Productivity is falling because of how executives are paid.
The main culprit: bonus culture; The challenge is to alter incentives from those that damage the economy to those that help it
Productivity has declined in all the major developed economies. This fall is not a mystery, as is often claimed. Poor productivity is a consequence of low investment, and in the UK and the US a major cause of low investment is the incentives created by the bonus culture — the practice (now almost ubiquitous in quoted companies) of paying executives huge bonuses to reward short-term success.
How much a company invests is a decision for its managers, and the way they approach that decision will depend on their incentives; that is what incentives are for.
But bonuses encourage managers to put more emphasis on the short term for which they are rewarded and pay less attention to the longer-term dangers their companies face. Competition takes time to materialise. Ten years hence, shareholders might rue your decision to cut investment or raise prices. But if you care only about the short term, for which most companies have a great deal of monopoly power, the same choice can boost profits.
In many public companies, management teams are likely to give less weight to the long-term risks of low investment and high prices than to their own short-term interests. We should therefore expect the rise in short term incentives to have been accompanied by low investment and high profit margins. This is exactly what has happened.
The bonus system may not be the only reason why investment has fallen. Management teams may see fewer profitable opportunities available because we lack exciting new technology, or they may expect growth to be weak. But this should have been offset by the fall in the cost of capital, as interest rates collapsed and the stock market boomed.
Productivity improves with the amount of capital per employee, and the efficiency with which it is used. With the capital stock growing so slowly it is not surprising that increases in productivity have almost stopped.
Management incentives are wrongly perceived as an issue for shareholders. But the bonus culture is a problem for the entire economy.
Increased monopoly power boosts profits and shareholders’ wealth but is bad for the rest of us. We seek to preserve competition in the interests of the economy. The effect of bonuses is very similar to a fall in competition as it encourages managements to exploit their companies’ short term monopoly power. Both need the attention of government.
The challenge is to alter incentives from those that damage the economy to those that help it. Bonuses should be linked to increases in productivity as well as to profit targets.