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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.