We have reached a tipping point. Inequality can no longer be treated as an afterthought. We need to focus the debate on how the benefits of growth are distributed.
Gustavo Gonzales, OECD secretary general1
The increasing inequality of income in many developed countries over the past several decades has roughly coincided with the decreasing aggregate share of earnings going to labour. As we discussed in Chapter 3, while the two trends are linked by structural changes in the economy and dominant political and economic beliefs, they should not be confused. It is perfectly possible for one to occur without the other, and there is evidence to suggest that their causes are distinct. At its most basic, there is no reason why a greater share of the pie taken by profits could not coexist with modest executive remuneration. In other words, the gains to capital could be reaped by millions of shareholders, not just a few hired hands. However, the effects on the living standards of the majority, as well as the growth rate of economies and inflationary or deflationary pressures are similar. Why is that so and how big a change in inequality are we talking about?
One of the few plausible economic theories actually backed up by evidence is that individuals’ propensity to consume (the proportion of income spent) tends to decrease with the amount of income they earn. Those at the bottom of the ladder need to consume all they can from their modest incomes. In contrast, there is a limit to the number of meals a rich person can eat. Although the very well off can spend excess cash on property and luxury goods, this is unlikely to soak up all their income. Put another way, those further up the income distribution scale earn more than enough to cover their needs and so are able to save a greater proportion. Research by Emmanuel Saez and Gabriel Zucman shows that the savings rate of those in the bottom 90th percentile in the US was about 0 per cent in 2010, about 20 per cent for those in the top 10th percentile of income distribution, and a whopping 40 per cent for the top 1 per cent.2 The same holds for the UK.3
Consequently, for any given economic pie, if income shifts from those at the lower end of the scale to those towards the top, the aggregate rate of consumption will fall. For every loss of $1 or £1 or €1 of income by the less fortunate, consumption will fall by close to $1 while the wealthy will only spend a miserly fraction of any extra $1 or £1 or €1.
An International Monetary Fund study from 20154 found:
an inverse relationship between the income share accruing to the rich (top 20 per cent) and economic growth. If the income share of the top 20 per cent increases by 1 percentage point, GDP growth is actually 0.08 percentage point lower in the following five years, suggesting that the benefits do not trickle down. Instead, a similar increase in the income share of the bottom 20 per cent (the poor) is associated with 0.38 percentage point higher growth.
A similar 2015 study from the OECD concluded the same thing. Interestingly, the negative correlation between inequality and growth is found even when controlling for a country’s income level. This isn’t simply a case of wealthier countries growing more slowly and also being more unequal.5
The IMF and OECD list some channels by which inequality might actually be causing lower growth. The most important one has to do with investment. When poor people have more money, they can afford to invest more in human capital (education and skills) and nutrition. Because these investments have diminishing marginal returns – the first year of schooling matters a lot more than the twentieth – every dollar invested by the poor raises national productivity by more than if it gets invested by the rich.
The analysis by the OECD, which draws on data for 31 countries covering the period 1970–2010, found that income inequality has a sizeable impact on growth. Between 1985 and 2005, for example, inequality rose on average across 19 OECD countries, an increase estimated to have knocked 4.7 percentage points off cumulative growth between 1990 and 2010. The report also found that, as inequality rose, there were significant falls in educational attainment and skills among families in lower-income groups, implying large amounts of wasted potential and lower social mobility.
According to the Bank Credit Analyst (BCA), countries with greater inequality, such as the US, tend to have a lower variation in earnings across generations. In other words, parental income in more equal societies such as Scandinavia ‘is a much less powerful predictor of income for future generations’.6 This has been exacerbated by the runaway cost inflation of higher education in America. From 1980 to 2013, tuition and book costs rose by over 800 per cent compared to nominal median income growth of just over 200 per cent. Little wonder that graduation rates among the lower half of income families stagnated over the period, while they rose from 30 per cent to over 70 per cent for those coming from top quartile income families.
If America was once the land of opportunity, those that have made it to the top have sawn off the rungs of the ladder to ensure their descendants are more likely to maintain their position. The obvious consequences are lack of growth in human capital for large sections of the population and the rising indebtedness of students, who can only bridge the increasing gap between the cost of higher education and income through loans.
