Why Rising Inequality Is A Concern For Shareholders

by: Shareholders Unite

Should it be the business of the government to meddle in how the economy distributes income?

There are several views to this. Much of the debate derives from considerations of fairness, but we'll leave that to the political philosophers. We're more concerned about the effects on the economy. We think that several detrimental effects can be perceived.

The effects on the company level should be of particular concern for shareholders, but there are wider concerns as well. As previous times have shown, reducing inequality doesn't necessarily have to blunt incentives, and could improve economic stability and social cohesion.

Causes

Probably the best account of the causes of rising inequality comes from Robert Frank. He notes that rising inequality is a phenomenon of virtually all professions and to a considerable extent the result of pay by relative performance. This tends to magnify small performances out of proportion, especially at the top.

This is in part the result of technological developments and globalization, which have opened up the market for many top performers, for instance, those of classical musicians. The top performers are world superstars earning large sums of money, whilst those that are only fractionally less accomplished earn very mediocre wages, the so-called "winner-take-all" phenomenon.

Of course, there is a lot more to be said about this (some of which we have already done), but we're more concerned about some of the effects in this article.

Executive Pay

Rising inequality is particularly manifest in executive pay, and it's here where it should be of most concern to shareholders. The debate is on rising executive pay is on again, not only in the US, but also in the UK.

The latter country has experienced a similar rise in executive pay (albeit from a smaller initial difference) and the conservative government is now about to implement some measures in order to restrict the divergence, and giving greater responsibility to shareholders to act as forces of moderation.

A short overview of the causes and consequences (some statistics from the UK):

Over the past 10 years, chief executives' pay has risen nine times faster than that of the median earner. Some bosses (British Gas, Xstrata and Barclays for example) are now being paid over 1,000 times the national median wage. The share of national income captured by the top 0.1% rose from 1.3% in 1979 to 6.5% by 2007. These rewards bear no relationship to risk. The bosses of big companies, though they call themselves risk-takers, are 13 times less likely to be sacked than the lowest paid workers.

These rewards are by no means necessary to incentivise CEOs; they're merely a reflection of status and power. This has become more clear when pay packages had to be made public. The expectation behind this policy was that it would lead to moderation, but in fact the opposite seems to have happened, where many executives now are indignant of earning less than their peers.

In previous times (and in other countries), the differences have been much smaller without a noticeable effect on entrepreneurship. Here is Jeroen van der Veer, former CEO of Shell (NYSE:RDS.A):

If I had been paid 50% more, I would not have done it better. If I had been paid 50% less, then I would not have done it worse.

The concentration on financial incentives could actually have a negative effect on performance, as studies for the Federal Reserve have shown. Incentives can get in the way of intrinsic motivation, narrow people's focus and restrict their range of thinking. In the UK, there are now proposals to give shareholders more powers to enforce executives' pay deals.

Damaging Effects

We discern at least for possible problems

  • Company cohesion
  • Social cohesion, with possible wide ranging effects
  • Economic stability
  • Demand and productivity growth

If wages and remuneration of company executives would move more in tune with one another this could produce more trust and cohesion in the organization, providing a sense of community. This isn't as trivial or touchy-feely as it might seem at first sight, trust improves cooperation and lowers transaction cost, and it would certainly improve management-labor relations. We'll get back to this below.

Rising inequality could have pretty serious effect for the social cohesion not only of organizations but of society at large. In a pretty thoroughly researched book, "The Spirit Level" by British social scientists Kate Pickett and Richard Wilkinson, many social ills (drug use, obesity, violence, mental illness, teenage pregnancy, illiteracy, etc.) are empirically related to the level of inequality in society.

With striking consistency, the authors say, the severity of social decay in different countries reflects a key difference among them: not the number of poor people or the depth of their poverty, but the size of the gap between the poorest and the richest.

