the ECB. To affect our machine payment transfer, the Greek NCB destroyed money without its assets becoming any smaller and in so doing acquired a liability to the ECB. This Greek Target liability can thus be thought of as a public debt provided to the country by the Eurozone. On the other hand, the Bundesbank created money without actually receiving any tangible assets from commercial banks. The Target claim it acquires compensates for that and thus can be thought of as a public credit given to the Eurozone, allowing recipients to buy foreign goods.

The Rescue facility before THE Rescue facility

To get at the full picture, we need to add another level of complexity. As described above, Target balances shift money from Greece to Germany. The Greek NCB destroys money when a payment request to buy the German machine comes in, and the Bundesbank creates money to wire to the vendor’s commercial bank in return. If this was the end of the story, there should be no money left at all in Greece. Their coffers should have been emptied long ago. Yet, the monetary base of periphery countries has actually grown slightly since the start of the crisis. What is going on?!

The money flowing out of the periphery countries via international transactions has been fully offset by the creation of new money by their NCBs. In effect, these NCBs have been issuing new money as a form of credit to finance the purchase of foreign goods, taking the place of the private credit that was free flowing before the financial crisis.

Likewise, in Germany, we should have seen an explosion in the monetary base given that the payment process demands the Bundesbank creates new money and this new money has not been used to purchase foreign assets. No such explosion has occurred. German commercial banks have not needed all the additional money flowing into them and thus have either reduced the amount they tend to borrow from the Bundesbank or have placed the unneeded liquidity at the ECB to earn interest.

Therefore, we have witnessed a huge shift in refinancing credit from Germany to Greece without any change occurring in the monetary base of these countries. This credit reallocation represents a capital export from Germany to Greece, a loan given by the Bundesbank to periphery countries, enabling them to buy more German goods than would otherwise be the case.

This public credit provision can be thought of as a hidden rescue facility, propping up the economies of the periphery countries long before the creation of official rescue provision. Sinn and Wollmershaeuser (2011) argue these flows are analogous to Eurobonds, the only difference being that Eurobonds imply transfers of existing money, while the Target credits imply a reallocation of money creation activity. Target credits thus also involve liabilities. If the periphery states go bankrupt, all Euro countries are liable for losses in proportion to their capital shares in the ECB. No wonder the Bundesbank has started to worry about Target imbalances…

We’ll take the Parthenon (and everything else)

In theory, given sufficient appetite, peripheral and core countries could go on swapping Target claims for real goods indefinitely, with imbalances becoming more entrenched over time. However, this is unsustainable. These imbalances reduce the ability of the ECB to influence the Eurozone economy and preserve and perpetuate the structural asymmetries at the heart of the crisis.

Given that Eurozone countries, by definition, operate within a single currency union, there are no automatic mechanisms to force the system back into balance. If we want adjustment, explicit policy action to tackle the heart of the problem is called for, i.e. credible steps to harmonise structural policy and reduce the asymmetries in productivity and demand across the Eurozone. We are yet to see believable policies to this effect, especially those that would challenge German dominance.

Rather, what we have seen in the last few weeks are moves by the Bundesbank to insure the €500bn Target claims it has built up against the Euro system. Given that these claims represent public loans to the periphery, they stand to loose a lot if the Euro was to suddenly collapse, some 20% of GDP in fact. The head of the Bundesbank has proposed that these claims be securitized, or in other words, he demands access to the Periphery property and asset markets to cover losses in the event of a Euro collapse. Wow. Shame we’ve already snatched the Elgin Marbles. Finally, the fact that this proposal has even been raised signals that the Bundesbank is deeply worried about the death of the Euro. For them to seek this kind of insurance, demise is still most definitely on the cards.

3 Comments

Posted in 101, Debt Crisis, Eurozone

Tagged banking, bundesbank, ECB, economy, eurobond, eurozone, finance, TARGET

Austerity v Growth: A False Dichotomy

Posted on February 26, 2012 | Leave a comment

Politicians’ commentary on the state of the UK economy remains frustratingly tendentious and unsophisticated. The rhetoric of both the “austerity” and “growth” camps is overly simplified and needlessly polarized. Action is needed to stimulate growth. However, this fact doesn’t necessitate adding to the debt burden. The economics of the fiscal multiplier implies greater concern should be given to the composition of spending cuts and tax rises. By designing our austerity strategy to reallocate resources to “high multiplier” activities, growth can be initiated during fiscal consolidation. Elucidating this common ground between the camps is required to move the debate forward and set the stage for the development of a credible and equitable austerity strategy.