In England, since the introduction of university fees in 2006, student debt has ballooned to over £100 billion, equivalent to over £50,000 per graduating student.7 This is even higher than in the US, where average debt on graduation is around £27,000.8 Fees were sold to the electorate under the guise of fairness – why should the entire population subsidise the beneficiaries of a university education? In practice, this has probably backfired as students from better-off families can pay their fees up front while those from more modest backgrounds either think twice about attending university or are saddled with debts at high interest rates – hardly a social leveller. We have yet to see the full impact on demand and on graduates starting working life handicapped by hefty debts.
Continental European students (and the Scots) have escaped such huge fees by and large, on the principle that society should provide a free education (but not maintenance) to all who will benefit from it, without discrimination. Higher education is seen as a public good, just like universal healthcare.
Growth is also negatively impacted when corrupt or uncompetitive practices contribute to rising inequality. Phenomena like crony capitalism – where friends of the ruling classes are allowed to appropriate large amounts of wealth for themselves through government contracts or protected monopolies – lead not only to inequality of income and wealth, but also to economic inefficiency. According to economists Sutirtha Bagchi and Jan Svejnar, ‘cronyism may also reduce growth by allowing the wealthy to exert greater influence on political policy, creating inefficient subsidies for themselves and unfair penalties for their rivals’.9
Bagchi and Svejnar found evidence for this; their research did indeed find a negative correlation between growth and inequality if, and only if, billionaires in a country acquired their fortunes through political connections. Inequality per se might not be so bad if it is the result of equal opportunity. But in the absence of fair competition through corrupt or anti-competitive practices inequality increases in a manner that is toxic economically, socially and ultimately politically.
The reduction in consumption from inequality can have knock-on effects as lower levels of demand and growth reduce companies’ investment, capacity is used up more slowly, and the return on future investment is expected to drop. Over time, the cumulative effects of this slower path can be significant. In other words, increasing inequality is inefficient from a pure economic growth point of view for a number of reasons. Some of these have to do with the demand side of the economy, but others are linked to the supply side of the growth equation. Most worryingly for free marketeers is the possibility that their principles have been hijacked by a self-serving self-replicating elite at the expense of everyone else, resulting in a spectacular misallocation of resources.
Very few dominant market positions by companies have been acquired by such obviously corrupt means, but there is no denying the power of company-sponsored political lobbyists. The very existence of companies with dominant market share, however acquired, belies the original rationale of the free market: the benefits of competition in the efficient allocation of resources. Adam Smith’s hand loses its invisibility cloak if it takes on the shape of a monopoly or even oligopoly that can maintain high margins and profits without the threat of erosion from competition.
The political elite, while ready to trumpet the virtues of the free market, are either in denial about the extent of uncompetitive practices in the economy or are reluctant to enforce competition by breaking up cartels or near-monopolies, for reasons we will return to in Chapter 7. Even leaving aside questions of fairness, the evidence points strongly to the conclusion that we have reached a level of inequality in most countries that is detrimental to their economies.
For example, the economic utility of an extra dollar of income per day is much greater for someone living in poverty than someone earning a comfortable living. There is therefore a case for redistributing income to reduce inequality on the utilitarian grounds of promoting the greatest happiness of the greatest number, subject perhaps to a constraint of not sacrificing overall growth too much as incentives are eroded. But even reduced incentives to become filthy rich (to coin a phrase) may not blunt growth prospects as much as some may protest. Sweden, one of the world’s most egalitarian societies, also has a growth rate near the top of the developed-country league, a clear refutation of the dogma that high inequality is the necessary by-product of a system offering strong enough incentives to encourage high growth.
So much for why rising inequality is incompatible with a healthy economy. What about the facts. How much inequality is there?
There are many different ways of measuring inequality of income. Economists tend to use the Gini coefficient, whereby a reading of 1 represents a completely unequal society (winner takes all) and 0 a completely equal one (everyone earns the average).
Figure 4.1: The Gini coefficient
So what does the data show?