The operative variable is status differential. The bigger the difference, the more it matters and the more intense the competition for status becomes. In an interview with the authors, Wilkinson argues:

We quote an American prison psychiatrist who goes so far as to say he's never seen a serious act of violence that wasn't provoked by loss of face or humiliation, and so on. And in more unequal societies, status matters even more. People judge each other more by status. There's more insecurity. And people at the bottom are more often excluded from the markers of status, the jobs and housing and cars, so they become even more touchy about how they're seen.

Economic Consequences

Even the IMF has joined in, arguing that rising inequality was a factor leading up to the 2008 crisis:

The paper, by the Fund's modelling unit, warned of "disastrous consequences" for the world economy unless workers regain their "bargaining power" against rentiers. It suggests radical changes to the tax system and debt relief for workers.

This is not the only IMF study that points to negative economic consequences of higher inequality, it tends to end periods of economic growth much sooner:

Growth spells were much more likely to end in regions with less-equal income distributions. The effect is large.

Rising inequality has left many US wage earners out of sharing the gains of increasing wealth, as wages increasingly lagged rises in productivity. They increasingly had to borrow to join the economic growth, something which added to the economic crisis of 2008.

If wages fail to keep up with rises in productivity, there is potentially an insufficiency in demand building up, as people at the top were the gains are concentrated are likely to safe more.
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Social Mobility

Rising inequality would perhaps be less of a problem if it went hand in hand with rising social mobility. In fact, quite the contrary seems to be happening. There seems to be a considerable amount of downward mobility in the middle classes.

Let Employees Share in the Gains

On balance, the evidence now is for little beneficial effect and mounting detrimental effects. Here is one small policy change that can mitigate some of these bad effects -- a policy change that would have some other beneficial effects as well. By letting employees share in the gains they create for the company, the link between wages and productivity growth can be restored, and wage earners wouldn't have to rely on increased borrowing to share the spoils of economic growth, as they did in the last couple of decades.

Such a policy would also give them a greater stake in the company, with possible increased effects on motivation. What's more, it would enlist their knowledge, experience and problem solving capabilities to improve productivity and efficiency. If they share in the spoils this creates, they have less to fear and more to gain. Often, employees do not have an incentive to look for improvements as they have little to gain from these and could make themselves redundant. But making a bigger part of wages flexible and dependent on improvements could have other possible benefits.

Labor Market Flexibility

In principle, companies can react to a reduction in demand for their output in different ways:

  • They can reduce the number of employees
  • They can reduce wages
  • They can reduce hours worked

What particular route is chosen depends on national differences and practices in labour markets. We noted how Germany, compared to the US, got through the 2008 financial crisis experiencing a slightly larger drop in GDP but no bulge in unemployment, while in the US, unemployment rose steeply. This has much to do with differences in labor market institutions.

While it is easy to fire employees in the US when demand slackens, in Germany this is considerably more difficult, and there are policies and practices that guide employers towards reducing hours rather than headcount. In Japan, unemployment didn't go up much either, as there is still a strong tradition of lifetime employment (even if this isn't what it used to be 20 years ago). Instead, wages are quite variable and tend to go down during slack periods.

We think that there are advantages in reducing hours and/or remuneration, rather than jobs. The company keeps hold of valued human capital. The cost of hiring and firing might be less in the US, but these are still not negligible. Selecting, training and monitoring new employees isn't without cost.

Also, keeping the workforce together during a crisis instills a sense of common destiny and community, which could have a beneficial effect on motivation. But the main benefits are for the wider economy. There is ample research suggesting that unemployment, especially in the longer-run, has numerous detrimental effects on motivation, skills, work ethic, well-being, and the like. Even families as a whole can be significantly affected, and there are, of course, the financial aspects. Whole communities can be affected.

There is also significant evidence that long-term unemployed face a number of hurdles in getting back into employment, the stigma of having been without a job is only one of these. So we simply argue that keeping workers on as much as possible through reducing hours and/or the variable part of reward has benefits for the employees themselves, for the company, and for society as a whole.

Of course, there are limits to this. When a company is on the brink, there will obviously come a moment when some employees have to be let go. By making a part of wage compensation variable, could provide a first buffer in times of recession, and keep unemployment from rising as much as it would otherwise do.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.