A SERIES OF ARTICLES FRoM THE 2011 EMEA CoMPENSATIoN ...

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THE PAY AND THE CRISIS Other countries are in similar positions, and this creates a very difficult background against which to make wage decisions, because as J.M. Keynes famously said, “Wages are sticky downwards.” These problems are exacerbated by regions with soft economies, where employment prospects generally are poor and deteriorating. Growth has slowed in major Organisation for Economic Co-operation and Development (OECD) economies, such as the US, the eurozone and Japan. These economies bounced back from the 2008–2009 recession nowhere near as strongly as is typical after a deep recession when spare capacity is quickly brought back into use. That didn’t happen this time – hence, the weak recovery and current softening. Most countries are only just in positive growth, a position that compromises their ability to tackle unemployment. Unemployment, which shot up during the recession, has remained very high. In the eurozone, it is around 10%, but this conceals some higher figures, such as the +20% figure in Spain. Unemployment is a lagging indicator, too, so it is likely to rise further given the current economic slowdown. And while this should, in theory, reduce the pressure on pay, that is certainly not evident at the top of organisations. Added to this is the leading indicator of business confidence, which fell sharply at the beginning of this year, according to surveys throughout the US and Europe, with further adverse implications for investment and unemployment. WHAT CAN POLICY MAKERS DO In truth, policy makers have little flexibility, because the drivers of economic policy in both Europe and the US already have both feet on the floor. Interest rates are close to zero, and although there is some scope for monetary easing, this has nowhere near as powerful an effect in stimulating growth as reducing interest rates does. And on the fiscal policy side, there is no flexibility at all: indeed, high levels of fiscal consolidation (10% of GDP in the US and 4% in the UK) are required in many countries in order to get back into a stable position. So the big question in terms of the macro-economy is: where do we go from here It is pretty clear that the economy has stalled, but whether it will do so for a while and then recover or go further downhill is difficult to predict. According to some analysis by Morgan Stanley on the four previous occasions over the past 50 years when the economy began to recover from a recession and then quickly stalled, in two cases the economy entered a double-dip recession and in the other two it picked up again. So the odds are 50–50 – but one may lean towards the pessimistic side, considering that there are so few levers the government can pull to reverse the trend. The best estimate is that, for the time being, we are going to be in a pretty flat economic environment, with below-trend growth for the next couple of years. And within that scope, some countries face the additional challenge of trying to adjust their competitiveness within the eurozone. But it could be worse than that, and the risks are mainly on the downside. LONG-TERM TRENDS IN PLAY Income inequality has been increasing in many countries for some years: top pay has risen much more than average pay, and pay in the financial sector in particular escalated dramatically before the crisis. Measured according to the Gini coefficient, 2 income became less equal in 19 of the OECD countries between 1985 and 2005, with the greatest discrepancy seen in New Zealand. Income inequality rose in the UK, too, though by less than the OECD average. However, the Gini coefficient is an aggregate measure of income distribution and conceals a more disturbing trend. For example, if you look at the top 10% and the bottom 10% of incomes in the UK between 1975 and 2008, the top 10% have accelerated – a trend replicated in many developed (and developing) countries. And the disparity is even higher among the top 1% of earners, with the top 10% of that top 1% seeing dramatic pay rises, pointing to a sort of “winner takes all” phenomenon right at the top of the income distribution curve. And in the banking sector, these trends are exaggerated further still, with relative pay (which started to rise at around the time of financial deregulation in 1990) now at an all-time high – even after the recession and 6 2 The Gini coefficient is a measure of the inequality of a distribution, a value of 0 expressing total equality and a value of 1 maximal inequality. It is commonly used as a measure of inequality of income or wealth.
THE PAY AND THE CRISIS government bailouts (at taxpayers’ expense) of many banks. No wonder resentment about top pay in the financial sector runs so high. Some particularly egregious examples of this phenomenon have served to focus this resentment. Harvard Business School researchers found recently that by 2008, share prices of Bear Stearns and Lehman Brothers had risen by four to four and a half times what they were in 2000, before collapsing to zero, leaving shareholders with nothing or next to nothing. 3 Over the same eight-year period, the top five executives in each of those firms received more than £1 billion in cash. Such calculations demonstrate that things have gone too far and inevitably feed into policy thinking. And these are not isolated examples. Separate research shows that between 2006 and 2010, investment banks were paying their employees, on average, 2.6 times pre-tax profits. This leaves very little on the table for shareholders and affects share prices, which, in turn, feeds through into pension funds and insurance companies and, thus, the wealth of individual savers. There is only one industry in which pay as a percentage of revenue rivals that of investment banks – Premier League football clubs in the UK. According to a special report in The Economist in May this year, in the 2008– 2009 season, Portsmouth paid out more than 100% of its revenue in wages (it has since gone bust) and Manchester City paid out 95%. 4 Five clubs beat UBS in terms of the percentage of income they paid out in wages. But the bubbling resentment about top pay is about more than the politics of envy. There is some interesting academic research 5 – led most notably by Nobel Prize winner Joseph Stiglitz – that gives weight to the argument that this sort of top-wage inflation may have been central to the financial crisis. In the US in particular, but also in the UK, median incomes stagnated for 10 years or longer, and people compensated by increasing their credit, to the extent that household debt as a proportion of GDP rose to astronomical levels. People were essentially sustaining their living standards through credit, leading to the credit explosion that created the crisis. And, of course, high-risk credit was made available by banks, which, in the short term at least, made extravagant profits as a result. So high pay is seen not just as an excrescence on the financial and real economy, but also as comprising a set of trends that are central to explaining why our economy behaved as it did at the end of the last decade. This is why pay is such a toxic topic, and why the days are long gone when a senior Labour politician could say, as former Business Secretary Peter Mandelson did in 1998: “We are intensely relaxed about people getting filthy rich.” No one in politics is relaxed about people making a lot of money these days. POLICY RESPONSES TO HIGH PAY Financial regulators, in particular, are taking a much deeper interest in pay than they used to. Regulators formerly began by looking at the question of incentives and risk, but their interest now goes well beyond that, and, following a clear set of political instructions, that interest is spreading to the nonfinancial sector as well. There has been a range of policy responses. Some are driven at a global level by the Financial Stability Board, instructed by the G20 finance ministers, and while implementation may differ in different regions, the changes are largely consistent. For example, regulators have required banks to disclose more detail on more people, to link incentives more closely to their risk appetites, to pay a larger proportion of bonuses in stock, to increase the deferred proportion of pay, and to introduce clawback mechanisms in order that bonuses may be clawed back if the expected profits fail to materialise. In the US, shareholders have introduced “say on pay” resolutions, allowing shareholders to vote on 3 Bebchuk LA, Cohen A and Spamann H. “The Wages of Failure: Executive Compensation at Bear Stearns and Lehman 2000–2008” (24 November 2009), Yale Journal on Regulation, Vol. 27, 2010, pp. 257–282; Harvard Law and Economics Discussion Paper No. 657; ECGI – Finance Working Paper No. 287. 4 “Special Report: International Banking”, The Economist (12 May 2011). 5 Stiglitz JE. Freefall: America, Free Markets, and the Sinking of the World Economy, New York: W.W. Norton & Company, 2010. 7
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Page 37 and 38: ABOUT THE AUTHORS Piia Pilv, Mercer

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