For the developed OECD-member countries for which we have data, the Gini coefficient for income rose from 0.29 to 0.32 (more unequal) from the mid-1980s to 2011, with some differences between countries. In the US it rose from around 0.34 to around 0.41 (by 2012) and a similar increase from 0.31 to 0.35 was seen in the UK. In France and Italy, never paid-up members of ‘liberal’ free-market ideology, there were more modest increases from around 0.30 and 0.29 respectively to 0.32 over the period.10
Perhaps the most important study in recent times has been Thomas Piketty’s Capital in the Twenty-First Century, a best-selling analysis of growing inequality within countries. Piketty’s hypothesis, supported by a wealth of empirical data, is that when the return on capital exceeds the economy’s growth rate, this increases the share of capital in national income, and since capital is more unequally distributed than labour income, this increases inequality. Whether past history is a sufficient guide to the future is always debatable, but his argument and evidence for rising inequality remain compelling. The study is also wide-ranging, showing that the Gini coefficient has increased by 10 per cent on average between 1980 and 2010 across all OECD countries. There are a few exceptions, with France, Turkey, Greece, Hungary and Belgium experiencing little variation over the period, in stark contrast to the Anglo-Saxon countries.
Nor is rising inequality confined to developed, self-styled-capitalist countries. A report by Peking University calculated the country’s Gini coefficient at 0.49 in 2012, having risen from around 0.3 in the 1980s. According to Zhou Xiaozheng, sociology professor at Renmin University in Beijing, ‘To put it simply, the poor are getting poorer and the rich are getting richer.’11 China’s Statistics Bureau claimed that the coefficient had fallen to 0.46 in 2014, but other estimates have calculated it as high as 0.61 in 2010 (according to the World Bank, a coefficient above 0.40 represents severe inequality). Only two of the twenty-five countries tracked by the World Bank are higher: South Africa at 0.63 and Brazil’s 0.53.
The other important vector of inequality affecting behaviour and the economy is wealth. The Bank Credit Analyst points out that inequality of wealth is greater than that of income in some countries. It registers a high 0.8 in the US, surprisingly followed by over 0.7 in France and over 0.6 in Italy. There could be many reasons for this, including the obvious one that the wealthiest disproportionately accumulate wealth through means other than current income, in the form of assets such as real estate, stocks and shares and even pension rights. Wealth has accumulated to a staggering degree at the top: one family, the Waltons, owners of Walmart stores, is said to have accumulated wealth equal to all that of the lowest 40 per cent of American families put together.12
According to the research by Saez, in 2013 the wealthiest 1 per cent of American households owned 42 per cent of all US wealth.13 Put it another way, the median wealth of America’s affluent families was nearly seven times that of middle-income families, up from about three and half times in 1983.14 In China the top 1 per cent own only 33 per cent of total wealth15 and the UK’s rich appear very restrained in comparison, with the top 1 per cent only owning anywhere between 11 per cent of the total pot16 and 23 per cent (equal with France), depending on who you ask.17 This shows the greater difficulty in gathering reliable data on wealth, which is largely not subject to direct tax.
In 2016 a study by the charity Oxfam made quite a splash when it calculated that the global top 1 per cent own as much as the remaining 99 per cent.18 That would imply that wealth inequality must be even greater outside the developed countries. Oxfam condemns a world where 26 people own as much as the poorest half of the world’s population. This compares with 388 super-rich people in 2010.
This trend is clearly unsustainable. Renowned linguist Noam Chomsky believes that the harm and bitterness created by a generation of neoliberalism risks causing more lasting damage than the Great Depression of the 1930s, when ‘despite the grim conditions, there was a sense of hopefulness, a belief that we’ll get out of this together’. In contrast, today this hope has ‘been largely supplanted by fear, despair, and isolation’.19 There can be few more damning comparisons for our modern age.
Gini coefficients may understate the changes in inequality because they are based on the average, which may itself be distorted by changes at the extremes such as increasingly skewed distributions of income towards the very top. The measure is also particularly sensitive to what is going on around the average, where the greatest weight of the population is found. Other measures capture more dramatically the different rates of increase of incomes depending on position in the distribution, and by how much the gains from economic growth have been captured by those at the very top.
