Incentive pay remains key to growth

OXxford Analytiuca
Published: March 01, 2009, 23:01

SUBJECT: Performance incentives in capitalism - what they are and why they matter.

SIGNIFICANCE:
The controversy over financial sector bonus awards in the United States
and elsewhere has generated debate about the value of incentive-based
pay systems. Most justifications for these remuneration schemes turn on
assumptions that performance is largely a function of engineered
incentives schemes (both positive and negative) - but these now appear
faulty or incomplete.

Monetary incentives are essential to capitalism and economic growth.

It is clear that
flawed incentive-based pay systems played a significant role in
exacerbating financial sector systemic risk, the bubble in US housing
and associated derivative products, and the current economic crisis.

However, incentives are a key factor in promoting innovation and entrepreneurial behaviour - which help drive long-term growth.

ANALYSIS:

Incentives are
fundamental to modern Western societies, affecting all aspects of
political, social and economic life. Free market economies embed the
concept of monetary gains as the key motives driving household,
corporate and individual behaviour. Equally significantly, the rule of
law, government and corporate institutions provide incentives (either
in the form of rewards, or penalties) to citizens to encourage, or
deter, certain forms of behaviour.

Incentive-based pay
systems were meant to embed this ethos in corporate structures:
rewarding leadership that benefited the company as a whole, and
deterring purely self-serving behaviour. Instead, they recently seem to
have done the opposite.

Super-productive CEOs?
Incentive-based remuneration for executives of public companies was
designed to align the interests of managers and shareholders, by
rewarding executives who presided over long-term value creation. Former
Treasury Secretary John Snow justified the huge growth of executive
compensation over the past two decades as a simple validation of such
incentive-pay systems: in the aggregate, he claimed, "it reflects the
marginal productivity of CEOs".

However, given the
sluggish responses of board-level compensation committees to the
massive shareholder-value destruction over the past year, such
justifications of the increasingly huge pay disparity between
executives and line workers appear increasingly questionable.

Performance government
While financial industry executives' bonuses have attracted the most
media attention, schemes designed to incentivise public sector
employees have been widespread in government agencies since the 1980s.
In the United States, United Kingdom and many other developed economies
(including Canada and Australia) senior-level bureaucrats work with
specific annual performance targets; exceeding them produces bonuses.

Such schemes can also
apply to the rank and file within government bureaucracies. UK National
Health Service reforms enacted since former Prime Minister Margaret
Thatcher's era have been based on encouraging efficiencies by hitting
performance targets in exchange for rewards.

Bonus culture The
current economic crisis has revealed that the objectives of bonus
schemes have become seriously misaligned from their outcomes: indeed,
incentives may have fuelled the leverage-based implosion of the
financial sector. For example, before finalising its merger with Bank
of America in December, approximately 700 Merrill Lynch managers and
employees were awarded bonuses of over $1 million (Dh3.67 million)
each, despite the fact that last year Merrill posted one of the largest
losses in US corporate history ($27 billion).

Types of incentives
While such anecdotes have stimulated public outrage, it is worth
remembering that incentive-pay was specifically designed to serve
public or shareholder interests better than ordinary forms of
remuneration. Incentives are judged the most efficient means to produce
desired collective and individual goods (both products and behaviours)
in society. There are several common types:

Financial incentives
In capitalist societies, economists and other social scientists believe
individuals respond most to direct monetary rewards. The profit motive
produces efficient market institutions governed by supply and demand,
which in turn rest on calculations about the human desire for monetary
gain. The simplest of these incentives is salaried pay based on
experience, expertise and training (or education); more complex schemes
involve pay directly linked to various measures of performance. Without
adequate monetary incentives and penalties, neo-liberal economists
argue, no society can attain efficient allocation of resources.

Targeted incentives To
achieve particular objectives, employers and governments design
incentives to ensure that people act towards these ends. For example,
US auto sector worker buyout schemes offer employees vouchers for new
cars, in exchange for accepting voluntary redundancy.

Moral incentives
Societies can provide intangible, but still significant, rewards in the
form of social capital to individuals and corporations that engage in
certain ostensibly altruistic activities. Such incentives are
non-monetised, but confer benefits that can reduce significantly the
cost of doing business.

