problems require new solutions. Economic policy today in Japan, the UK and the
US is failing to produce a recovery. This is not, as is often claimed, because
old solutions are being only half-heartedly employed, but because the existence
of the new key problem is being ignored. The ex-ante savings’ surplus in
the business sector has become structural. The implicit though seldom stated
assumption of most Keynesians is that such surpluses are cyclical and will
disappear as the animal spirits of entrepreneurs return.
typical example of this assumption is found in a recent article by Jonathan
Portes and John Van Reenen
which claims that “...the textbook prescription – followed successfully by the
1992-1997 government – (is) that the deficit cutting should follow, not
precede, sustained recovery.” But the assumption that sustained recovery will duly
arrive in reasonable time depends on the current savings’ surplus of the
corporate sector being a cyclical problem. However, as the evidence clearly
shows, corporate behaviour in the UK and US has changed so that the cash
surplus of the business sector has become a structural phenomenon. Attempts to
offset the surplus in the business sector by fiscal means alone would therefore
require large semi-permanent deficits and thus provide no prospect of national
debt ratios being brought under control within a reasonable time. If and when
we subsequently recovered, a rise in inflationary expectations would, under
these conditions, be highly likely and a more severe recession than we have
today would then be needed to bring such expectations down again.
While fiscal policy
is appropriate to prevent a cyclical rise in private ex-ante net savings
from causing a slump, the change in corporate behaviour has rendered it
inadequate for generating recovery. Keynes’s famous quip, that in the long run
we are all dead, was a way of sidestepping this important issue. Budget
deficits prevent ex-ante savings’ surpluses from causing recessions, and
no other solution is needed provided that the surpluses are cyclical. But if,
as seems the case today, the surpluses are structural, then we are now living
in the long-term and other policies are vital if we are to achieve a
pattern has been for the business sector to run a cash deficit. In the US this has
averaged 1% of GDP since 1960, but the sector is currently running a cash
surplus of over 3% of GDP. The UK shows a similar pattern, with an average
deficit of 1.6% since 1987 and a current surplus of 5% of GDP.
Unless one sector’s
changes accidentally offset another’s, swings in the ex-ante savings of
any part of the private sector will need to be offset by swings in the fiscal
deficit. The business sector’s net savings appear to be the most volatile and
the ex-post swings in this sector have been strongly correlated with
government deficits in both the UK and US, as I show in Table 1.
Changes in the ex-ante
savings’ balances of the business sector seem therefore to have been the major
cause of the changes required in budget policy (Charts 1 & 2).
A simple equilibrium
model shows that the business sector naturally runs a cash deficit. If the
business share of GDP, its leverage and capital/output ratio are stable, then
the net additions to the capital stock will be less than the net additions to
corporate equity and the difference will be financed by a steady growth in net
Corporate behaviour has changed in both the UK and the US in recent years. The change has taken three forms. First, the published profits of companies in the US, (I don’t have data for the UK), have become dramatically more volatile than those in the national accounts (Chart 3). Second, corporate investment has weakened in the US (Chart 4) and third, profits margins have become wider (Chart 5). All these changes fit with the alteration in corporate behaviour that should be expected following the change in the way management is remunerated.
does not appear to have changed in other G5 countries. While I can find no
suitable data for Germany, profit margins for non-financial companies in both
France and Japan have shown declining trends. Attempts to explain the rising
trends in the UK and the US need therefore to be specific to those countries.
This fits with the change in corporate incentives and behaviour, which appears
to be a purely Anglophone issue.
It also means that changes in technology or the impact of globalisation which
apply to all G5 countries cannot account for the rise in UK and US profit
Since the future is
unknowable, management decisions involve risk, with different types of
decisions involving types of risk. Decisions to invest in new capital equipment
reduce the risks that a company will lose market share, either because it will otherwise
be unable to meet rising demand or because its labour costs per unit of output will
rise relative to those of its competitors. However, neither the benefits of capital
spending nor the risks of under-investment show up quickly. Pricing decisions
have diametrically different risks. Holding up profit margins in weak markets
or pushing them up in any conditions increases the long-term risks of losing
market share, but protects short-term profits and thus has low short-term risks
for managements’ remuneration.
A change in the
incentives given to managements will change their willingness to take risks and
the balance between the long-term and short-term risks. In recent years there
has been a huge change in the way US and UK managements are remunerated. Basic
salaries have ceased to constitute the major part of executives’ incomes and
stock options and bonuses have come to dominate. According to Frydman and
Jenter (2010), basic salaries in 2008 were only 16% of total executive pay. The
non-salary part of the total pay is highly volatile and depends on short-term
changes, particularly in share prices, earnings per share and sometimes returns
on corporate equity. As the measures are short-term ones and the jobs of senior
executives change frequently, the change in remuneration has altered their
perception of their business risks and increased the difference between the
risks for shareholders and the risks for management. The long-term risks inherent
in high profit margins and low capital investment have become much less
important and the costs to management of short-term falls in profit margins
have become much greater. As the target levels for share prices and earnings
per share are habitually “rebased” in the event of changes in management and
sharp falls in profits, managements naturally favour volatility of profits and
The change in
accounting practice from “marked to cost” to “marked to market” has greatly
increased the differences between profits as published by companies and those
shown in the national accounts, which basically remain “marked to cost”. The
change has also sharply increased the ability of management to put, if only
temporarily, a favourable or an unfavourable interpretation on current profits.