In 2014 Atkinson and Morelli looked in more detail at income inequality in the US.20 Their data shows that the last time incomes were as unevenly distributed as now was in the 1920s. The subsequent fifty years saw a trend towards greater equality as the state grew more interventionist after the crash of 1929, the Great Depression and the Second World War. Banks and credit were tightly controlled and progressive tax rates climbed.
The pendulum then began its long swing back to historic extremes of inequality as the interventionist state was rolled back and free-market ideology took over. Back in 2006 an analysis of IRS data in the US by Emmanuel Saez and Thomas Piketty showed that the share of income earned by the top 1 per cent was as large as in 1928.21 The share of all income before tax earned by the top 1 per cent is currently around 20 per cent of the total, similar to the peak in the 1920s, but more than double the roughly 8 per cent of the early 1970s. The top 10 per cent saw their income share rise from 25.3 per cent in 1979 to 30.6 per cent in 2016.22 According to Jon Cowan of the centre-left think tank Third Way, ‘everyone agrees what the core problem is in that we are seeing an erosion of middle-class prosperity … where people disagree is what you do to address it’.23 Little wonder that the recovery in the West is anaemic, weaker than past recoveries, and continuously disappointing the expectations of political and economic elites. David Madland of the Center for American Progress explains why finally the American political process is responding when he says, ‘The basic reality is that the economy is not working for most Americans.’
America is far from unique in evolving towards a system where winner takes almost all. And the collateral damage is not confined to the stagnant living standards of the middle classes. Those extolling the benefits to developing nations of globalisation ignore the absolute poverty that exists at the lower end of the social spectrum even within the world’s richest countries.
Italy is one of the world’s richest nations, a member of the elite G7 club, yet, according to its national statistics agency, about 6.2 million Italians live in absolute poverty, twice the number compared to ten years previously. Four million are estimated to suffer from hunger, of whom 10 per cent are children under five years old. According to the think tank Censis, 60 per cent of those interviewed recently feared ending their lives in poverty as the economy falters. Lack of growth since 2000 has compounded rising inequality. The share of total income earned by those in the bottom half of the income distribution fell from 30 per cent in 1980 to 24 per cent in 2016 while the top 10 per cent progressed from 23 per cent to 29 per cent over the period. The national mood is a toxic combination of rage and resignation.24
In the UK real earnings fell more than 9 per cent in the six years from March 2008, the steepest and longest drop since records began in the mid-nineteenth century.
This rising inequality trend has been less pronounced in northern continental European countries that never fully embraced red-blooded free-market ideology. In Germany the income share of the top 1 per cent has hardly changed, from a little over 10 per cent, with the top 10 per cent earning around 175 per cent of the median, up a paltry amount from 150 per cent fifty years ago. Germany is widely recognised and admired as a template for commercial and economic success and strength, and yet it has preserved its own form of market economy where the interests of all stakeholders in society are balanced through governance structures at the company and industry level. It also has a much smaller financial sector, preferring traditional engineering to financial engineering.
But the picture is not all rosy there either. Markus Grabka and Carsten Schroeder of the German Institute for Economic Research in Berlin noted that while Germany enjoyed near full employment in 2017, this was thanks to a policy of low wages. Nine million workers, or 24.5 per cent of those employed (compared to 18.9 per cent for OECD countries), earned less than two thirds of the median wage of €15 per hour, which itself is lower that it was in 2003. The German economic engine runs on workers who make around €19,656 a year, less than the average wage in all OECD countries bar Mexico. Low-wage jobs are even more prevalent among workers with an immigrant background and those in the east of the country, with purchasing power often comparable to that of workers in emerging markets. Upward mobility is low with people stuck without much chance of advancement.
The French picture is even more egalitarian, with the share of the top 1 per cent not changing at all from a little below 10 per cent of the total, and the top 10 per cent actually losing ground relative to the median over the past four decades.25
Countries like Germany, France or Sweden show that inequality is not an inevitable consequence of the workings of a modern, efficient economy. Neither does inequality imply higher growth; quite the reverse. It is neither a necessary nor sufficient condition for success or the avoidance of crises. The truth is that inequality and its progression are a result of the political process, not of economics, a process tied to an ideology that dictates that government should keep its hands off the market and its allocation of resources and wealth, whatever the outcome.