Coercive incentives
Centralised state planning systems, such as those in many Communist and
authoritarian countries, also created incentives - but failure to meet
these targets resulted in such severe punishment. Such coercive
incentives exist, in much milder forms, in developed capitalist
economies.

The story of recent
problems with incentive pay systems is interwoven with the effects of
rule changes in US and international financial markets since the late
1990s. They helped facilitate the growth of a massive, leverage-fuelled
financial market:

Financial markets
bubble These changes, coupled with a period of exceptionally low
interest rates following the 2001-02 recession, encouraged the growth
of a massive property market bubble - abetted by an even larger
expansion in the market for mortgage-backed securities and associated
derivative products.

Bumper profits The
bubble, in turn, produced several years of record profits at financial
services companies, which were reflected in increasingly large
executive bonuses collected through incentives packages. Subsequent
incentives packages provided even greater incentives to increase
profits -largely through using cheap, plentiful credit to gear up and
further expand lending via disintermediated, structured products.

Illusory gains Many of
the leverage-driven gains of the bubble years turned out to be
illusory. For example, Merrill Lynch lost a total of approximately
$35.8 billion in 2007 and 2008 - a figure equal to the total earnings
of the firm over the past eleven years.

Incentives and moral
hazard The great danger in creating any system of incentives is that it
may unwittingly encourage behaviour subject to moral hazard - that is,
circumstances under which individuals or firms engage in increasingly
risky actions because they perceive that the costs or adverse
consequences of such behaviour may be borne by others. In the case of
the interplay between incentive pay at financial firms and the housing
market bubble, this appears to have occurred: massive profits reflected
in executive pay encouraged further leverage, without enquiring too
closely about the risks involved.

Yet it is also clear
that properly structured incentives can mitigate, rather than promote,
risky behaviour in several key respects:

1. Subtle nudge
incentives: Two prominent University of Chicago economists long have
argued that giving individuals a gentle nudge towards more sensible
behaviour can produce outsized dividends. Under this "libertarian
paternalism" relatively small changes in environment or policy - for
instance, a small compulsory saving scheme for workers or placing
healthy food in more visible places in supermarkets - can result in
very positive behavioural changes.

Their scheme
essentially involves a mild form of social engineering, whereby small
changes in choice options - what they term "choice architecture" - can
have significant outcomes for society and individuals.

Under nudge initiative
plans, incentives are regularly modified to guide citizens towards more
sensible lifestyle, economic and social choices. Intellectually, this
thesis builds on the important findings of behavioural economists about
how individual market decisions are sometimes irrational or
self-defeating; therefore, fostering good decision-making sometimes
requires structuring choices.

Nudge incentives also
represent an attempt to forge a middle way between neo-liberal market
incentives (which are premised on individual and corporate rationality)
and the coercive incentives practice by state-planned economies. The
framework aims to find a balance between cumbersome social democratic
planning and market fundamentalism.

2. Growth incentives
Economic growth and development depend to some extent upon incentives
institutionalised in public policy. For example, a significant factor
in the rapid economic growth enjoyed by Ireland in the 15 years before
2008 was a generous corporate taxation regime, which gave incentives to
large international corporations to locate there.

3. Innovation
incentives Successful entrepreneurial economies make an effort to
encourage both established firms and start-ups to innovate. Policy can
create incentives to sustain and foster entrepreneurial behaviour. For
example, regulation can be minimised for new start up firms. Guaranteed
lines of credit are also important. Property, patent and copyright
rights need to be enforced effectively to affirm the incentive to
engage in innovative work.

The importance of
innovation to economic growth was a lasting insight of the Austrian
economist, Joseph Schumpeter, who argued that institutional
arrangements could create the incentives appropriate to innovative
activity at the firm level.

Investing in ideas is
distinct from fixed capital investments since an idea can be used by
anyone once it has been formulated. Idea generation rests, in part,
upon incentives to ensure that firms recover the costs of investment in
research and technology.

The scale of financial
sector bonuses in the period from 2003-2007, and the single-mindedness
with which executives continue to pursue these -

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