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Just Wages

28 Dec 2006 - Bruno Prior

The tensions of excess, both in private and public sectors, are starting to display themselves in debates over the just level of wages for various occupations. These debates occur every now and then, usually provoked by a sense of disparity related to imbalances in the economy, themselves created by lopsided government intervention. Not surprisingly, given Gordon's predilections for the City, big corporates and micro-management by an overweening bureaucracy, the focus at the moment is on the remuneration of bankers, business leaders, management consultants, politicians and senior civil servants.

Following the recent announcement of record profits and record bonuses at many of the leading Wall Street and City banks, the Telegraph reports today that the number of public sector staff on six-figure salaries (i.e. > £100,000) has trebled in the past five years, whilst Brendan Barber (general secretary of the TUC, but usually a measured critic of business) has called for a "debate" about "how big and how justified" the rewards of directors of FTSE 100 companies should be, given that they have increased 105% in real terms since 2000, while average wages have increased only 6%. Put another way, these bosses now earn 98 times more than their employees. Bosses of AIM-listed businesses haven't been doing too bad either, some of them being paid over £1m for the first time. MPs' recent claims that they deserve an increase in their basic salary from around £60,000 to £100,000 received mixed press - some people feeling that it was worth paying to get a better quality of politician, others feeling that they didn't deserve a pay increase given their supposedly poor levels of performance and the pay squeeze on other public servants. There was further criticism of the high levels of pay for many public-sector executives (i.e. quangocrats), whose average pay awards are now second only to bosses in the City financial sector. Quangocrats' pay levels have been causing concern for a while now, without any sign of a retreat.

These debates are always characterised by an absence of intellectual consistency. Most participants argue that those they favour should be paid as much as is necessary to get "the best person for the job", whilst those they do not favour should be paid no more than is necessary to fill the post. Some eschew these generalisations for even greater simplicities - people should be paid according to the amount of work they put in, according to their performance / the results of their efforts, or, for the unreformed socialists, according to their needs. Whatever system is used, what unites almost all commentators is that they seem determined to invent their own personal scale of worth, as though it would be possible to devise a just scale of wages that could be imposed from above if only people would recognise the truth of the commentator's personal value system.

What is the truth? How are we to know whether people are being paid enough or too much?

Let's first put to bed the socialist idiocy of paying people according to their needs. As our needs do not change much whether we work hard or not at all, payment according to needs (assuming they could be calculated) would remove all incentive to work, destroy the economy and make it impossible to obtain the goods and services that we wanted.

Payment according to the amount of time worked is little better. If one is paid simply for turning up and not for the value of one's efforts, all incentive to make an effort, and improve productivity and efficiency, is eliminated. Those who do least will be best rewarded for their efforts. Such a system would be a charter for placemanship and indolence.

Payment according to performance/results sounds attractive but has significant drawbacks in practice. In the private sector, it is possible, though problematic, to define a measure of performance against which pay will be assessed, but in the public sector, this is meaningless (though often touted). As Ludwig von Mises explained in his 1945 work -Bureaucracy- (II.3):

The objectives of public administration cannot be measured in money terms and cannot be checked by accountancy methods. Take a nation-wide police system like the United States FBI. There is no yardstick available that could establish whether the expenses incurred by one of its regional or local branches were not excessive. The expenditures of a police station are not reimbursed by its successful management and do not vary in proportion to the success attained. If the head of the whole bureau were to leave his subordinate station chiefs a free hand with regard to money expenditure, the result would be a large increase in costs as every one of them would be zealous to improve the service of his branch as much as possible. It would become impossible for the top executive to keep the expenditures within the appropriations allocated by the representatives of the people or within any limits whatever. It is not because of punctiliousness that the administrative regulations fix how much can be spent by each local office for cleaning the premises, for furniture repairs, and for lighting and heating. Within a business concern such things can be left without hesitation to the discretion of the responsible local manager. He will not spend more than necessary because it is, as it were, his money; if he wastes the concern's money, he jeopardizes the branch's profit and thereby indirectly hurts his own interests. But it is another matter with the local chief of a government agency. In spending more money he can, very often at least, improve the result of his conduct of affairs. Thrift must be imposed on him by regimentation.

