In the age of secular stagnation – although the age’s dawn has not yet dawned on the Australian government – one of the central economic questions is: what has caused productivity growth to decline? As far back as 1987, Robert Solow, a Nobel laureate in economics, said: “You can see the computer age everywhere but in the productivity statistics.” This failure of massive investment in information technology to boost productivity growth became known as the productivity paradox.
Why Solow was concerned about it is not because of an economic truism demonstrated by equation-laden models but by history’s proof – from the invention of fire and the wheel onwards – that innovation is a key driver of prosperity and growth.
However, a new book Productivity and the Bonus Culture and a journal article by Andrew Smithers, who founded asset manager Smithers & Co after working for a range of companies including Warburg, argues that the financial crisis and its ramifications are not the primary cause of slow growth over the past decade but rather that it is a result of adverse changes in demography and productivity.
Now if you are member of the Morrison Government the keys to solving the problem are removing ‘green tape’, de-regulation, labour market reform (code for hobbling unions although what that will do for painfully slow wages growth is obvious) and getting the budget into the black (which overlooks too many facts and options to list).
In contrast Smithers suggests another greater problem – one which our government is unlikely to get serious about – that declining productivity in the UK and US is inextricably linked to low investment induced by the bonus culture.
Jonathan Ford, writing in the Financial Times (12 August 2019) reviewing Smithers’ book said: “Studies may suggest that innovation pays dividends for companies, with returns averaging 10-15 per cent on projects, according to studies, and sometimes touching 30 per cent (although they are sometimes difficult to measure). But these benefits tend only to emerge over the longer term.”
“Contrast that with the focus of most listed companies’ incentive arrangements…..Not only do these prioritise financial measures such as profits and earnings per share (which managers can and do influence through profit-maximising manoeuvres such as cost-cuts and share buybacks); they are also relentlessly short term. Even the so-called ‘long-term incentive plans’ that make up more than half the annual pay of FTSE 350 executives generally only run for three years.
“Weigh the components determining L-tip payouts by whether they encourage or discourage innovation and it’s easy to see why R&D doesn’t get much of a look-in in the boardroom.”
Smithers suggests that growth in performance-related pay since the 1980s in both the US and UK has encouraged executives to keep profit margins high; substitute equity with dangerous amounts of leverage; and, to avoid new investment (other than takeovers and what not); while contributing to earnings volatility. He argues that these factors are major contributors to an ongoing productivity crisis.
Two months after Smithers’ book was published in June this year the UK innovation charity, Nesta, produced a report – The Invisible Drag on UK R&D: how corporate incentives within the FTSE 350 inhibit innovation – which concludes: “This study of incentives for FTSE 350 executives suggests that remuneration packages are dominated by measures that inhibit corporate innovation.”
The report says: “Firms and their shareholders typically say that they care about long-term value creation. One would therefore expect that the incentives given to company management would, on balance, encourage innovation. This study of incentives in the FTSE 350 suggests that the opposite is the case. It finds that just 16 per cent of total FTSE 350 annual bonus conditions encourage spending on innovation compared to 39 per cent which discourage it; and, that long-term incentive plans are even more strongly skewed towards discouraging executives from innovating at a ratio of 6:1.”
“The benefits from correcting this could be very large indeed. For the firms concerned, it should prompt an internal examination of the real incentives or disincentives to innovate. For shareholders, including fund managers, it should prompt a re-consideration of whether they should be approving incentive packages that discourage innovation.”
The report makes a number of policy recommendations including: companies should examine their remuneration packages to encourage the pursuit of innovation and long-term value creation; investors should use their power to demand better incentives for investment in innovation through shareholder votes on remuneration packages; financial reporting guidelines “should explicitly include innovation as a measure of effective stewardship; and whether “the value of R&D tax credits is reduced by improper executive incentives.”
Jonathan Ford said: “the UK government has set a challenge that feels in many ways akin to our very own moonshot (echoes of the Morrison Government here?). It wants to raise spending on research and development from 1.8 to 2.4 per cent of gross domestic product over the next eight years. Sounds tough? Well, it ought not to seem all that Herculean. After all, OECD nations invest on average about 2.3 per cent of GDP, while some such as Sweden and Germany do even more. But that’s to ignore Britain’s distinctly iffy record. The country isn’t just a laggard; it has actually been drifting backwards. Spool back to 1981 and the UK was spending 2 per cent.”
So how does this compare with the Australian record? We know all about the business bonus situation here but what about R&D? The Australian Bureau of Statistics produces regular reports on GERD (Gross expenditure on R&D by business, government, higher education and the not for profit sector). In 2008-2009 the total spent was 2.25% of GDP. In the latest 2017-2018 figures the total as a percentage of GDP was 1.79%. How good is that?
It’s a bit like corporate tax cuts – as demonstrated by the Trump corporate tax cuts – they go on share buybacks and significant bonuses for CEOs but not on R&D or increased wages.
You don’t have to go as far back as Marx to find prescient views of this. Even popular novelists were aware of the problem – as the posthumous Peter Temple collection of reviews, essays and short stories illustrates in a Temple 2001 essay on Raymond Chandler which cites his observation about the perniciousness of the corporation: “Beyond a certain point of size and power it is more tyrannical than the State, more unscrupulous, less subject to any form of inspection…in the end it destroys the very thing it purports to represent – free competition.”
And he might have added it destroys prosperity boosting innovation as oligopoly becomes common and Adam Smith’s comments on what business actually thinks about competition versus price fixing are show to be still relevant.
Noel Turnbull is retired and blogs at http://noelturnbull.com/blog/