How has this dogma expressed itself within the economic structure of the Anglo-Saxon countries? According to the distinguished economist John Kay, about one third of the top US 1 per cent income earners and an even greater proportion of the top 0.1 per cent are corporate executives. He also notes that rising inequality in some countries is mainly the result of ‘the growth of the finance sector; and the explosion of the remuneration of senior executives’.26
Figure 4.2: Relative proportions of public sector, service and manufacturing jobs, UK 1980–2009
In the 2017/18 tax year, median gross full-time income in the UK stood at £29,58827 compared to average salaries in finance (excluding bonuses) of around £35,000 (2019).28 Not only are finance professionals better paid; there are many more of them than thirty years ago. Finance has been one of the few consistently growing sectors of the UK economy over that period. Political establishments complacently bought the idea that making things, aka manufacturing, was a dispensable ‘old economy’ activity that could be wound down in developed countries in favour of more sophisticated, higher value-added services, of which, in the case of the UK, finance was the jewel in the crown (see Figure 4.2). This meant manufacturing could be outsourced abroad to cheaper locations without risk, the second pillar of the justification for globalisation. It took the GFC for developed countries to rediscover the virtues of manufacturing and express the desire to rebalance from financial engineering to plain old-fashioned engineering.
Figure 4.3: Average compensation: financial sector versus total private sector, US 1929–2011
Figure 4.3 shows the relative pay of finance employees in the US over time. Interestingly, this pay was equivalent to the levels of 1929 just before the Wall Street Crash. It was in reaction to the catastrophic consequences of finance’s excesses in the 1920s that the US authorities passed the Glass-Steagall Act in 1933 to put an end to casino banking and prevent a repetition of the Great Depression. It is no coincidence that the same causes produced the same effects within less than a decade of the act’s repeal under President Clinton in 1999, not because the dividing line between retail and investment banking had not become blurred, but because it signalled a no-holds-barred growth strategy to all banks.
One should not distort these facts into a conspiracy theory. Financiers did not set out decades ago to launch a campaign to boost pay for themselves and their employees. Rather, finance has been a passive but massive beneficiary of the extraordinary and unprecedented ski-slope of falling inflation, interest rates and government bond yields since their peak in 1981. Falling interest rates and deregulation enabled them to offer cheaper and cheaper credit to a population looking for instant gratification.
The world has changed dramatically since the early 1980s. The rejection of the post-Second World War Bretton Woods order of fixed exchange rates, gold backing the US dollar, big government spending, redistributing income from the rich through high taxation and the power of the big labour unions had already started in 1971. It took another decade of chaos, in the form of oil crises and inflation threatening to run out of control, to provoke the birth by forceps of the new regime of monetary discipline at the Fed under Paul Volcker. He squeezed interest rates higher until the inflationary pips squeaked, and the triumph of the Reagan-Thatcherite free-market, small government, anti-union ideology completed the delivery of the new free-market consensus.
The cycle turned, the bargaining power of organised labour faded with union membership and rising competition from low-cost countries, while tax rates on income and capital fell. In the short term, the retreat in labour’s share of GDP and the stagnation of real wages in the lower classes could be made up through easy credit as various restrictions (such as hire purchase rules in the UK) were removed in a lending free-for-all. Not only did the supply of credit grow faster than economies, particularly in the Anglo-Saxon world, but the demand was there, all too eager to mop it up. Finance professionals thrived, and their high incomes contributed to inequality. A supposedly virtuous circle of rising productivity, falling unit costs of production, falling inflation and accommodative central banks lowering interest rates provided increasingly affordable borrowing conditions. Ever lower interest rates made consumption growth affordable for those on stagnant incomes, as debt service costs stayed under control. Until they didn’t.
When the economy showed signs of overheating, the Fed and other central banks such as the Bank of England raised rates according to the old playbook, to keep inflation under control. By the late 1990s, however, enough debt had built up in the global economy, in emerging market countries or technology and telecommunication companies, that it took only modest interest rate rises (by past standards) to crash the system as debtors defaulted. Central banks were oblivious of the degree to which the build-up of debt had made parts of the economy more sensitive to interest rates.