In so far as management can influence the level of published profits, relative
to their economic level, the change in the way management is paid is likely to
result in their increased volatility. Profit margins and investment have
historically fluctuated with cyclical changes in the economy; the change in
management incentives will naturally tend to push up profit margins and push
down investment, relative to the impact that would previously have occurred
from the cyclical position of the economy.
The expected pattern
is that observed. Chart 3 shows that the volatility of earnings per share, as
published by US listed companies in the S&P 500 Index, used to be very
similar to the volatility of profits after tax of US companies as shown in the national
accounts, but have in recent years become more than four times more volatile.
The impact of the
change in management remuneration on investment and pricing is also as
expected. Chart 4 shows that business investment has not only fluctuated with
the cyclical state of the economy, as estimated by the OECD, but has been on a
strongly declining trend and Chart 5 shows that profit margins have both moved
with the cycle and have had a rising trend.
Another way of
looking at this is to compare the allocation of cash generated from operations
between money spent with longer term or shorter term considerations in mind.
Capital investment by corporations reduces longer term risks and thus shows the
emphasis given by management to the longer term, while cash paid out to
shareholders in the form of either dividends or buy-backs shows the emphasis
placed by management on the shorter term. Chart 6 shows the ratio of money spent on
reducing longer term risks compared with that spent on reducing short-term
ones. The falling ratio thus shows how the shorter term considerations have
increasingly dominated management decisions.
Charts 7 and 8 show
that there have been similar changes in the UK, as business investment has
fallen profit margins have risen, relative to the level of the output gap;
though the cyclical pattern with regard to investment is less clear for the UK
than it is in the case of the US.
I am not alone in
seeing the change in the way the managements are now being rewarded as damaging
the economy. In December 2011 the Federal Reserve Bank of New York published by
a paper by John Donaldson, Natalia Gershun and Marc Giannoni, which set out a
theoretical model of the way the change in management remuneration was likely
to cause serious damage to the economy.
The policy of waiting
for sustained recovery before cutting back on the fiscal deficit may have been
successful in the 1990s, but will not be today when the behaviour of companies
has changed with the change in managements’ incentives. New policies are
required. In order to bring down the fiscal deficit without pushing the UK
economy into deep recession, the new policies must address the fiscal deficit’s
twin causes, rather than simply assuming that the problems will disappear of
their own accord. The two sectors whose savings’ surpluses need to be offset by
large fiscal deficits are those in the corporate and foreign sectors.
The surplus in the
foreign sector is the easier of the two problems to tackle and simply involves
intervention in the foreign exchange market to depress sterling - at least to a
lower level than it would have been in the absence of intervention. The resulting
additions to the foreign exchange reserves will be matched by a lower savings’
surplus of the foreign sector compared with that which would otherwise have
been the case. Over the past decade the foreign exchange reserves of China have
risen by US$3trn. and those of Brazil, India
and Russia combined by a further US$1trn. It cannot make sense for the UK, which has a larger fiscal deficit problem
than the “BRICS”, to eschew similar action. Currency intervention cannot be an
acceptable policy for those without large fiscal deficits and unacceptable for
those with them.
If the world has an ex-ante private sector savings’ surplus
and needs a larger fiscal deficit to offset it, then the additional load cannot
sensibly fall on those who have already borne the policy burden. Furthermore,
those who should ease their fiscal policies will be less eager to do so if they
are the only countries which are apparently permitted the relatively easy
option of offsetting any weakness in domestic demand by currency intervention.
In the 1930s sterling
was devalued with the result that the UK performed much better than France,
which maintained its exchange rate. It is said that when the former Labour
Chancellor, Philip Snowden, saw the success of this policy he remarked that
“Nobody told us that we could do that”. Economists should be telling the
present UK government that they can almost certainly stimulate demand by
increasing our foreign exchange reserves and, if they wish to be re-elected,
they must start doing so soon.
in the foreign exchange market is likely to cause the real exchange rate to be
lower than it otherwise would have been and thus should not only stimulate a reduction in the current account deficit
but also an increase in business investment. Foreign trade is 70% goods and 30%
services, whereas output for domestic demand is not more than 20% goods. A fall
in the trade deficit is thus likely to increase the importance of goods in
total output and, as the produced capital/output ratio of goods’ production is
much higher than that for services, a fall in the external trade deficit should
be accompanied by a rise in business investment and thus a fall in the sector’s
A more fundamental
approach to reducing the corporate sector’s structural savings’ surplus is more
difficult. A major improvement requires a large change in the way management is
remunerated. In my view this will require the development of a new “best practice”
contract under which pay should be aligned with the national interest and not
against it, as it is with current bonus practices. For example, this could be
achieved by making increases in output and investment, in addition to
improvements in earnings per share or the return on equity, a necessary
condition for the payment of bonuses. This is a complicated and difficult issue
and is unlikely to be implemented unless the present problem of perverse
incentives is understood. It is clear that this is not yet the case and the
first requirement is that we should have a public debate on the subject. I hope
this paper will help stimulate discussion of this key problem.
 UK should have waited to enforce
austerity published in the Financial Times 2nd August, 2012.
 US data are available since 1960 but UK
data only since 1987.
 Some Unpleasant General Equilibrium Implications
for Executive Incentive Compensation Contracts by John B. Donaldson,
Natalia Gershun and Marc Giannoni, published in December 2011 by the Federal
Reserve Bank of New York as Staff Report No. 531.