Capital Wins, Labor Loses, But Andrew Smithers Says It Can’t Go On
Warehouse manager at operations desk on computer. Photo courtesy of John McBride & Company Inc.
Paul Solman: Jon Shayne is not just the world’s No. 1 econo-crooner, belting out economics tunes of his own invention under the stage name Merle Hazard at his own website and for the PBS NewsHour audience on inflation, on the Greek debt crisis, on the euro crisis in general, on too-big-to-fail banks, and most recently, on the fiscal cliff.
No, Shayne/Hazard is no one-trick pony. He is also a noted money manager, recently highlighted by Forbes magazine for his perspicacity in stock-picking. Wrote Forbes: “If you follow the stock market, Jon Shayne is worth a good, long listen. Especially now.”
Having listened to Jon plenty over the past few years, I agree, especially with his emphasis on the increasing share of national income commanded by the owners of capital, in contrast to labor. This angle is the focus of Forbes’ story as well.
So I asked Jon to elaborate for the Making Sen$e audience. He has done so by interviewing the person who inspired his thoughts on the subject, British economist Andrew Smithers, who formerly ran the asset management business of S.G. Warburg, and now heads up his own consulting firm, Smithers & Co., in London and has produced this chart:
The chart shows the relative shares of national income captured by labor and capital in the U.S. from 1929 to the middle of 2012. As you can see, the last couple of decades have not been as kind to those who work for companies as to those who own them. Not nearly. Here’s Smithers’ explanation to Jon:
ANDREW SMITHERS: All output is for somebody’s benefit, either those who work for the firm (the labor share) or those who provide the capital (the profit share). Labor’s share has never been lower or the profit share higher. These shares of course add up to 100 percent, before the government has taxed both labor and capital.
JON SHAYNE: What do you think has caused labor’s share to fall below its average to a new historical low, and capital’s share to rise to the higher highest peak ever?
ANDREW SMITHERS: The change in the way company managements are remunerated has been dramatic in this century. Salaries have ceased to be the main source of income to senior management, with bonuses and options taking over. There has been major change in management incentives and it should not cause surprise, though it evidently has to most economists, that management behavior has changed. The current incentives discourage investment and encourage high profit margins.
This is dangerous for companies’ long-term prospects as it increases their risk of losing market share and reduces their ability to reduce costs. It is very damaging for the economy, but it maximizes the income of managements. Senior management positions change frequently, so if management wish to get rich, they have to get rich quickly.
I am not alone in this diagnosis. A recent report from the Federal Reserve Bank of New York comes to the same conclusion from a theoretical analysis as I have come from data analysis.
JON SHAYNE: How do bonuses today encourage profitability above investment? I guess you mean that they are tied to changes in earnings per share, or return on capital, rather than to the growth of companies’ output?
ANDREW SMITHERS: Yes, the current way in which managements are rewarded is perverse from an economic viewpoint. Adam Smith pointed out that some characteristics of human beings such as greed, which are often unpleasant at a personal level, can nonetheless bring social benefits. But this is not necessarily the case under current remuneration systems; greed is increasingly the cause of harm rather than help to the economy.
JON SHAYNE: On the graph, do we know how much of labor’s share represents what managers earn? If their share has gone up over the decades, through stock options and the like, which I believe is the case, then the average worker is getting even a bit less than it looks, correct?
ANDREW SMITHERS: Yes, there have been two major changes. First, the share of output which goes to all employees has fallen to its lowest recorded level. Second, the proportion of total remuneration that goes to the higher paid has shot up. Both of these changes have been bad from the viewpoint of the average worker. The result is that current management reward systems are producing both economic damage and social disquiet.
JON SHAYNE: What is the role of changes in technology that, for example, allow a credit card company to put an English-language call center in India? There is greater ability to send jobs abroad now than there ever was before. Are you saying that boardroom bonus culture explains all of the reduction in labor’s share?