We will return to the central role played by the build-up in debt in the next chapter. It is sufficient to say here that powerful economic forces conspired to encourage the rapid expansion of the financial sector over the last thirty-five years, aided and abetted by compliant politicians and regulators.
The Glass-Steagall Act had separated the activities of deposit-taking commercial banks from securities underwriting such as mortgage-backed securities. Its repeal in 1999 was the formal recognition that it had become toothless. Most notably, Citibank’s 1998 affiliation with Salomon Smith Barney, one of the largest US securities firms, was permitted under the Federal Reserve Board’s then existing interpretation of the act. Arguably, the act’s repeal took the final brake off the finance industry and contributed to an historic financial bubble whose bursting still reverberates today.
If the portrayal of Gordon Gekko in the 1987 movie Wall Street was an exaggeration, it was closer to the truth than many might like to believe. The main character’s one-liner ‘Greed is good’ encapsulated and legitimised the new regime. The statistics on top pay are illuminating. According to the Economic Policy Institute, in 2017 ‘CEO compensation at the largest [350 by revenue in the US] corporations has ballooned by 979 per cent since 1978, when adjusted for inflation [my italics]. A typical worker’s compensation grew a measly 10.2 per cent over the same period.’ The average CEO total compensation was $18.9 million. The average ratio of CEO compensation to the median worker in their company stood at 312:1, up from about 58:1 in 1989 and 20:1 in 1965.29
This trend is not confined to the US. UK ratios may be less extreme, but the progression is still spectacular, leading to an observation from an official of the High Pay Commission of a ‘30-year trend of increasing top pay that has left the earnings gap between the very richest and the rest of society wider than at any point since Queen Victoria was on the throne’.30 The report cites the example of Barclays, where top pay was 75 times that of the average worker. In 1979 the multiple was 14.5.
Stagnant shareholder returns in recent years have not prevented FTSE 100 company CEOs’ pay from rising inexorably, serenely detached from reality. While the FTSE 100 is at broadly similar levels to late 1999, meaning that shareholders have received an annual return of about 2 per cent after inflation, purely from dividends, CEO pay has risen several hundred per cent over the period. The average pay of a FTSE 100 company CEO was equivalent to 129 of their employees in 2016,31 growing almost six times faster between 2000 and 2014.32
A study by Robert Naess at Nordea Bank on how CEO pay affects company returns shows that from 2008 to 2018 the hundred US companies with the lowest CEO compensation within the S&P 500 index outperformed the hundred with the highest-paid CEOs every year except 2013, and by a wide margin: 17.2 per cent per annum versus 8.4 per cent.33
If companies cannot justify top executive pay rises in terms of performance or shareholders’ returns, they fall back on the defence that you need to pay enough to attract the best talent. Unfortunately, although this may be true in some cases, it fails to square with the facts in aggregate. Not everyone can hire top talent. And since company remuneration committees recommend securing the services of the best managers by paying top-quartile compensation, companies keep leapfrogging each other to demonstrate they are paying more to get the best. Turning the pay-incentives argument on its head, companies justify their high pay policies as evidence of good governance.
Even in more socially minded Germany, where pockets of resistance to the market free-for-all have survived to this day, things have got to the point where Der Spiegel wrote in 2013, ‘Average employee wages have increased by 6.1 per cent since 2000, while the salaries of senior executives at companies traded on Germany’s DAX stock exchange index have risen by almost 55 per cent during that time period.’
Elsewhere, Der Spiegel expressed concern that the poverty and wealth gap ‘has reached disconcerting proportions in Germany. Many can no longer support themselves with the money they earn in a full-time job. Almost one in four workers earns less than 9.15 euros an hour, which translates to about 19,000 euros a year. This is less than one-seven hundredth of what the CEO of VW makes.’ While this was denounced as unacceptable by Chancellor Angela Merkel at the time, little has changed since.
The increasing debate over high-end pay has prompted a belated response from governments and regulators. There has been a smattering of legislation around the developed world designed to appear to be doing something to tackle the trend. Since 2014 in the UK new rules have forced companies to seek shareholder approval for their pay policies as well as holding an advisory vote on the report of the committees that set top executive pay. These reports should now detail these compensation packages more clearly and compare them to pay across the company. It may seem odd that company management, who after all are the hired hands and agents for the owning shareholders, should have got away with little transparency about pay up until very recently. One can also be forgiven for speculating whether they could have got away with it longer had their egregious self-awarded pay rises not reached such extremes as to attract attention. Greed may be good, but only up to a point.
