• Bonuses – for Good or Ill?

    Eyebrows and ire were both raised by last week’s reports of the huge bonuses – contributing to even bigger remuneration packages – paid out to the executives of some of our leading companies, even when those companies had seen profit margins fall substantially. Nothing more strongly suggests that the lessons that seemed such a clear legacy of the global financial meltdown just a few brief months ago have been quickly and conveniently forgotten.

    Even the justification offered by the spokesman for the Institute of Directors was redolent of a distinctly pre-recession complacency. “If we are to attract the talent we need,” he solemnly intoned, “we have to pay salaries to match those paid in the rest of the world.” It’s a wonderful thing, the global economy; it requires us to push up New Zealand’s top salaries in an attempt to match world levels, but at the same time requires wages for ordinary employees to be driven down to the benchmarks set by the lowest-wage economies.

    The supposed need to pay a top executive 100 times the income of his skilled employees is a self-serving nonsense produced by a small charmed circle who claim the right to set their own (and their mates’) pay rates. But the bonus culture which seems to have emerged unscathed from the recession is objectionable, not just because it produces scandalous inequities in terms of total remuneration, but because it is seriously deficient as a means of producing better economic performance.

    The payment of very large “performance” bonuses is, we should note, a feature of a peculiarly Anglo-American business culture whose quasi-religious faith in the infallibility of market forces should surely have been dealt a major blow by the implosion of the last year or so. But the case against it rests on sound principle and practice rather than ideological preference.

    I have had personal experience from both sides, as an executive and a director, of performance bonus schemes. On the basis of that experience, I believe that they promote attitudes that are the very antithesis of those we need.

    The theory is that, if executives have “skin in the game” (or any of the other macho phrases used to justify the practice), they will try harder and produce a better performance. The reality is, however, that bonus schemes encourage the very deficiencies which have bedevilled our economic performance over a long period.

    First, they engender a focus on the short-term at the expense of the longer-term health of the enterprise. “Short-termism” is a well recognised affliction of Anglo-American economies; it leads to cost-cutting and profit-taking over a short time horizon as alternatives to what we really need – investment, building new capacity, productivity improvements and strategic perspectives.

    Secondly, bonus schemes often distort performance, diverting attention from the issues that should really be addressed in favour of those which happen to be relevant to the bonus. Because many of the factors that determine a company’s performance are beyond the capacity of an individual executive to influence – macro-economic conditions are the most obvious example – they either have to be discounted, or applied even though it is clearly irrational to do so.

    The result is that boards usually either make a broad judgment as to what constitutes good performance in given circumstances, without reference to the factors (like a recession) that have really determined performance, thereby destroying the fiction that performance evaluation is based on measurable and accurate data, or they substitute for their own judgment a set of criteria which at least have the merit of being measurable, even if they are seriously irrelevant.

    If they take the first course, the “performance” that is allegedly being measured all too often becomes nothing more than a reflection of whether or not the board feels strong enough to risk alienating the executive by withholding a bonus or part of it. That seems to have been the story of the bonuses reported here over the past week or so.

    If they take the second course, and pretend to be measuring performance accurately according to quantitative criteria, the danger is that the executive focuses on the bonus criteria, even if they are barely relevant to any sensible judgment of good performance.

    The issue of whether or not a bonus is paid, and how much, can also be destructive of a good relationship between governance and management. Some boards will purport to be able to measure performance to the last percentage point. An executive who has done well may well feel cheated if the board says that only 75% of a bonus is to be paid. And if the bonus scheme extends to a larger group of executives, the issue of who gets what percentage of bonuses (bearing in mind that such information rarely stays confidential) can engender feelings of resentment and unfairness – hardly conducive to good human resource management.

    There is a much better practice, to be found in better-run economies than our own, which we should emulate. Top executives should be paid a proper rate for the job (and I have no objection to high salaries per se) on the assumption that, having been appointed, they will deliver a satisfactory performance. A less than satisfactory performance should be dealt with as a performance issue. An exceptional performance – above and beyond the call of duty – should be rewarded with a genuine, but one-off, bonus.

    This would require many employment contracts to be re-negotiated, not necessarily with a view to bringing total remuneration down, but with the aim of removing many of the deleterious effects of the current practice, and producing more transparent and defensible arrangements. It is up to boards (and shareholders) to take this more sensible approach.

    Bryan Gould

    30 August 2009

    This article was published in the New Zealand Herald on 3 September, and an amended version appeared in the online Guardian on 5 September.