ANDREW SMITHERS: Not necessarily, but for the most part. Changes in economies often have multiple causes; however, two common explanations do not fit the facts. (1) The fall in labor’s bargaining power. As the following chart shows, labor’s bargaining power, in so far as it can be measured by trade union power, has fallen steadily since the end of the war. However, in the first 30 years profit margins fell and only then rose. (2) Technology applies everywhere but while profit margins have risen in the UK and U.S., they have fallen, for example, in Japan and France. If technology had been a factor then margins would have risen in all G5 countries.
JON SHAYNE: What is your expectation about how the pie will be divided in the years ahead?
ANDREW SMITHERS: The long-term averages appear to be stable. In other words, the shares will tend to revert back to normal. Profit margins will therefore fall and employees’ incomes should rise relative to output.
JON SHAYNE: You devote yourself to close analysis of economic data from all of the world’s major economies. What are the biggest insights you have had from this work — things that are not apparent to most policy makers and investors?
ANDREW SMITHERS: My wife calls this my “smug bucket” bit, i.e., I explain why I am right and most people wrong. I am, however, aware that it is possible, though of course unlikely, that I am not always right. The things that in my view are most often misunderstood are:
(1) That U.S. corporate balance sheets are not “in good shape” as many and perhaps most investment banks claim. The data published by the Federal Reserve in the Flow of Funds Accounts of the United States (“Z1”) show that non-financial corporate debt (Z1 Table B.102) is near its all-time high and the same conclusion comes from comparing debt with corporate output.
(2) At the same time as claiming that corporations have low leverage, it is commonly claimed that the economy is suffering from companies’ wish to deleverage. This example of cognitive dissonance comes from both assumptions being wrong. Balance sheets are highly leveraged but companies are not seeking to deleverage. U.S. companies are currently buying back equity at an annual rate of $400 billion a year, which serves to increase debt ratios and is clearly incompatible with the assumption that they are seeking to deleverage.
Policymakers need to recognize that the problem is not deleveraging but the perverse incentives of current management remuneration contracts. These need to be changed. Otherwise bringing the fiscal deficit under control is highly likely to produce another recession.
JON SHAYNE: How is bringing the deficit down likely to produce another recession?
ANDREW SMITHERS: The standard assumption of most Keynesian and monetary economists is that the current imbalance in the economy which results in the large cash flow surplus of the corporate sector is cyclical and will change when entrepreneurs recover their animal spirits, either naturally or because there is so much money around. The data suggest otherwise. They point to the current imbalance being structural, not cyclical, and needing a structural change in management remuneration contracts for it to change.
As the problem is unlikely to be solved quickly it poses two risks to the economy. The first is that premature fiscal tightening will push the economy back into recession. The second is that too much delay will cause people to expect inflation to rise and this will probably cause actual inflation to pick up.
Unfortunately this matter is seldom if ever discussed and I hope your efforts will help to change this. I cannot see much hope of changing policy to address this complex problem unless it is first widely discussed.
Andrew provides research to over 100 money managers around the world (including me), and is the author of books such as Japan’s Key Problems for the 21st Century (with David Asher) (Diamond Press in Japanese 1999), Valuing Wall Street (with Stephen Wright) (McGraw-Hill, 2000) and Wall Street Revalued — Imperfect Markets and Inept Central Bankers (Wiley, 2009).
On YouTube, there is video of Andrew being interviewed by John Authers of the Financial Times in August 2012 on the bonus culture, and on CNBC and elsewhere. He wrote a chapter entitled “Can We Identify Bubbles and Stabilize the System?” in “The Future of Finance: The LSE Report”, published by the London School of Economics and Political Science in September 2010.
By the way, while this piece was in production, Paul Krugman wrote an interesting New York Times column on the same topic. In Krugman’s view, the cause of the decline in labor’s share is less than clear, but he thinks that technology and weakening antitrust enforcement are both factors. I’ll ask Andrew about it, next chance I get.