Elsewhere, in 2013 the European Union capped bonuses for investment bankers, and Switzerland approved a referendum that makes company shareholders responsible for setting the chief executive’s salary. By 2018, the European Banking Authority was reporting that the number of bankers in the European Union earning a million euros ($1.2 million) or more had fallen in 2016 as the EU’s cap on bonuses drove a shift towards fixed pay. The million-plus club decreased to 4,597, down by 10.6 per cent from 2015, the London-based regulator said. However, the EBA reports salary data in euros, and the decline was largely the result of the pound’s depreciation against the common currency in the aftermath of the Brexit referendum in June 2016. The vast majority of high-earning European bankers worked in the UK – 3,539 of the EU total – and most were paid in pounds. Stripping out the exchange-rate effect, the decline was just 2.5 per cent.
The legislation on bonuses has been totally ineffectual: the number of high-paid bankers has actually increased, and they have simply upped their base salaries to offset bonus limits – to the detriment of shareholders since rewards are now even less tied to results.
In 2015 the US Securities and Exchange Commission (SEC) decided to require companies to publish the ratio between their chief executive officer’s pay and that of their median employees from 2017. Business lobbyists were not amused, calling the move costly and meaningless. At the time, a report in the Financial Times, a newspaper known more for the pink colour of its paper than of its views, noted that between 1978 and 2013 American chief executives’ inflation-adjusted pay had risen twice as much as US stock market returns to shareholders. It suggested that the SEC’s new rule was ‘a response to real public concern. The pay gap has not just resulted in anger about corporate excess. The sense that those at the top are appropriating the spoils for themselves has undermined support for the capitalist system itself.’
We are, no doubt, in the early stages of the pendulum beginning to swing back the other way. That does not mean that those who have been the biggest winners recognise the profound change in public mood which is altering the political landscape. The sense of entitlement built up over decades of inaction by governments and authorities is unlikely to dissolve overnight. There have been waves of ineffectual protest before (remember Occupy Wall Street?), so why should they worry that this time is different?
In 2014 journalist Kate Burgess pointed out that the 650 members of the UK House of Commons, responsible for legislation for over 65 million people, were each paid £67,000 for a total cost to the country of £43 million. That is how much one CEO at the time, Sir Martin Sorrell, then boss of WPP, an advertising company, is reported to have earned in one year. It is not hard to challenge such relative rewards in terms of societal value, and yet our elected representatives are reluctant to do so, presumably partly for fear of companies and their top executives decamping to more accommodating tax jurisdictions. Even if WPP shareholders enjoyed a return of over 170 per cent including dividends over five years, and Sorrell’s pay was linked to share price performance, one may ask where are the economists’ cost-benefit analyses of such a situation?
In another case of corporate chutzpah, the corporate governance of insurance claims processor Quindell came under fire for granting over £25 million worth of stock options to its new chairman, deputy chairman and existing executives.34 Some of these options were exercisable within twelve months, disregarding the UK’s Corporate Governance Code’s recommendation that options ‘should not be exercisable in less than three years’. The award also casually disregarded the code’s recommendation that the compensation of non-executives, such as the chairman, should not include options, in the interests of providing some distance and independence from management. It seems that as long as restrictions on executive pay exist only in advisory form rather than being legally binding, many will brazenly disregard them.
In fairness, some institutional investors, such as Standard Life Investments, have exercised their shareholder powers, while in 2012 investors succeeded in unseating the CEOs of AstraZeneca, Aviva and Trinity Mirror after protests at annual meetings. However, according to the FT, more shareholder protests have been registered against non-binding remuneration reports than against binding votes on pay policy, suggesting that shareholders’ bark may be greater than their bite.35 By July 2018 there had been eighteen cases where at least 20 per cent of shareholders voted down the executive compensation packages, twice as many as in 2017. Nevertheless, these voters were still in a minority in almost all cases, and the votes were advisory rather than binding.
