A ‘shareholders’ spring’ is not enough

By John Plender

The “shareholder spring” revolt over boardroom pay is a welcome, if overdue, assertion of the rights of ownership. Yet it needs to go a great deal further if it is to address those aspects of executive pay that are most economically damaging. These relate to the prevailing bonus culture and its impact on the investment and savings behaviour of the corporate sector in the US and UK.

A striking feature of corporate balance sheets on which I have commented before is the build up of corporate savings in the English-speaking countries. This reflects, first, a secular rise in profit margins that defies the economic cycle. In the US, for example, profit margins are now at record high levels despite the economy being relatively weak, with spare capacity and a high rate of unemployment. The data in the UK are less clear cut, but the trend appears broadly similar.

Then, in both countries, there is a secular decline in business investment, which is not apparent in either France or Germany. Hence the tendency to towards surplus savings in the quoted corporate sector, which traditionally used to be a net borrower, leaving it to households to do the bulk of the saving.

In the case of the UK, Andrew Smithers of Smithers & Co points out that the fall in the investment ratio might partly be explained by a declining return on capital in manufacturing. He nonetheless provides compelling evidence that falling business investment results primarily from the incentives embedded in the Anglo-American bonus culture.*

Consider the most popular metrics employed in bonus schemes. Earnings per share is a manipulable target which is easy to pump up in the short term at longer-term cost to the business. Return on equity can be increased in the short term by taking on more leverage. Yet this comes at the cost of weakening the balance sheet and potential destruction of economic value – witness the disastrous bonus-driven behaviour in the banking sector. Total shareholder return for a majority of companies will be more a reflection of movements in the stock market generally than the performance of the company.

Only those in a state of higher innocence would fail to see the potential impact of these metrics on behaviour. All of them have the disadvantage that they encourage executives to resist the cuts in profit margins that might result in the short term from increasing investment in fixed assets. The choice between steering cash flow towards investment or paying it out in dividends and share buybacks thus incorporates a clear bias in favour of distribution. In poorly designed bonus schemes the buybacks are a means of boosting earnings per share because they shrink the number of shares by which earnings have to be divided. The outcome is that quoted companies in the US and UK will inevitably lose market share to foreign and unquoted competitors.

There are wider ramifications. The rise in profit margins means a fall in the labour share of output. This is great for the rich but not for the poor, who own no shares. At the same time the bonus culture has increased the income of the highly paid relative to the rest. This contributes to income inequality – another syndrome that has been particularly extreme in the English-speaking countries and which led to the Occupy Wall Street movement, with its slogan “we are the 99 per cent”.

A more fundamental economic point made by Mr Smithers is that the accumulation of business savings means that fiscal deficits will not fall as readily in a cyclical economic recovery as they have in the past, not least because large fiscal deficits will be necessary to prevent a fall back into recession. If this is ignored in economic policy, he adds, a return to recession is likely either because attempts to rein in fiscal deficits will be too fast, or because their continued high level will cause inflationary expectations to rise. It should be clear from this that policy initiatives to cap bonuses and make say-on-pay votes mandatory do not go far enough to prevent the competitive disadvantages that arise from the bonus culture. The need is for a more radical re-examination of where or even whether bonuses are necessary and at the very least a shift back towards cash as the predominant component of executive pay. That, in itself, would strike a blow for simplicity in a world where executive pay has become absurdly over-complicated.

Yet policy makers should tread with care. In the Clinton administration’s first term in the early 1990s the Internal Revenue Code was changed so that executive pay ceased to be tax allowable over $1m a year.

There followed an explosion in the use of stock options and the entrenchment of the bonus culture, which then spread to the rest of the English-speaking world.

The law of unintended consequences lurks just around the corner.
 

* ‘The Change in Corporate Behaviour’, Report No. 401