We are fascinated by what other people earn. But in recent months natural snoopiness has turned into political outrage. Taxpayers in many countries have seen funds that their governments have been forced to push through the front doors of banks, to save them from self-inflicted collapse, slipping out of the back door in big bonuses.
President Obama has introduced stringent limits on bonuses for executives of companies receiving federal aid. Governments across Europe have also responded to the popular mood with restrictions on executive pay as a condition of bank bailouts. The British government is steering an uncertain course between urging pay restraint and leaving management to run the banks that are now at least partly owned by the state. It has also announced a review of pay and risk management, chaired by David Walker, a City grandee.
This is a swift about-turn and a reminder that attitudes to pay—how high and low it should go, and how it should be set—can change radically from era to era. In the 1970s, it was considered normal for the government to use incomes policy to determine pay increases. Then, over the next 15 or 20 years, a different, market-oriented view of pay took hold.
The broad picture is well known: against a backdrop of rising incomes and rising inequality a small number at the very top began pulling away from the merely well-off. City of London bonuses rose from £5bn in 2003 to £14bn in 2007, while financial bonuses reached $33bn in New York in 2007. (Despite the crunch they were still $18bn last year.) Finance has been exceptional because of its profitability and the unusual ease of measuring the contribution of top performers. But there has been a similar divergence at the very top in other sectors: sport, entertainment, some of the professions and mainstream business. In the US, for instance, CEO pay in large companies was 275 times higher than average worker pay (about $40,000 a year) in 2007, compared to only 35 times in the mid 1970s. In Britain median pay rose from £18,848 in 2000 to £24,914 in 2008, but the earnings of FTSE 100 directors rose from £884,445 to £2.36m.
So long as good times rolled, few complained that a banker got paid 100 times more than a nurse. The system seemed to work not least because the taxes paid by wealthy bankers meant lots of extra nurses could be hired. But now the system clearly is not working, at least in part because of the huge incentive-distorting banker bonuses.
As a result questions once heard only on the wilder reaches of the left are now mainstream. How did earnings at the top get so huge? Will the crisis mean the end of such astronomical awards, either by self-restraint from individuals and organisations or new government regulation? And, perhaps more philosophically, what is a banker actually worth?
There are broadly two economic explanations of how earnings are set. In the first, workers and bosses bargain for shares of what economists call rents—the income from any activity—usually within an agreed framework of judgements about the value of different jobs. The second is based on what economists call marginal utility: the value of a worker, and how much they earn, is determined by how much they make for their organisation. In general the left has preferred the first approach, while the right has preferred the second, with its emphasis on market forces.
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David Metcalf of the LSE, a longtime observer of industrial relations, points out that for 30 years after the war collective bargaining (or wages councils) set the pay of 90 per cent of workers. Only a few at the top and bottom were not covered. This implicit social contract kept a firm lid on individual gain and kept wage differentials low.
The reforms of the 1980s, including much lower marginal tax rates, opened the way for the marginal utility approach to play a bigger role. Many people were, by then, fed up with enterprise-crushing pay regimes. And there were changes to structure of the economy, in which technology, globalisation and rising incomes were encouraging a consumer culture that eroded postwar collectivism. Moreover, such prosperity reduced opposition to the few earning more than the many because earnings were no longer felt to be a zero-sum game. The economist John Kay sums up the change in attitudes: "There was a culture shift in the 1980s. Before that nobody thought it appropriate to earn more than a senior judge. Even directors of ICI didn't pay themselves very much."
Tournament theory provides another explanation for huge wages at the top. This is similar to marginal utility, but stresses relative rather than absolute performance. A person's value, the theory claims, relates to how they perform relative to someone else. Small variations in ability result in big differences in pay. These distributions—well known in sports and entertainment, but increasingly familiar in banking too—are also known as "winner takes all" markets.
During the last two decades globalisation enlarged the size of the markets from which money could be made, making such markets more common. David Beckham, for instance, now earned more than a slightly less good footballer in part because of his millions of fans around the world and their willingness to buy Beckham shirts. In much the same way global investment banks wanted only world-class analysts, and were willing to pay superstar wages to get them.
At the same time top corporate managers took the opportunity to demand and justify bigger differentials in earnings, while lower marginal tax rates made this more worthwhile. The arithmetic was simple. If a company has revenues of £20bn, an improvement in performance of just half of 1 per cent translates into £100m. Paying the CEO believed to be responsible for that improvement £1m or even £10m was barely a rounding error for the company and its shareholders—though a huge amount for the CEO personally.
Academics gave the pay wheel another spin. In a seminal paper for the Harvard Business Review in 1990, "CEO Incentives—It's Not How Much You Pay, But How," Professors Michael C Jensen and Kevin J Murphy argued that, contrary to public opinion, many CEOs were poorly paid relative to their actual and potential contribution to their companies. Instead, performance could be improved by bumping up the proportion of company shares in compensation packages. This would then "align" the interests of shareholders, who were the owners (or principals) of the company, and the executives who were their agents. Another paper, published in McKinsey Quarterly in 2001 talked of a "war for talent," in which only top wages would secure the best people.
But such theories overlooked what was happening on the ground. The ability of senior managers, especially in finance, to claim ever larger sums owed as much to old-fashioned negotiating clout as to their talents. As finance businesses grew richer and more complex, shareholders, regulators and the press struggled to follow what went on within. Shareholders were mostly made up of pension funds and insurance companies that often invested according to computer-driven models. Pay committees of corporate boards were full of other executives, and were advised by "remuneration consultants" and headhunters whose interest was in higher earnings for their clients. As a former CEO told me: "I never met a remuneration consultant who didn't put an executive in the top quartile—but they can't all be above average."
