In The Pursuit of Happiness

The release of the report by the Commission on the Measurement of Economic Performance and Social Progress led by two Nobel Laureattes Joseph Stiglitz and Amartya Sen on 14 September has stimulated discussion on whether the "growth fetish" or the "GDP fetish" as Stiglitz puts it is somewhat misplaced.

The report notes that certain aspects of national income accounting could be responsible for providing misleading signals to us in our performance oriented world. These include the non-valuation of non-market activity and household related labour, the inclusion of environmentally destructive or socially undesireable activity, the undervaluation of quality improvements in products and the focus on inputs such as government expenditure rather than the efficiency and effectiveness of such inputs in providing desireable outcomes.

One of the more notable recommendations made by the commission had to do with incorporating other indicators of social wellbeing along with GDP to provide a more well-rounded picture of progress and development given the advances in econometric techniques that make such measurement possible.

The World Values Survey has been doing this for years. Measuring country results for both GDP per capita adjusted for purchasing power and a thing called the Subjective Well Being Index, the survey results has provided an "arc of happiness" that depicts the way in which economic well being contributes to overall well being. This arc suggests that past a certain level of income, say US$10 000 per annum, economic growth provides a diminishing marginal return on human happiness.

Back to the commission: one other important observation made was that reducing social inequality should be high up on the agenda of any government. As Stiglitz notes,

This means that there is increasing disparity between average (mean) income and the median income (that of the "typical" person, whose income lies in the middle of the distribution of all incomes).

Dealing with income inequality could mean addressing both sides of the distribution. At the top end, the compensation of corporate executives has to be governed properly, while on the opposite end, the need to improve access to education, healthcare and jobs for the most socially disadvantaged groups must be prioritised.

Poor Incentives

If you were prudent enough to save and invest your money rather than spend and borrow more money, you have probably taken a hit in your shares portfolio and will face rising inflation in the next few years as a double dip recession (a W shaped recovery) takes place, eating away at your cash holdings. The banks that have been rescued and recapitalised using reserve infusions are loath to lend under the current environment and therefore will not raise rates on cash and term deposits even as the reserve rates increase given that they are awash with cash.

If you were a rural bank, saving and loans company or credit union that maintained a healthy balance sheet and avoided risky derivatives, then you were not in line for a government guarantee or a subsidised line of credit during the height of the financial crisis. You instead would have the added burden of competing with larger subsidised commercial banks with AAA credit rating not as a result of their prudential risk taking but as a result of sovereign guarantees. Your employees have probably been faced with pay cuts or no bonuses unlike the corporate executives of the bailed out entities courtesy of taxpayer dollars.

If you are in a business that was deemed “too small to rescue” having been cautious in leveraging your operation and prudent in evaluating expansion projects, then you probably did not receive any cash handouts through the stimulus plan, unlike the relics of some old smokestack age that got heaps of support to remain open. You will probably be facing higher taxes in the coming years as the need to repay the deficits in a slower growth environment forces many governments to raise taxes from “productive” units of the economy.

If you are a relatively low polluting, eco-friendly operation, then you are definitely not going to be in line for a “free” carbon credit courtesy of the government unlike trade exposed carbon intensive industries. You instead are going to have to absorb the full cost of what little emissions your outfit produces.

Is it just me, or do others see that something is truly going haywire in the system of incentives that the current crises-busting policies have adopted (by “crises”, I mean both the GFC and the CPC or Carbon Pollution Crisis)?

The Social Insurance of Private Risk: Executive Compensation and the Merits of Government Intervention

The ire for Wall Street that has been the hallmark of anti-globalisation activists has become mainstream as evidenced by the notorious name recall of such entities like AIG and Pac Brands in Australia. The legitimacy of government bailouts for firms that have turned around and paid their senior executives hefty bonuses has been called into question. Legislators and responsible governments that approved such dole outs have scorned these practices citing the fact that the social insurance of private risk-taking has occurred.

They have not realised that it was government policy that set them on this course to begin with by encouraging such dubious lending practices in the housing market to the so called ninjas ("no income, no job, no assets"). AIG merely sought to manage away such risks through credit swaps and other financial derivatives. The lack of oversight into these contracts did not help them hold back when times were good.

System dynamics heralded as the science of unintended consequences tells us that when prolonged feedback loops are present policymakers will often fail to connect the dots that link their actions with such perverse outcomes. They may instead associate adverse consequences with near-term causes (in this case "greed") and formulate their responses based on them.

Insuring executives against risk is not a bad practice per se. In fact, it is desireable to some extent. To use a sports analogy, every club guarantees its "star players" an incentive to "go for it" in the field, even though they risk injury that could jeopardise the rest of their careers in the process. What would happen if a player "held back" at crucial moments in a championship match for this very reason? Salaries remain fixed whether the player is fit for the entire season and are not dependent on the team winning the tournament (although renewal of contracts might).

In the case of David Beckham, when he transferred to the LA Galaxy franchise, his prominence allowed them to maximise receipts from footbal matches held at their stadium. This alone made his outrageous salary worth every penny. For the same reason, some executives may focus on generating short-term growth in market share or profits to the detriment of long-term sustainability.






David Beckham's outrageous salary was worth every penny for LA Galaxy.


But even if their remuneration were based on some long-term metric such as growth of value in the company's stock, there would be no reason for the firm to stick to the contract once it has established that an executive decision (say outsourcing of production overseas) sets the firm on good financial footing. Some savings may in fact be derived by paying him out if he is nearing retirement (could this be the case with Pacific Brands?) and makes the setting of executive pay a tricky business because a long-term contract merely becomes the starting point for renegotiation later.

On the one hand, if they are not insured against failure, CEOs may become too averse at taking investment decisions if there is a possibility for large losses. On the other hand, critics have turned to the mechanisms for setting pay and the way it can be captured by corporate executives.

Board members who are meant to be independent in making decisions covering this area often share an affinity with their Chief Executives by virtue of having been nominated by him (or her) in the first place. So called compensation experts suffer the same fate as external auditors, often screened by CEOs before getting hired by the board. The difficulty here is in designing good corporate governance practices to avoid these forms of capture.

In the end, if the attainment of desirable social ends, such as a more equitable distribution of property or the protection of jobs in an uncompetitive industry, was offered in promoting risky projects in the private sector, society should not balk at insuring these social experiments from failure. The problem is that when these programs were formulated, they may have been designed with an eye at preserving the short-term electability of a politician, but that merely leaves us where this discussion began.