Sunday, 8 January 2012

Executive Pay: acknowledging market failure

David Cameron was on the BBC this morning talking about the excesses of executive pay. What I liked about what he said was his clear identification of the problem as market failure. We do not hear this phrase enough in public discourse – indeed the BBC in the linked report puts market failure in quotes! It was good to hear a Conservative Prime Minister saying it too. (Perhaps having a PPE degree helped!)
                I remember naively saying after the credit crunch that at least it would put an end to the idea that markets always work, and that regulation was always unnecessary. We would instead, I hoped, have a more intelligent discussion that acknowledged market failures and focused on the best ways of dealing with them. That did not seem to happen. In part that is because the right wing think tanks that are paid to spin the ‘markets always know best/state intervention is always bad’ line carried on getting their funding. But what should have happened is that this line lost credibility because someone would immediately reply with the knock out ‘you mean like financial markets’. I’m not quite sure why this didn’t happen.
                Whether the measures the government is due to announce will have any impact on executive pay is another matter. The Prime Minister talked about transparency, and shareholder power. I'm not sure strengthening either will have much impact. This is because it remains unclear exactly what the source of market failure is, and why it should have become so much more important in the last few decades. (Or perhaps the market failure was always there, and the other forces that used to restrain excessive executive pay have withered.) A key piece of evidence is that these trends have differed a lot among countries, as this wonderful database indicates. (Executive pay and the 0.1% share are not the same thing, but Atkinson, Anthony B., Thomas Piketty, and Emmanuel Saez. 2011. "Top Incomes in the Long Run of History." Journal of Economic Literature, 49(1): 3–71. suggest the former is a major cause of the recent increase in the latter.) Although this paper is full of ideas that could help explain the trends shown below, we are a long way from a comprehensive account.

4 comments:

  1. I think one contributing factor may be the equally astonishing skyrocketing executive pay in America. British companies, more than any other major economy, have to compete for executives with American firms. Now due to mostly political and regulatory reasons, the pay of American executives has increased substantially and it may be that what we see in Britain is, partly, the spill-over.

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  2. Since you invoke "market failure", in which there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off, could you let us know what what is the "correct" percentage of income share for the top .1% for the years and countries cited that makes market participants better of without making other market participants worse off? It looks a lot to me like an assertion, a graph that doesn't prove the assertion, and a lot of hand-waving. I'm not saying your wrong, I'm just wondering how this proves your case.

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  3. +1 to Justin. It could just as well be used to show that low executive pay leads to stagnant economic growth... or to show as in the example of Japan that high tax rates lead to alternative forms of compensation that are tax-advantaged and/or not reportable, e.g. extremely high retirement payments to directors and officers in Japan.

    Also, if you believe in EMH then shareholders through their elected representatives (i.e. Directors) will maximize profits by hiring and paying execs in a manner to maximize the difference between the gain in profitability and the cost of the exec. To the extent that profits are correlated with sales (turnover) then high executive pay will tend to maximize GDP. I don't necessarily agree with this as there are a lot of overcompensated executive who are paid based on the wrong metrics, but the good execs are way underpaid both in terms of their contribution to the company, GDP growth and social utility.

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  4. Simon

    Do you really understand what you're talking about or is this some way of greasing up to other like minded economists.

    US firms are the most profitable they have ever been in history. Executive pay is tied to profitability. Perhaps you think it ought to be tied to the level of unemployment or some other metric which you consider socially acceptable. However if you think this is an example of market failure you really are in an ivory tower.

    By the way, how is you pay doing. Have you asked for a cut recently?

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