‘Management’, economist Andrew Smithers told the FT’s Martin Wolf over lunch recently, ‘is not an intellectually satisfying occupation. It consists of telling people things that you’re not sure about and they don’t want to hear. So I’ve been much, much happier since I ran my own business and so can do what I want intellectually.’
Smithers runs an eponymous boutique advisory firm in the City, and his agreeable scepticism about management at the personal level carries over into his professional analysis of its role in the economy as a whole.
To be blunt, Smithers believes that most economists, in love with mathematically modellable theory, have got the real economy dramatically wrong. There is no mystery about the snail-like recovery from recession, puzzlingly lagging company investment and productivity, and higher than predicted inflation, he says. The recession is structural, not cyclical, and it is caused by changed management behaviour brought about by bonuses and incentives.
The argument is straightforward and compelling, and as outlined at a recent seminar at the High Pay Centre (more fully developed in a book entitled The Road to Recovery) goes like this.
Over the last 20 years there has been a revolution in management pay in the US and UK. As we know, total pay has soared. It has also shifted from being mainly salaries to being mainly bonuses (83 per cent of the total in the US), the aim being to align the interests of managers with those of shareholders.
As intended, the incentives have sharply changed managers’ behaviour. Unfortunately, their effect has been to align the interests of managers not with those of long-term investors but predatory and ultra short-term shareholders such as hedge funds and private equity.
‘These incentives came out of business schools, whose understanding of options theory evidently wasn’t very good,’ notes Smithers briskly. ‘Options depend on volatility. So they don’t do what they were designed to do and are damaging for the economy as a whole.’
Under the changed pay dispensation, the key risk for managers is not getting huge bonuses in the short period (currently around four years) of their tenure. The easiest way to combat this risk is to engineer sharp rises in return on equity (RoE) and earnings per share (EPS), or shareholder value for short, by jacking up short-term profit margins and buying back shares. That of course risks undermining their companies by making them uncompetitive compared with rivals which do continue to invest for the longer term. Significantly, private companies, where the incentives are weaker, are investing at twice the rate of quoted ones, according to research.
As Smithers shows with a huge assemblage of charts and graphs (be warned: his book although fascinating is not an easy read), this is exactly what is happening. In the US and UK companies are awash with cash and business investment has collapsed. At the same time, companies on both sides of the Atlantic are now buying back their own shares at the ‘astonishingly high’ rate of 2-3 per cent of GDP.
Viewed through the Smithers’ lens, conundrums that currently stump orthodox economists – the tardiness and timidity of the recovery, the failure of quantitative easing to spur investment, and declining labour productivity – suddenly come into sharp focus.
Although the cost of capital is currently negligible, with near-zero interest rates and sky-high equity prices, ‘if management’s perception of the cost of capital is the cost of not buying back their own shares, then, of course, there is a large wedge between the perceived cost of capital to management and the real cost of capital to companies’. So QE has no effect on investment.
Meanwhile, the changed management behaviour also makes the disappointing productivity performance suddenly ‘highly explicable’. Because managers don’t want to invest in plant and equipment, which would drag down RoE and EPS in the short term, to meet any increase in demand they choose to employ more people. But without more capital, diminishing returns to scale push down productivity. QED.
Smithers is of course not the first to point out the problems the bonus culture poses for the economy. His findings chime with similar narratives from one or two other sceptical observers such as Bill Lazonick, who has found that in recent years many large US corporates have been spending more than their total profits on dividends and buybacks, a strategy which he dubs ‘downsize and distribute’ to contrast with the ‘retain and reinvest’ policies that drove allocation before the advent of the shareholder value ideology in the 1980s. Many others, not least the High Pay Centre, have done much to underline the harm that pay inequalities do to society and the fabric of the individual firm
But Smithers’ is the most detailed and thorough assault on the effects of incentives on the economy as a whole. Because orthodox economics ignores these effects, he charges, official forecasts are wronger than they would otherwise be, and economic policies are not only ineffective, they make the achievement of non-inflationary deficit reduction, and hence sustainable growth, much more difficult. Smithers is the first mainstream economist to say it straight out: dismantling the bonus culture that governs managers’ investment decisions is the single most important task facing economic as well as social policymakers in the world today.