In the US, Oracle founder and CEO Larry Ellison has faced shareholder pressure on pay. It was reported that Mr Ellison enjoyed an annual package averaging $77 million over the three years to 2013 even though a majority of shareholders had voted against the company’s remuneration policy in the advisory vote for two consecutive years. This did not stop him claiming $108.9 million in compensation in fiscal year 2018, although only $3.6 million was in cash, the rest being the value of a grant of stock options on Oracle.
Perhaps the most insidious mechanism that top management has found to game the system is through the use of apparently respectable share buy-backs. The rationale is that if companies cannot find a productive and profitable use for their cash, they should maximise shareholder value by paying it out to shareholders. This can be in the form of increased dividends or by buying back company shares. Managements prefer the latter as dividends are supposed to be regular rather than one-off payments, and share buy-backs have the advantage of arithmetically boosting earnings per share (fewer outstanding shares are left as a company buys some back and cancels them). Since earnings-per-share growth is a key performance indicator used to calculate top executive compensation, this has been a popular strategy in recent years. It would be justified if companies bought back their own shares because they had good reason to view these as undervalued and cheap, thereby improving capital efficiency and shareholder value. Unfortunately, there is little evidence that this is the case.
Buy-backs in the US hit a peak in 2007, right at the peak of the housing bubble and when shares were at their most expensive. According to a Deloitte survey of North American chief financial officers in 2013, only 11 per cent thought their own stock overvalued, even while they thought that 60 per cent of US equities in general were overvalued. In other words, buy-backs tend to be poorly timed, are based on contradictory assumptions, and often destroy shareholder value. Companies should be issuing new equity at high valuations towards the end of the cycle, not buying it back.
Worse still, low interest rates have encouraged company managements to load their companies with new debt, the proceeds of which are used to buy back company shares. So managers weaken their balance sheets, making them more vulnerable to rising interest rates, in order to juice up their remuneration. In some cases, such as at Boeing, the company has been the largest buyer of its own shares in recent years, using cash it has not reinvested to design new planes or maximise quality control.
The only conclusion that can be reached is that, even if a company does not grow earnings much or at all for shareholders, it will find ways to justify handsome top executive pay rises. BP CEO Bob Dudley received a 20 per cent increase in total pay in 2015 to nearly $20 million despite the company making its worst loss ever ($5.2 billion) and BP shares falling 13 per cent in that year. The company justified this on the grounds of performance on safety, project management and cost-cutting – 5,000 jobs were cut, saving money to finance part of Dudley’s pay hike.
In summary, over the last three decades those hired to run companies on behalf of their owners have seen their pay rise exorbitantly relative to the pay of the workforces and also to the returns to those owners – the shareholders. This is unlikely to be a reflection of the skill or hard work or contribution of the top executives compared with the rest of their staff; rather it is due to laissez-faire government regulation and the passivity of public equity shareholders, many of whom behave more as share renters than owners, given the short average period of time they own a company’s shares. This has given carte blanche to top executives gaming the system, at least until the excesses become too egregious to ignore.
This pay explosion is the result of several trends: the growing share of profits as a proportion of national economies; the increasing valuation of those profits by the markets, in turn partly due to management buying back company shares with the company’s own money in order to boost measured earnings per share under cover of ‘shareholder value’ slogans; and remuneration committees staffed partly by other CEOs, which encourages a game of compensation leapfrog.
While it is impossible for everyone to hire the best managers, it is entirely possible for the best managers to hop from job to job in a pay-for-talent auction, perpetually pulling up the average in the process. Neither the labour force that produces a company’s output, nor the company’s shareholders benefit from this game and yet it has been tolerated up until now.
The income elite has learned to game the system to its advantage under the theoretical cover of a free-market ideology, and in practice through the power of lobbying and contributions to politicians’ election campaigns. They have also honed their skills at influencing regulators directly or through their political contacts, to maintain regimes that preserve their interests. The trouble is, they have been so successful that the masses below them, on whom they depend to consume their products, have been slowly starved of income growth. While this could be masked for some time by the addition of credit to stagnant or slowly rising wages, like all Ponzi schemes, there comes a point where not enough new money can be created to maintain demand and profits growth.