  • Sin and the City

    Twenty three years ago, the City was excitedly awaiting the Big Bang – the moment which would usher in a new era of self-regulation of the financial services industry. I had a grandstand view of the impending arrival. The legislation to prepare for the Big Bang was called the Financial Services Bill, and I spent several intense weeks leading for the Opposition as the Bill was taken through its Standing Committee stage.

    Mrs Thatcher’s government, in line with its free-market philosophy, was very clear that the City could in essence be trusted to regulate itself. They resisted all attempts to give the regulators some teeth. The next few years of what some called self-regulation but which was in reality a free-for-all saw a huge expansion in financial services, in the size of the institutions providing them, in the sums of money involved, and in the rewards “earned” by those who worked in the City.

    For those of us who argued at the time that the “free” market was not infallible, and (in line with Keynes, who had warned that financial markets were peculiarly prone to excess) that the City would require substantial regulation, subsequent events have come as no surprise. Even we, however, could not have foreseen the size of the money-go-round, spinning ever faster, that produced outrageous fortunes for a few and, eventually, crash and ruin for many.

    Nor could we imagine that it would be a New Labour government that would become the most enthusiastic cheerleaders for the new lords of the universe. So dazzled were Ministers by the riches generated in the City that they did not think to enquire as to how many of those they claimed to represent actually benefited from the new wealth – wealth largely gouged out of the pockets of the rest of us.

    The current revulsion at City excesses – the inflated bonuses, commissions, salaries and perks – is understandable; so, too, the anger at the growing evidence that nothing has changed and that those responsible for the mess will be paid mega-bucks for (allegedly) cleaning it up.

    But the reaction to the greed and irresponsibility of the financial free-for-all, while natural, is a diversion from the real point. The reason for the government’s continuing genuflection to the City is that, after 23 years of unregulated City operations, and a growing reliance on financial services to keep the economy moving forward, the collapse of the City means that there is nothing much left.

    The game is given away in the Chancellor’s statement this week on his plans for future regulation of financial services. His constant references to the importance of the City to our economy should be seen, not as an endorsement of the course followed over the last 23 years, but as a confession of failure. It is an admission of how far governmental indulgence of City excesses has distorted our economy and how big has been the price that the rest of us have had to pay for the rewards that City operators have milked from that same economy.

    The real damage suffered as a consequence of the City’s domination of our economy is not to be measured, in other words, only in terms of the current crash and financial meltdown. The weight given to the City’s interests over a long period has seriously distorted our economic performance – and the more successful the City seemed, the more important its earnings to our national accounts, the more other parts of the economy were allowed to wither away.

    The problem is not a new one; it was Winston Churchill who, as Chancellor of the Exchequer, remarked in 1925, “I would rather see Finance less proud and Industry more content.” An excessive attachment to the interests of those who hold and manipulate existing assets, at the expense of those who want to create new wealth, is – after all – a characteristic of mature economies which have substantial assets to protect – and we have been a mature economy for 150 years.

    But the era of self-regulation and the demands of the global market meant that this policy bias became magnified many times over. Economic policy as a whole was tailored over this period to serve the City’s interests – so consistently, and over such a long time, that it was no longer recognised as abnormal. There was, we were assured “no alternative”; the global market meant that if the City were not given free rein, others would muscle in on their territory.

    So, monetary policy was given centre stage. The policy itself was handed over to bankers, so that it was no longer subject to scrutiny and Ministers were no longer accountable for it, but so that it could be decided for a limited purpose that – arguably – primarily served the purposes of one part only of the wider economy.

    Macro-economic policy was largely abandoned. Keynes was dismissed and forgotten. Interest rates were pressed into service to maintain the value of the currency and to underpin financial assets that might otherwise have been regarded as of dubious value. Little or no attention was paid to the competitiveness of the rest of the British economy, so that any thought of following an exchange rate policy that would stimulate exports, employment and investment simply never occurred to our policy-makers; manufacturing in particular was allowed to continue its relentless decline. Most of our economic eggs were placed in the financial services basket and only City operators had access to the golden eggs amongst them.

    That is why the global crisis has hit the United Kingdom harder than anywhere else. The financial meltdown has meant that we have nothing much else to fall back on. And that is why the government has gone back – cap in hand – to the authors of the great misfortune, to ask them to dig us out of the hole. There is no better hole to find.

    Millions will pay the price of the financial collapse with their jobs, homes and taxes. But many more – and over a much longer period – will suffer in ways that they do not even recognise as a result of the policy priority given to City fat cats whose primary focus remains their own privilege rather than the British economy. Whether through indifference or cowardice, our politicians seem intent on perpetuating a 23 year-old error.

    Bryan Gould

    6 July 2009

    This article was published in the online Guardian on 9 July