Intercontinental Finance, Issue 127/14, 1st September 2014
Invest in management incentives and secular stagnation
The last financial crisis, like those which followed the 1929 crash in the US and 1989 crash in Japan, was caused by excess debt, with the trigger provided by falling real asset prices such as shares and property.
Exploring key practical issues to prevent a repetition of the crisis including how to reduce debt for governments, households and business, and the ways to rebalance economies, both internally and with regard to their external balances.
A key problem that I identify in my new book arises from the revolution that has occurred in both the amount and the way corporate managements are paid in the UK and the US. The big change is a fairly recent one having occurred over the past 15 to 20 years. Not only has management pay shot up but, from being mainly based on basic salary, the bulk now consists of bonuses and similar extras which depend on increases in earnings per share, return on equity or share prices.
Between 1992 and 2008 US CEO bonuses and similar extras rose from $1.3 million to $5.0 million, measured at constant prices and increased from 57 per cent of basic salary to 83 per cent.
This huge change in incentives has naturally enough produced a major change in management behaviour. It has had a profound effect on the economies of the UK and the US, but one that has been totally ignored by the vast majority of economists.
To understand how the change in incentives has affected behaviour, it is important to consider the risks that companies run and the very different risks that are run by senior management. Among the various risks run by companies, a serious loss of market share is probably the most damaging over the longer term.
As market share falls, a company has to spread its overheads over a level of sales which is shrinking relative to that of its competitors, and it has increased difficulty in matching their expenditure on advertising, research, marketing and sales.
Market share can be lost through uncompetitive pricing, insufficient improvement in the quality of the product and a failure to keep costs falling as fast as those of its competitors. The routes to improving market share are therefore to keep pricing competitive and to invest in new plant and equipment.
Reducing the longer term risks thus comes at short-term cost in terms of having lower profits than would be likely with a more aggressive pricing policy and in terms of earnings per share, or return on equity, by spending money on new equipment rather than buy-backs.
The change in management remuneration has not changed these longer term risks but it has changed the willingness of management to take them. This is because the key risks to those running businesses which they do not own is that they will fail to receive vast rewards during the relatively short period of time during which they are likely to be in command.
Full article: ICF 127-14 – Getting the Economy Going
The full article was originally published by Intercontinental Finance who have kindly allowed us to post on my website.