MACRO-ECONOMICS:How do we explain outrageous salaries and bonuses for bankers and business leaders who oversaw failure? It's all part of the game, says economist Tim Harford
'MICRO-ECONOMICS CONCERNS things that economists are specifically wrong about, while macro-economics concerns things that economists are wrong about generally." So wrote American contrarian PJ O'Rourke in his book Eat the Rich, issued six years before Freakonomics changed the way we, and book publishers, viewed the dismal science.
Today, it's only a slight exaggeration to describe social scientists as the rock stars of business publishing: men like Malcolm Gladwell and Steven Levitt are popularising the topic with a shift in focus, away from traditional data sources - inflation, economic growth, exchange rate fluctuations, etc - to apply their analysis to the minutiae of day-to-day life.
This transition has been propelled by an explosion in the availability of source material: data is being collated on every part of our lives, from how we travel to work and behave in supermarkets, to what we search for on the internet. These numbers are then crunched to produce myriad conclusions, some of them useful, some of them dangerous.
Writer Tim Harford, who plies his trade in the Financial Times under the pseudonym "The Undercover Economist", was the first economic agony aunt, using theory to answer readers' problems. His new book, The Logic of Life, is an attempt to explain how we spend our time responding to a series of incentives and trade-offs. This allows for a host of intriguing "man bites dog" scenarios: why is there a boom in oral sex among American teenagers? Is divorce underrated? And, more topically, why the boss is overpaid.
Harford points to Tournament Theory to explain the outrageous salaries of people such as former RBS chief executive Fred Goodwin, whose remuneration, he says, is not linked to the success or failure of the bank, but is an incentive to other executives. Office life, say economists, is akin to a tournament, using a set of incentives and punishments to reward the most competitive and, in some case, the luckiest workers.
When applied to the very top level of corporate executives, the link between performance and reward is very tenuous indeed. "A very good corporate executive can generate billions of dollars of value for shareholders, and I've no problem with them being rewarded well," says Harford, talking to The Irish Times. However, the resentment relates to those who are over-rewarded for failure, as in the case of "Fred the Shred". As with any other walk of life, winning does not have much to do with fairness.
Harford refers to Michael Eisner, boss of Disney, who earned $400 million (€301 million) over his 13 years in charge of the company. How could shareholders justify this extravagance?
The answer is that the boss's multimillion dollar pay packet is not intended to motivate the likes of Eisner, but to motivate his would-be replacements to work so hard that they create the remaining portion of wealth between them. There is a hitch, however.
"Economists found that when there is one large significant shareholder there is an incentive to control pay," says Harford. Central government is now that one significant shareholder, a factor which should, in theory, act to link executive pay to performance. But, this depends on governments' ability to set clear objectives - something missing thus far.
"Their [the British government's] focus is, 'We don't want these guys to be paid that much money,' which is the wrong question. We need to pay them in a way that properly links what they're doing to performance, and here is where it gets really tricky. It is very hard to measure performance.
"And what is it we want the banks to do? It really isn't clear. When Northern Rock was nationalised they were told [by the UK government] that they would be paid the staff bonus if they can pay the government's loan back quickly. So they wrote this contract and Northern Rock cut off lending, tightened up credit conditions, tried to get mortgage holders to switch accounts to other lenders, and got a lot of its loan repaid and used it to re-pay the government. This is exactly what the government had asked them to do. But it is only after the fact that people started to say, 'That's not what we want them to do at all - we want them to start lending again.'
"If we are looking to incentivise bankers, what is it we want them to do? Are they performing on behalf of the bank's shareholders? Or, on behalf of the taxpayer? Or the broader economy? I don't know the answer, and I sympathise with governments, because it has all happened so quickly. They keep coming up with crazy plans and the objective changes every few weeks."
The speed of events has undermined the economists' core faith in free markets and their ability to offer feedback on the business performance. In particular, the complexity and rate of innovation in the financial sector meant it was impossible to comprehend the sheer scale of the market for the new debt-based financial products. This, says Harford, continues to have enormous implications.
The great merit of markets he says, and the reason they usually work well, is not that the people operating in them are particularly smart or clever, but that "when they do something stupid, they get punished quickly".
This feedback forms the rough and tumble of business life: a company fails, somebody else comes in to pick up the assets that are worth saving, and rehire the people who are worth hiring, and the organisation continues on its way. The economic text books tell us entrepreneurs must suffer for their incompetence and, likewise, the market will ensure that good ideas spread, creating wealth.
"One of the things that went wrong in the financial crisis was that this market [for financial derivatives] grew so quickly, and the feedback didn't come," says Harford, who puts the value of the total market for derivatives at $1.25 quadrillion (according to figures from mid-2008). This, he says with knowing understatement, is what economists call "a very big number". Put another way, it is one billion, billion dollars, or 1,000 trillion. As a point of reference, the size of the world economy is estimated to be in the region of $50 trillion.
"Derivatives are a fairly new idea, and sophisticated derivatives are a very new idea. They've come from nowhere in the last 10 years to being worth this very large number. And it turns out these derivatives were not a good idea, but the feedback came too late and the market is just too big - these guys were just adding zeros, it boggles the mind."
The financial markets evolved in this way because the vast incentives to earn money outweighed the risk of collapse.
"It is so easy to mimic a successful firm if you are willing to take the small risk of blowing up," Harford says, "so it's perfectly possible for an ordinary financial firm to look like a brilliant financial firm if you are willing to say, 'One year in 100 you are going to blow up'. That additional chance gave them the leverage they needed to look really good. It was being pointed out," he says, citing Prof Peyton Young, an economist at Oxford University, as someone who was shouting about this problem back in the boom years. "But we economists didn't put all the pieces together. We saw all the problems but we didn't see that they were interconnected and that they would all go wrong at the same time."
There's an irony to the rise in the popularity of micro-economics, just as the big stuff, the global economy, falls apart.
"Micro is about money you don't have, and macro is about money the government is out of," was the second part of PJ O'Rourke's quote. It sounds more like the truth with every passing day.