So the argument that in order to remain competitive in a global market for talent it was essential to pay top dollar went unchallenged—the one group which might have challenged it, the unions, were weak to disappearing in the private sector. Yet this "great man" theory of corporate pay—the idea that a few people at the very top contribute so much to the wealth of a company—was always implausible. The average reign of a FTSE 100 CEO is only a few years. Some leave their mark. But many are corporate bureaucrats, intelligent and well organised but no more so than a senior civil servant who is paid a small fraction of a CEO.
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So big reversals have occurred and could happen again. In Britain, as in many other developed countries, there is a broad political consensus that there should be no return to business as usual. But how to prevent that, let alone shape a different future, is much less clear. Alastair Hatchett, head of pay and HR services at Income Data Services, says: "There aren't many mechanisms for challenging the way pay has gone." Kay has his doubts too: "My fear—and to a large degree expectation—is that what we'll get in the next couple of years is a reconstruction with a view to putting the show back on the road again, with the outcome of an even bigger accident five to ten years from now."
Recent events do not inspire confidence that individual and organisational self-regulation will be enough. The alternative is for government to take the lead. The crisis gives it a whip to beat the financial sector, where it has either big stakes or is supporting insurance schemes. But government could, if it wanted to, influence pay in other ways. About 20 per cent of the workforce is employed by the state. Instead of taking corporate sector pay as its reference point, the public sector could keep its top employees' pay to sensible levels. Equally, Jon Cruddas, an influential Labour MP has called for a "maximum wage"; many supporters of this idea have proposed that organisations seeking public procurement contracts would have to show that highest earners were paid no more than 40 times the company average.
No British government in the next few years is likely to become so interventionist, unless a long recession leads to a big shift in public opinion. It is more likely that the tone will be set by bodies such as the Financial Services Authority (FSA), which have the power to regulate and encourage self-regulation. The FSA could set a template for pay restraint, which could be copied by other professional and regulatory bodies, especially those like lawyers and accountants whose high earners tend to be connected to the financial sector. If the financial sector led the high reward dance on the way up, perhaps it can do so on the way down too.
How might this happen? Financial sector pay will be constrained as a byproduct of regulators finding ways to reduce the risks banks and other institutions take, which in turn cut profits and therefore pay. One way to achieve this is to increase the amount of capital banks have to set against an asset or transaction. Another measure, likely to be considered by both the FSA and the Walker review, would be delaying bonus payments until profits from the business are known—a provision UBS, the Swiss bank, recently introduced, and which is sometimes known as a deferred bonus arrangement. There will also be proposals for greater disclosure of who earns what. In the past the biggest earners have often been city traders, not directors. But traders' pay is not currently revealed in company reports. (Richard Lambert, director-general of the CBI, warns that greater disclosure can have the effect of legitimising higher pay, at least in the good times: "It was thought in the 1980s that to put directors' pay in the public domain would be helpful, but it may have made things worse.")
Many of these ideas are likely to be hard to enforce and easy to evade. It is difficult, for instance, to see how they would constrain partnerships—partners in City law firms like Slaughter & May and Linklaters earned £1.5m to £2m in 2008 and are not expected to do much worse this year. Equally, super-high pay is, to an extent, a global phenomenon, and anyone trying to limit it will require extensive co-operation across countries. It may be that given the difficulties involved in interfering in pay setting in a market economy the best way to bring differentials down to more acceptable levels is through the tax system—the recent plan for a top marginal rate of 45 per cent could be just the first step. Introducing higher tax rates to counter excessive pay would also be easier with international co-operation—perhaps something for the G20 to discuss in London in April.
Whatever happens scope certainly exists for greater fairness in pay structures—a notion that might bring back the Victorian notion of the deserving and the undeserving rich (as well as poor). Andrew Oswald, professor of economics at Warwick University, observes that a search for the words "deservedness" and "deservingness" in the economic literature on pay draws a blank. Maybe the field has been left to the technicians and market zealots for too long. Income differentials are not as high everywhere as the US and Britain. Scandinavia, Germany and Japan are more equal. A mature economy does not have to be inegalitarian to prosper, although patterns of income distribution are also connected to economic factors, like dependence on finance and creative industries, and cultural factors, like openness to risk.
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How far any process of pay moderation will go, and how long it might last, will ultimately depend on social attitudes. At present, despite anger over bonuses, there seems to be little appetite for a new puritanism. Yet an underlying sense of morality—whether it is "right" to earn a particular amount in a job—has persisted through the years of plenty. A 2007 YouGov survey asked: "what do you think is a reasonable income?" for various occupations. Some were close to the mark. A reasonable income for an experienced nurse was put at £33,000; for someone working in a supermarket checkout it was £15,000. But for a top footballer the estimate was £62,000—about half of what Manchester United pays Ronaldo a week. And for a managing director of one of Britain's top companies, a reasonable income was thought to be £120,000, one twentieth of what an FTSE CEO can command.
Such figures show a gap between pay and public expectations. David Conroy, who leads the rewards practice at Mercer, the remuneration consultants, goes further, arguing that "there is a backlash against excessive packages. The government will exert influence indirectly. It could even be a punitive period." But a move back to the 1960s, with its rather bleak solidarity, only seems likely if an even sharper public backlash combines with a retreat from globalisation to create a new economic nationalism; a mixture that fortunately seems improbable at present.
The most plausible future is a period of slow growth in which banks operate more as utilities, governments and regulators keep the lid on very high earnings and public attitudes—coloured by higher unemployment—revert to an underlying morality of what a job is worth to society. It will be big change from the last 30 years, in which society will attach a lower valuation to a banker's worth in both social esteem and cash. But, whether a banker or not, we will still remain fascinated by how much our neighbour earns.
Discuss this article at First Drafts, Prospect's blog; and read James Alexander's companion piece on banking's bonus culturehere