In public administration there is no connexion between revenue and expenditure. The public services are spending money only; the insignificant income derived from special sources (for example, the sale of printed matter by the Government Printing Office) is more or less accidental. The revenue derived from customs and taxes is not "produced" by the administrative apparatus. Its source is the law, not the activities of customs officers and tax collectors. It is not the merit of a collector of internal revenue that the residents of his district are richer and pay higher taxes than those of another district. The time and effort required for the administrative handling of an income tax return are not in proportion to the amount of taxable income it concerns.

In public administration there is no market price for achievements. This makes it indispensable to operate public offices according to principles entirely different from those applied under the profit motive.

Clearly, few of our current politicians and commentators have read Mises or given such careful thought to the reality of managing our public services. There is almost a consensus amongst the chattering classes that payment should be for performance, even amongst the bureaucracy, without anyone bothering to suggest a practical way of measuring that performance. This impossibility was understood in the days when Britain had an elite civil service, but sadly decades of contraction, expansion and target-setting have nearly destroyed the old ethos.

The chattering classes would do well to consider another passage along similar lines from -Bureaucracy- (II.4):

It is vain to advocate a bureaucratic reform through the appointment of businessmen as heads of various departments. The quality of being an entrepreneur is not inherent in the personality of the entrepreneur; it is inherent in the position which he occupies in the framework of market society. A former entrepreneur who is given charge of a government bureau is in this capacity no longer a businessman but a bureaucrat. His objective can no longer be profit, but compliance with the rules and regulations. As head of a bureau he may have the power to alter some minor rules and some matters of internal procedure. But the setting of the bureau's activities is determined by rules and regulations which are beyond his reach.

It is a widespread illusion that the efficiency of government bureaux could be improved by management engineers and their methods of scientific management. However, such plans stem from a radical misconstruction of the objectives of civil government.

Like any kind of engineering, management engineering too is conditioned by the availability of a method of calculation. Such a method exists in profit-seeking business. Here the profit-and-loss statement is supreme. The problem of bureaucratic management is precisely the absence of such a method of calculation.

In the field of profit-seeking enterprise the objective of the management engineer's activities is clearly determined by the primacy of the profit motive. His task is to reduce costs without impairing the market value of the result or to reduce costs more than the ensuing reduction of the market value or to raise the market value of the result more than the required rise in costs. But in the field of government the result has no price on a market. It can neither be bought not sold.

Let us consider three examples.

A police department has the job of protecting a defence plant against sabotage. It assigns thirty constables to this duty. The responsible inspector does not need the advice of an efficiency expert in order to discover that he could save money by reducing the guard to only twenty men. But the question is: Does this economy outweigh the increase in risk? There are serious things at stake: national defence, the morale of the armed forces and of civilians, repercussions in the field of foreign affairs, the lives of many upright workers. All these valuable things cannot be assessed in terms of money. The responsibility rests entirely with Parliament in allocating the appropriations required and with the executive branch of the Government. They cannot evade it by leaving the decision to an irresponsible adviser.

The remaining two examples reinforce the case, but the point is made. The "devolution" of bureaucratic powers to unaccountable public bodies (of which Gordon is so fond), and the widespread deployment of management consultants (themselves no strangers to accusations that they are overpaid) across the departments of government, are steps in precisely the wrong direction. Politicians and civil servants should exercise their judgment and responsibility directly and be paid sufficient to attract people of sufficient judgment into the roles. They should not be paid on some spurious notion of rewarding performance.

Even in the private sector, performance-related pay for senior jobs is fraught with hazard. Enron demonstrated the risks. Well-run companies need to invest and plan for the long-term as well as operating to maximise the short-term benefit. The short-term and long-term are often in juxtaposition (investment will reduce short-term profit). Performance-related pay strongly incentivises the maximising of short-term profit, which may not be in the company's best interests. Good managers will strike a balance. But avaricious managers may drive up short-term profits in order to maximise their personal benefit, at the expense of long-term prospects, with the intention of leaving the services of the company before the consequences of their choices are felt. In appointing senior executives, shareholders must, therefore, give greatest priority to their estimation of the honesty, competence and vision of the candidates, and not simply rely on an incentive package. Their principal means of knowing whether a candidate offers that honesty, competence and vision is by their reputation. A candidate with a strong reputation will cost more money. Levels of senior executive pay, in other words, should be determined by their reputation and the judgment of those who appoint them.