Recession? Depression?

More than two years since the UK entered recession, the much anticipated recovery is yet to make its appearance. This week the ONS confirmed that the economy contracted by 0.2% in the last quarter of 2011, a consequence of chronically weak business investment and manufacturing. GDP remains almost 4% below pre-crisis peak. Comparing the current recovery to those following past recessions is chilling. The graph below, taken from Jonathan Portes’ blog, shows that output has already been depressed for longer than that experienced during the Great Depression, and looks set to remain so for the foreseeable future.

The current malaise is the product of weak demand, causing the economy to operate approximately 3% below its potential, and of reduced potential supply. Households and the government are set on consolidating their balance sheets and the Eurozone crisis has effectively foreclosed an export led recovery. There is thus little incentive for investment. The latest negative growth figures therefore come as no surprise.

Ongoing weak demand and reductions in supply capacity are linked, a phenomenon economists call “hysteresis”. If demand for a firm’s output is depressed for a prolonged period, machinery is scrapped and planned investments go unimplemented. Workplace skills and the likelihood of returning to work altogether decline in the length of an unemployment spell, reducing the stock of “human capital” in the economy. Not only has unemployment continued to rise in the UK, but it is increasingly long term and concentrated among the young. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics (see, for example, Gregg and Tominey (2005) and Mroz and Savage (2006)). Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair, they did not choose to be born at a time dictating they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Poor growth prospects ultimately make it harder to finance those dreaded debts. Low economic activity implies lower tax revenues, acting to undermine the UK’s fiscal credibility. In November, the OBR announced that £15bn of tightening is required in addition to what was initially anticipated to meet the deficit reduction targets. Moody’s, the rating agency, put the UK’s AAA credit rating on negative outlook, citing weak growth prospects and Eurozone exposure as justification.

Austerity v. Growth: A False Dichotomy

It seems like an impossible situation. Low growth undermines our fiscal credibility but, so we are told, raising government spending is off the cards as it will add to the national debt, spooking the markets, creating financial turmoil. With both austerity and growth strategies, it seems to be a case of damned if we do, damned if we don’t.

However, all is not lost. First, the downside risks of slowing the pace of fiscal consolidation are overblown and small relative to the costs of continued deficient demand but, leaving this to one side, the situation is not as hopeless as presented. We are not, in fact, faced with the choice of austerity or growth. This dichotomy is false and damaging. Rather than seeing this as a one-or-the-other problem, we should focus on the design of austerity strategy and how fiscal consolidation can be achieved with the lowest impact on growth and demand. It isn’t just a case of “tighten or not” but also “how to tighten”. By reallocating government resources to activities with a high fiscal multiplier, growth can be supported while the budget deficit is reduced. Enacting this principle also implies equitable policy reforms, dictating a transfer of resources from the richest to the poorest in society.

The Fiscal Multiplier

The fiscal multiplier gives the impact that changes in government spending have on overall demand in the economy. With a multiplier of 1, an extra pound of government spending raises total demand in the economy just by a pound. However, we generally expect the size of the multiplier to be greater than 1. Imagine government spending is increased by 1. This additional £1 then represents income which is spent. Let households spend a fraction c of their income. c is defined as the “marginal propensity to consume”. This extra c of spending then represents income for someone else…..who spends c of it….and so on. Thus, one can think of the total increase in demand leading from the £1 of government spending as

1 + c + c²+ c³ + …

Therefore, there can be a more than proportionate increase in demand with increase in government spending.

The actual size of fiscal multipliers is difficult to measure but a moment’s thought suggests they will vary across government activities. Resources should be shifted to high multiplier activities and the burden of cuts should be disproportionately concentrated on those with low propensities to consume. Imagine a balanced budget policy, taking income from one group and transferring it to another. Although fiscally neutral, the policy will boost growth if spending rises by more among the recipients than it falls among the funders. This will be the case if the marginal propensity to consume is higher among the recipients. By redesigning our austerity strategy to shift resources to high multiplier groups and activities, growth can be stimulated without a need to increase the debt burden.

What could this look like?

The analysis above suggests that cuts should be targeted at those with a low marginal propensity to consume, while those with higher MPCs should be protected. We shall also see that enacting this thinking implies equitable policy changes, dictating transfers of wealth to low income groups in society.

