Anthony Hilton: Our economy is held back by a short-term culture of bonuses

Anthony Hilton
Evening Standard, 21st June 2017


The City economist Andrew Smithers once wrote a book, Valuing Wall Street, about how the policies of Alan Greenspan, then head of the US Federal Reserve, were distorting New York’s share prices and that this was almost certainly going to end badly.

He specialises in data-driven research and his conclusions are always firmly rooted in the available evidence, but Greenspan at the time was widely hailed as the maestro, the man who single-handedly kept the US economy on the path of growth, so no one paid much attention to Smithers’s warning.

The financial crash duly arrived about three years later to universal complaints that “nobody had seen it coming.” The greater truth of course was that those who had seen it coming were not listened to.
More recently, Smithers wrote another book, The Road to Recovery, which explained that the economy in this country and in the US was suffering badly because of the way executives were now being paid.

He had noticed that business investment in both countries was in long-term decline and he began looking closely at the available data — particularly the more comprehensive stuff which is available across the Atlantic — to find out why. 

After extensive research into national income and corporate profit data, he came to the conclusion that the present system of bonuses made executives less willing to invest, because they did not want to do anything which might cause a short-term hit to profits.

Systems which had been brought in to encourage executives to deliver high performance were having the opposite effect because they were badly designed.

The problem is that although investment should deliver long-term growth, it almost always also causes a short-term hit to profits partly because of its cost and also because new expensive bits of kit rarely work perfectly first time, and cost money and time to sort out.

Executives know this and they also know they will lose their bonus if things turn out badly. In depressingly high numbers they prefer not to take the chance.

They still have to get profits growth from somewhere of course but what tends to happen is that they achieve this instead by pushing up prices to milk their existing products.

Such a strategy risks doing severe damage to the business in the medium term because it ultimately causes a sharp loss of market share when customers realise what is happening, and competitors take advantage of the over-pricing firm’s vulnerability.

But by then the executives are long gone, bonuses firmly in trouser pocket, leaving a permanently weakened business behind them.
It is important to recognise, however, that this is not just a problem for the individual company and the shareholders; it affects the performance of the whole economy.

Investment in new and better capital means workers become more efficient and add more value for every hour worked.
It is this additional wealth creation which leads to higher incomes and tax receipts and drives the improvement in living standards. But without sufficient investment productivity languishes — as it has for a decade here and in the US — and living standards languish with it.

Smithers’s message is quite simple. The bonuses paid to management are creating perverse incentives which are undermining the economy and contributing to the decline in living standards experienced by most of the population.

Poor productivity — ours is among the worst in any of the world’s advanced economies — is at the root of most of the problems the country faces: it is the principle reason no government in recent times has been able to balance the books; it is the reason we cannot afford the necessary levels of investment in public services; it is why so many people need two jobs to make ends meet.

There will be no lasting solution to our productivity shortfall unless we first get to grips with the bonus culture.

Smithers hoped his book would ignite a debate which would create a deeper understanding of the problem and this would get something done about badly designed bonuses.

But, as with his Greenspan book, people did not pay attention. The issue has never made it onto the agenda in boardrooms.
Perhaps we should not be surprised. As the American writer Upton Sinclair once observed “it is difficult to get a man to understand something when his salary depends on his not understanding it”.

The remarkable thing about Smithers is that he is refusing to give up. Though he is 80 this year he has just returned to the fray and, with yet more research, done a demolition job on at least some of his critics who thought they could deny his conclusions by undermining his analysis.

In the process he has enlisted the help of Martin Weale, a stalwart of the Bank of England’s monetary policy committee, who commented on an earlier draft of his paper.

Not that Smithers needs such support — but it is a further good reason to give serious consideration to his claim “that US data provide clear evidence that the decline in tangible fixed investment can be attributed to the change in management incentives.” Maybe this time more people will listen.

Anthony Hilton: Our Economy is held back by a short-term culture of bonuses - London Evening Standard

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