Financial News, a Dow Jones Company, 23rd January 2012
More than 2,500 of the world’s top politicians, bankers and industrialists meet at the snow-covered Swiss mountain village of Davos on Wednesday [Jan 25] for the start of the annual five-day conference of leaders which sets out to change the world.
This year, the issue of the environmental impact of industry has slipped down the agenda and right at the top is changing the model for growth and employment.
Let us hope the debates get round to boardroom incentive models, for it is those which need shaking up.
The claim, that the rich get richer and the poor get poorer, is a constant theme of populists. Over the past thirty years or so, however, it has had the unusual quality of being accurate. The gap is socially disruptive and politicians are threatening “to do something about it”.
Action is seen to be popular, but sadly it looks unlikely that any action taken will alleviate the problem, as debate is concentrating on symptoms rather than causes.
There are several different reasons why the gap between rich and poor has widened. Some of these are untreatable. The financial benefits of fame and education have grown massively with globalisation. It has increased the relative value of the brand names of the famous and, with the entry of the emerging world, the supply of undereducated labour has risen relative to the total; although this second cause of inequality should ease over time as education standards improve.
A more worrying change has been a rise in the share of profits compared with wages. This not only adds to social tensions, but greatly damages the economy. Unless this is widely understood, new policies are unlikely to mitigate the problem and understanding is improbable so long as the issue is so little aired and debated.
It is easy to distinguish between pertinent and irrelevant analyses of the issue. The former hones in on the rise in profit margins, which the latter ignores. An habitual sin of those who comment on the economy is a failure to examine the evidence carefully.
Data, if used at all, are selected to support a preconceived view rather than to provide an aid to understanding. The exceptional feature of the economy today is the behaviour of profit margins. This is at the heart of the expansion in the gap that has grown between rich and poor in both income and wealth.
Comments on the growth in this gap which fail to deal with the widening of profit margins are common and irrelevant to the issue.
According to generally accepted economic theory, typified by the near ubiquitous Cobb-Douglas production function, the share of output that goes to labour and that which goes to profits is stable over time. The share fluctuates around a stable long-term average.
Margins tend to fall when times and competition are tough and recover in booms. The exceptional feature of today is that margins, for all companies in the US, but also for financial ones in the UK, are at or near record levels at a time when the economy is far from booming. Current conditions are without precedent.
A return to more normal conditions is essential for sustained recovery. The massive deficits of the public sector must come down. As a matter of identity, this will require an exactly equal fall in the cash flow of the private sector, which is divided into households and businesses.
In the western developed world, notably in the Anglophone economies, households have been saving little and spending much, and cannot afford a large drop in their savings. A large part of the decline in private sector cash flow must therefore fall heavily on business, through some combination of lower profits, though lower margins, and higher investment.
As companies save more of their incomes than households, savings rise when margins rise. If the rise in profit margins had been accompanied by an offsetting rise in business investment, then the economy would not have been weak, but this has not happened. The rise in profit margins has thus raised intended savings more than investment and governments have therefore increased their dissavings, in the form of higher fiscal deficits, to prevent the depression which it would otherwise have caused.
One common explanation of why margins are so high is that trade unions have become less powerful. Another is the entry of China into the world economy. Neither of these fits the facts, nor do they explain why business has not responded to high profits with high investment.
Employees have become steadily less unionised since the end of the World War II. During the first 35 years profit margins trended down and, since then, up. They would need to have risen steadily for the whole period for this explanation to be credible.
China’s arrival could explain a sudden rise in profit margins as labour supply rose sharply relative to capital. But with China’s massive investment, margins should have been falling back for some years now.
What explains both the rise in margins and the weakness of investment is the change in the way management is paid.
Bonuses are now the dominant part of pay for senior people and are based on short-term measures, such as changes in earnings per share, return on corporate equity or share prices. This encourages action which has short-term benefits, such as increased leverage to finance buy-backs and discourages action which has a negative short-term impact, but helps in the longer term, such as capital investment.
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This article first appeared in Financial News.
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