Exploiting variation in fiscal multipliers lies behind the Social Market Foundation’s suggestion of cutting high rate income tax relief on pension savings and capping ISA contributions. Such a policy would extract more tax revenue from those in a relatively secure financial position, who are better able to smooth the impact of cuts and tax rises, thereby minimising the impact of consolidation on overall demand. The SMF calculates that halving higher rate tax relief on pension contributions would save £6.7bn annually, while an ISA cap of £15,000 would generate an additional £1bn each year. Tightening should also be done through greater targeting of benefits rather than a reduction in their general level. Families at the bottom of the income distribution, without a savings safety net, are likely to have much higher marginal propensities to consume. Their income levels should thus be protected as far as possible on efficiency, as well as equity, grounds. Therefore, greater means testing of benefits should be enacted. Making child benefit and subsidies such as winter fuel payments and bus passes only available to the most disadvantaged in society will save huge sums but protect those who need it most.

Funds from savings created by efficient, equitable redesigns of the welfare system should be used to instigate a public works programme to facilitate a transition to a new industrial economy and restore the productive capacity of the economy. There are plenty of private sector projects in the pipeline that could be quickly undertaken given government funding. For example, as mentioned by Gerald Holtham, there is a private consortium willing to build the Severn barrage, a multi-billion pound scheme to supply 5 per cent of the UK’s electricity needs, given some guarantee on electricity prices. Investment spending could be rapidly deployed on schemes such as toll roads, that produce a revenue stream, and to support the UK’s broken housing market. We face a chronic shortage of housing in this country. The number of people waiting for social housing rose by 4.5% in 2010/2011, with 1.84million on the list in April 2011. Supporting investment in the housing stock would have huge social value and give a boost to the construction industry.

Further, funds could provide an initial capital injection to a small business bank or increase the scale of the coalition’s green investment bank. A new small business bank could make use of existing agencies to allocate and dispense the loans, offering them to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. The focus on small businesses should prove especially affective at job creation given research funded by the Kauffman Foundation showing that all net new private-sector jobs in America were created by companies less than five years old.

A middle ground exists

We need to move beyond the unnecessarily polarised austerity-growth debate. Casting these aims as mutually exclusive is misleading and unhelpful, contributing to policy inertia and unnecessarily limiting debate on how we achieve fiscal consolidation. Action must be taken to improve the UK’s growth prospects. The fact that we simultaneously want to get the public finances under control does not imply nothing can be done. The government’s hands are not fully tied, it must use them.

Something for Nothing? Understanding Executive Pay

Posted on January 30, 2012 | 2 comments

Critiques of executive compensation don’t have to center on fairness, although, clearly, this is an important concern. Current remuneration levels are a product of market failure and executive capture of the pay setting process and can be attacked on efficiency, not just equity, grounds. However, direct regulation of wages via maximum rates or restrictions on the ratio of highest to lowest are not the way forward. Radical restructuring of the structure of executive pay and how it’s reported are achievable goals, with potentially far reaching consequences. The government must act to reduce the salience of phony “performance pay” deals and increase the bite of the ‘outrage constraint’.

To infinity and beyond

The staggering level of executive pay hit the headlines last week. Commentators were ablaze at the news that the boss of RBS, a nationalised bank, was awarded a bonus (which he declined yesterday) of just under £1million. Actually, a focus on this bonus somewhat misses the point as it misrepresents the true scale of his salary. The Independent report that Hester’s total remuneration could reach a phenomenal £50million in the next few years conditional on RBS’s share price so, in the grand scheme of things, a £1million bonus isn’t the big issue here.

However, singling out individuals or just focusing on “the bankers” underplays the extent of the issue. Executive and CEO compensation has been hurtling to heaven since the late 1980s. Average CEO compensation for the top 500 firms in the US more than quadrupled over the 1990s. Some UK bosses earn over 1000 times the national median wage. In the last year alone, a time of stagnant growth, executive pay in the FTSE 100 rose on average by 49%, compared with just 2.7% for the average worker.

Yet, such comparisons and figures may be misleading. Firms have got much bigger over the period, many (until recently) performing much better. The structure of our economy has also been transformed. One needs to correct for these changes to ensure we are comparing ‘like with like’ across time. However, controlling for factors such as firm size, industry classification and firm performance relative to industry average, still leaves us with staggering rises in average CEO remuneration to account for. For example, Bebchuk and Grinstein (2005) calculate that had the relationship between such factors and CEO compensation stayed constant in the US over the 90s, compensation would have only risen by half as much as what was actually witnessed.

