Download High_Pay_Centre_6.3.2014

Perverse Management Incentives
Damage The Economy
Andrew Smithers
www.smithers.co.uk
High Pay Centre
London 6th March 2014
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!
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.
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.
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).
Slide 5: UK: Output Gap and PNFCs' Gross Margins.
5
4
35.5
3
35.0
2
34.5
1
34.0
0
-1
33.5
-2
Non-financial Gross Profit Margins
33.0
-3
Output Gap
32.5
-4
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Data Sources: ONS BB (FBDA & NRJK) and OECD Economic Outlook Vol. 93.
Difference between actual GDP and potential in
percentage points.
Profits, before depreciation, interest and tax, as % of
GDP.
36.0
Slide 6. UK: Business Investment and Output Gaps.
5
Business Investment as % of GDP
11.0
4
Output Gap
10.5
3
10.0
2
9.5
1
9.0
0
8.5
-1
8.0
-2
7.5
-3
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Data Sources: OECD Economic Outlook Vol. 93 and ONS via Ecowin.
2012
2013
Actual GDP minus potential in percentage points.
Business investment as % of GDP at current prices.
11.5
36.0
11.5
35.5
11.0
10.5
35.0
10.0
34.5
9.5
34.0
9.0
33.5
8.5
Non-financial Gross Profit Margins
33.0
8.0
Business Investment as % of GDP
32.5
7.5
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
Data Sources: ONS BB. Table 3.3.2 (FARR, FBDA & NRJK) and ONS via Ecowin.
2012
Business investment as % of GDP.
Non-financial profits, before capital consumption, as % of
gross output.
Slide 7. UK: PNFCs' Profit Margins and Investment.
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.
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.
Slide 10. UK: Interest Rates and Stock Market.
4,000
10 Year Bonds
5.5
3,750
3 Months T-bills
5.0
FT All-Share Index
3,500
4.5
3,250
4.0
3.5
3,000
3.0
2,750
2.5
2,500
2.0
2,250
1.5
2,000
1.0
1,750
0.5
0.0
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Data Sources: Reuters and FT via Ecowin.
2011
2012
2013
1,500
2014
FT All-Share (ex-investment trusts) Index.
Interest rates % p.a. on 3 month T-bills and 10 year
Government bonds.
6.0
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.
Slide 12. UK: Labour Productivity.
% p.a. change in GDP at constant prices per person
employed.
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
Change % p.a.
-0.5
-1.0
1997
1999
2001
2003
2005
2007
Data Source: ONS via Ecowin.
2009
2011
2013
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.
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).
Slide 15. UK: Output Gaps and Inflation.
5.0
4
Output Gaps
4.5
Inflation
4.0
3
3.5
2
3.0
1
2.5
0
2.0
-1
1.5
-2
1.0
-3
0.5
1997
1999
2001
2003
2005
2007
2009
Data Sources: OECD Economic Outlook Vols 93 & 89.
2011
2013
% change in CPI over year.
Difference between actual and potential GDP in
percentage points.
5
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).
Fiscal deficit (+) or surplus (-) as % of GDP.
12
9
Fiscal Deficit (+)
10
Corporate Net Lending (+)
7
8
5
6
3
4
1
2
-1
0
-2
-3
-4
-5
1987
1989
1991
1993
1995
1997
1999
2001
2003
Data Source: ONS via Ecowin.
2005
2007
2009
2011
Business net lending (+) or borrowing (-) as % of GDP.
Slide 17. UK: Fiscal Deficit and Business Net Lending.
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.