Perverse Management Incentives Damage The Economy Andrew Smithers www.smithers.co.uk

1. Perverse Management Incentives Damage The Economy Andrew Smithers www.smithers.co.uk High Pay Centre London 6th March 2014

2. Slide 1. Changed Incentives Change Behaviour. • There has been a revolution in management pay in the UK and the US. • Total pay has rocketed and shifted from being mainly salaries to being mainly bonuses. • The huge change in incentives has, naturally, produced a big change in management behaviour. • This is what incentives are for!

3. Slide 2. Longer Term Risks for Companies. • The key longer term risk for companies is loss of market share through: (i) Uncompetitive pricing. (ii) Higher production costs than competitors. • Competitive pricing and high investment reduce these risks.

4. Slide 3. The Risks for Management. • The key risk for management is not getting huge bonuses during their brief stay in office. • Sharp rises in RoE and EPS minimise managements’ risk through: (i) Maximising short-term profit margins. (ii) Preferring buy-backs to investment.

5. Slide 4. The Shift in Risk Assessment. • We should therefore expect (i) lower business investment and (ii) higher profit margins. • Relative to output gaps profit margins have risen (Slide 5). • Investment has fallen relative to GDP and the assumed output gap (Slide 6). • Investment has fallen relative to profit margins (Slide 7). N.B. (The US shows the same symptoms as the UK).

9. Slide 8. Experience Accords with Expectations and Theory. • Management incentives have changed behaviour as expected. • They have encouraged high profit margins and low investment. • Managements therefore prefer buy-backs to investment in plant. • In 2012 (latest data) PNFCs had net savings’ surpluses of 2% of GDP and spent 2.3% of GDP on buy-backs.

10. Slide 9. Cost of Capital. • The cost of capital to companies has fallen dramatically, with near zero interest rates and high equity prices (Slide 10). • But perverse incentives have pushed up the cost of capital to management. • Investing reduces funds available for dividends and buy-backs and usually lowers short-term profits.

12. Slide 11. Forecasting Errors. • Investment (Slide 6) and productivity (Slide 12) have been below expectations. • While inflation has been above (Slide 15). • Forecasters have failed to allow for the change in management remuneration.

14. Slide 13. Poor Productivity. • This should be no surprise; it is due to the rise in the cost of capital as perceived by managers. • So companies prefer to employ more labour rather than more capital. (Technically this changes the “coefficient of substitution”). • “Diminishing returns to scale” lowers productivity.

15. Slide 14. Inflation. • Inflation is expected to fall if there is an output gap. • There has been an assumed output gap in the UK every year since 2009. • Nonetheless, inflation has not been on a falling trend (Slide 15). • It has been held up by higher than usual profit margins (Slide 5).

17. Slide 16. The Fiscal Deficit. • Fiscal deficits are needed to prevent or at least ameliorate recessions. • They are needed when other sectors wish to save more than they wish to invest. • The business sector is the usual problem (Slide 17).

19. Slide 18. Conclusions. • The savings’ surpluses of the UK (and the US) business sectors are due to management incentives. • As they are structural rather than cyclical, a successful fiscal policy needs a change in management incentives. • This is also needed to increase investment, productivity and real wages. • Forecasts would be less prone to error if they were adjusted to allow for the change in management behaviour.