Something for nothing?

How can these rises be explained? Justified? The orthodox view sees pay setting boards operating at “arms length” from executives, setting their pay to maximize shareholder value. Pay is set to attract and retain the best people for the job and provide the right incentives. Under this view, we’d have to look for things like big changes in the added-value of executives, the ‘cost’ they face in doing their job and the size of their ‘outside option’. However, extensive research indicates that none of these factors can account for the scale of growth witnessed. Efficient market mechanisms are not the main engines driving the growth of high pay.

The incorporation of large performance related payments has been a big contributor to the executive pay flood. In 2010, the median bonus for maximum performance of a FTSE 100 executive commanded a bonus worth 150% of basic salary. Stock options have become a central feature of remuneration packages without any offsetting adjustment of cash based compensation.

Linking pay to performance is motivated by what economists call the “principal agent problem” and provides a way of aligning the interests of agents, i.e. executives, to the owners of the company, i.e. the shareholders. However, strong incentive pay is only justified when, among many other factors, executive effort has a strong link to profitability, when high pay actually incentivises high effort and does not crowd out other “intrinsic” motivations or inefficiently distort executive attention. These requirements are not met in reality.

Experimental studies in behavioural economics and psychology highlight that high pay as an incentive mechanism is often counter productive. The link between explicit financial incentives and performance is tenuous at best, and negative at worse. As soon as tasks become complex, or even just marginally more taxing than ‘mindless’, financial rewards are consistently found to have a negative impact on overall performance. And this is the conclusion of studies coming out of Chicago and LSE, the ‘establishment of the establishment’, as Daniel Pink puts it. Bonus culture has also been cited as a cause of dangerous short termism and unsustainable strategising. Furthermore, qualitative evidence suggests that those at the top are often motivated by things other than money. As the former CEO of Shell puts it:

You have to realize: If I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.

Even if there was a strong case for performance related pay, this wouldn’t justify the size and structure of current pay packages. “Performance” elements in current packages are actually largely independent of individual action. No attempt is made to discriminate between general rises in company value and those arising from the good governance of executives. Executive influence is likely to have played a large part in this. The extreme complexity of schemes and wide freedoms to unload share based incentives have enabled executives to obtain much larger amounts of compensation than more cost-effective plans would have ever provided. Incentive payments have largely been a smoke screen, making it easier for CEOs to justify excessive pay levels even though these performance schemes are fundamentally flawed.

Bloated pay is thus a product of market failure, not the consequence of efficient procedures designed to maximize shareholder vale. Executives have substantial influence over their own pay levels and board members have insufficient incentives to engage in unpleasant haggling over remuneration packages. Complicated compensation packages have been dressed up as well designed incentive schemes to make huge payments more palatable. In general, these schemes are not cost-efficient and overstate the true value of executives to their firms.

Slimming these cats down

Government action is required to get top pay under control. However, direct wage controls, such as specifying some maximum salary, are not the way forward. This instrument is too blunt, so would be grossly inefficient, and would damage the competitiveness of the UK economy given that other countries are not about to follow suit. Further, a maximum salary rate is politically infeasible and so energy is better spent exploring viable options.

The calls to raise shareholder control of the pay setting process are valid, although, unlikely to do enough. Data complied by a leading advisory body, Pirc, demonstrates that shareholders don’t currently exercise the rights they already have to curtail executive pay. Shareholders are increasingly hedge funds and overseas investors who hold shares for such a short time that they have no interest in the inner workings of companies. Their gains are likely to come via speculation.

Raising the diversity of remuneration committees will help to guard against ‘crony capitalism’ and compensate for weak shareholder discipline. The High Pay Commission recommends that employees from lower down the firm structure have an input into the structure of remuneration. I also feel that effort should also be made for other industry professionals, and potentially academics, to play a role in the committee.

In my opinion, radical restructuring of the structure of executive pay and how it is reported are achievable and potentially very effective ways of reigning in top pay. Compensation packages must be made simpler and be presented in a standardized format. Taking first the structure of pay packages, the illusion that bonus payments and complicated incentive plans actually live up to their names must be shattered and salaries restructured accordingly. Studies highlighting the bogus nature of most performance plans should be bought to public attention. Pay packages should be restricted to contain only a single performance related element and that chosen performance measure should be in someway linked to the medium or long term health of the company to try to break the chronic short termism infecting many head offices. Enforcing a simplification of salary structure will also limit the role of compensation consultants, whose advice has been cited as a cause of the increased complexity of modern remuneration packages.

Public outrage and pressure from workers lower down the company structure can only be effectively generated with adequate information. This “outrage constraint” is an important curb on top pay but it has been weak over the last few decades, muted by the smoke screen created by complicated, ineffectual incentive plans and the rising stock market. The stock market boom has provided a convenient justification for pay inflation even though a firm’s stock market value is only weakly (if at all) linked to its earnings and performance and the actions of its executives. Steven Hester’s bonus refusal is evidence that transparency and public pressure can initiate change. The High Pay Commission found attempts to actively “camoflauge” salary packages, with ever more complicated pay arrangements often buried in the depths of impenetrable reports. It has not been easy to find out how much executives actually bring home. Simplifying pay packages as I’ve argued above, combined with a requirement of standardized reporting will make it easier for public outrage to be created and directed at excessive, unjustifiable pay deals. Further, publishing the ratio of median to top incomes should be a legal requirement for publically listed companies. The new economics foundation report covers this consideration in great detail. Making executive pay and its divergence from that of the average company worker will raise the salience of top pay in public discourse, helping to curtail capture at the top.

In conclusion, executive pay is not the product of an efficient market. Performance payments are red herrings, not structured to optimally solve ‘principle agent’ problems but to line individual war chests. The level of pay should not be regulated, but its structure should. Packages must be simplified and their reporting made more transparent. These reforms are achievable and should be swiftly enacted.

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Posted in UK Current Affairs, UK Economy, Uncategorized

Tagged banking, ceo compensation, economy, executive pay, market failure, remuneration levels, wages

Desperately Seeking Stimulus

Posted on September 20, 2011 | 3 comments

Plan B is for Bankruptcy? Bullshit. Bold, government backed programmes are needed to kick-start the economy and stem the jobs crisis.

No, we are not out of the woods. The green shoots of recovery still remain smothered by a thick layer of mud. UK unemployment rose to 2.51million people in July. That’s 7.9% of the workforce. A fifth of UK youths are now jobless. These dismal figures are a consequence of hefty falls in public sector employment and pathetic rates of private sector job creation, much lower than that expected by the Treasury and OBR. Furthermore, the UK ranked a pitiful 25^th out of 27 countries for growth over the past year, only Romania and Portugal did worse. The Institute for Fiscal Studies shovels more gloom into the mix with the news that median net household income suffered its largest one-year drop since 1981 in the last financial year, battered by the real falls in earnings, benefits and tax credits.

These are not transient troubles. Martin Weale and co authors estimate that the current recession will be the longest since the war, highly likely to lead to a greater cumulative loss of value than the Great Depression. Martin Wolf in the FT argues that it is probable for the depression to last 72 months, making it 50% longer than its longest predecessor in a century. Furthermore, the singular focus on austerity across Europe will act to black out any light at the end of the tunnel. Cameron’s description of the current figures as “disappointing” is, therefore, a gross understatement.

You would think that the continued flow of feeble figures would trigger a revaluation of the current macroeconomic strategy. But no, “Plan B is for BANKRUPTCY” we are told, “The UK will be able to ‘weather the storm’”. Little convincing evidence has been supplied to support these claims. Despite all signals pointing towards a need for change, Osborne insists that no amendments will be made to Britain’s deficit reduction programme. Although Britain does need to make credible its promise to get the public finances in better shape, such policy inflexibility is reckless. We need to slow down austerity implementation to ensure that the scars this recession leaves on the economy are not deeper than need be.

The slowdown began with a collapse in economic demand. However, it is looking more and more likely that this will get locked in by a contraction of supply. A contraction in supply means that we will find it harder to produce ‘stuff’ at the same rate as before. That a fall in demand can feed into a permanent downgrade to our growth prospects is a phenomenon known as hysteresis by economists. If demand for a firm’s output is depressed for a prolonged period, machinery may be scrapped and businesses could decide not to follow through on planned investments. The chaos in the financial sector has resulted in credit being allocated inefficiently at the wrong cost. Others note that a worker’s productivity can be harmed by unemployment. If one is out of a job for a long time, workplace skills start to fade and you become less employable. In addition, the longer someone is out of a job, the more likely it is for them to drop out of the labour market altogether. For example, women may decide to stay at home, early retirement may become an option or that back pain that’s always plagued you may become a reason to seek different types of benefits.

All of this acts to depress the trend rate of growth that the economy can sustainably achieve and will ultimately make it harder to pay those dreaded debts. With slower growth, tax revenues will remain depressed for longer than the Treasury and OBR expected when making their budget projections. Preventing the temporary blemishes associated with recession from becoming permanent scars is of upmost importance.

Unemployment of all ilks is associated with economic and social ills but the current concentration of joblessness among the young and low skilled is something of particular concern. Youth unemployment has especially pernicious consequences, affecting the individual and economy for far longer than the spell of joblessness itself. Those experiencing spells of unemployment while young face significant wage penalties and a higher risk of future joblessness compared to their peers for decades, even after controlling for a wide array of individual and family characteristics. For example, see the evidence in Gregg and Tominey (2005) for the UK and Mroz and Savage (2006) for the US. Thus, the fact that 18% of 16-24year olds are ‘NEETs’ (Not in Employment, Education or Training) should be sending alarm bells ringing through Whitehall. Their current idleness is not just an awful waste of their talents at this particular moment but makes it more likely for them to become trapped in dead-end areas of the labour market for much of their adult life. This is unfair for them, it’s not their fault that their birth date dictated they join the workforce during the worst post-war recession, as well as being highly damaging to the wider economy.

Furthermore, as the riots bought to attention earlier in the summer, unemployed youths facing a dearth of opportunity are not guaranteed to sit quietly. Unsurprisingly, increases in youth unemployment are associated with a range of social ills. For example, Carmichael and Ward (2001) found youth unemployment is associated with a statistically significant increase in burglary, fraud and forgery, theft and total crime rates. A third of NEETs agree with the statement that their life has ‘no purpose’. The social consequences of a large number of marginalised youths, who are assess their lives as purposeless, are scary to think about.

Some argue that government led job creation is a misnomer. They are wrong. The government has a role in supporting employment through this recession. Bold, innovative programmes are required to help ease the jobs crisis. Given the uncertainty and pessimism that currently clouds private sector vision and judgement, government involvement and financial backing are required to get them started. Technological change and globalisation imply that we also need to shift are thinking on how best to deal with the current labour market woes. Public works programmes represent one strategy to be explored but they are expensive and will create far fewer jobs today than they did in the past. Quoted in The Economist, the major of New York, Michael Bloomberg, notes that new government sponsored construction works will not solve the problem. “The technology is different. If you built the Hoover dam today, you would do it with far fewer people… The average worker standing in line for benefits tends not to be muscular.”

One new idea which I find particularly attractive is the creation of a small business bank. It could either be created through an initial injection of government capital or bonds funded by the Monetary Policy Committee and make use of existing agencies to allocate and dispense the loans. Credit allocation is currently a total mess. Banks aren’t lending to solvent businesses which need cash to invest and grow. If such a bank was set up, it could offer loans to small businesses at low rates, potentially concentrating funds in areas of especially afflicted by unemployment. This strategy has a number of attractions. Easing the funding restrictions on entrepreneurs and small businesses should help to kick-start innovation and growth while supporting employment. The focus on small businesses should prove especially affective at job creation. Research funded by the Kauffman Foundation shows that all net new private-sector jobs in America were created by companies less than five years old. Further, no one can turn round and say, “Oh, think of the benefits culture you’re creating”. This strategy is positive; it’s about supporting new ideas and existing businesses to thrive. In this way, the roots of the problem, as well as its consequences, are targeted.

Over the last few decades, a polarisation of the labour market into ‘lousy’ and ‘lovely’ jobs with little in between has been noted. Many routine manual jobs can now be coded up and performed by computers and machines. Other jobs are now able to be performed by individuals on the other side of the world. These hard facts need to be acknowledged by policymakers and reflected in the design of new labour market policy. Training and education systems need to be overhauled to reflect the new set of skills needed by employers. However, we also need to sit back and think through the consequences that these developments have for our vision of the modern job market. What can be done to best prepare individuals for the new world of work? How can we make the distribution of work more equitable?

These are hard questions but a few things are self evident with little deep thought. Slowing the pace of public sector redundancies will slow the rise in unemployment. Creation of something like a small business bank would not have to add to the public sector debt and could help propel the recovery forward. The government cannot afford to be complacent. A slower recovery adds to the cost of fixing their finances and creates long term hardship for many in society. The UK economy is Desperately Seeking Stimulus. Plan B is for Bankruptcy? Bullshit.