In practice, this should be the same on the public-service side of the fence. Taking into consideration the whole remuneration package, including benefits such as pensions, politicians should be setting the wages of their civil servants, who will exercise the levers of power on their behalf and on whom they are therefore very dependent for their own reputation, at levels that ensure that the best operators remain in the service. If the public think those wages are excessive, they should vote for politicians who would set civil-service wages at a lower level. Beyond that, it is for neither the public nor commentators to say that the levels of pay for government professionals are somehow morally wrong.

The wages of politicians themselves should be determined by what their constituents judge they should pay in order to secure the services of someone of suitable calibre to represent their interests. This, of course, is not how the system works, but it is a useful pointer to how it should work. It makes no more sense to have a central-bargaining system for MPs than for any other walk of life. If the people of Bradford don't want to spend much on their representation, but the people of Leeds want the best representation, why should they both be stuck with the same bill and the same quality of candidate? Candidates should declare the wage they require if elected to the post and it should be displayed by their name on the ballot paper, so that people can balance their cost against their merits when deciding who to vote for. The cost of representation at the rate specified by the winning candidate would be raised from local taxation.

So we have come down firmly in the "whatever the employer is prepared to pay to get the right person for the job" camp. This is hardly a radical position. The notion that the -just price- for anything (including wages) is the -market price- dates back at least to Theodosius. It is the alternative theories that represent departures from the mainstream, regularly dredged up and equally regularly shown not to work.

Having settled for this approach, though, we should be consistent and agree that the same logic applies lower down the chain within public and private organisations and for the self-employed. People should be paid what those who employ them believe them to be worth. This is, in any case, the natural way of things, and would need no spelling out if it were not for a number of obstacles, amongst which central pay bargaining and employment protection are the greatest impediments. It is not prudent businessmen who seek the lowest common denominator of employment. If the reputation and performance of yourself and your business depend on the performance of those who work for you, as they always do, a prudent businessman will be inclined to pay sufficient to secure the services of the best operators in their fields. Central bargaining frustrates this objective. By ensuring that people carrying out similar jobs receive similar amounts of pay regardless of their ability, unions remove the incentive for businessmen to pay more for better performers. Employment protection exacerbates the problem. By making it difficult for businessmen to correct any mistakes in appointment or promotion, the businessman is encouraged to be more conservative in pay awards if there is a risk that he may be stuck with them, right or wrong. It is therefore rational for businessmen operating within the constraints of central bargaining and strong employment protection to drive down costs as far as possible, as they have no way of knowing that paying more will deliver better quality.

Central bargaining and employment protection are the enemies of the hard-working or skillful working person. They drag all workers down to the level of the worst. They benefit primarily those who would receive less than the average if central bargaining were abandoned - that is the lazy or ineffective worker. It makes winners of the indolent and losers of the industrious. The notion of a fair wage for a fair day's work, though it sounds attractive, is the root of all our illusions about appropriate levels of pay.

If that is the theory, how are we doing in practice? The answer seems to be: not very well. It has already been pointed out that the system for remunerating politicians and many workers does not even begin to resemble a sensible system. Civil servants have been converted from solution-finders to target-chasers, in the false understanding that the bureaucracy can be run on a performance-related basis. And even at the top levels of the private sector, where it would seem that executives are indeed being rewarded what their employers judge them to be worth, there are serious doubts as to whether pay levels are being judged critically. When businesses are doing well, executives are rewarded. When businesses are doing badly, executive pay often still rises, as it is argued that it is necessary to retain the best people to turn the situation around. There are plenty of examples of executives being paid handsomely as the value slides of the business over which they preside. If this were a rational market, would values be ever-increasing regardless of circumstance?

There are a number of reasons why executive pay settlements are not always realistic. The most important is the trend away from owner management (or at least direct personal shareholder involvement in operations) of modest-sized businesses, to professional managers without investment in the large businesses they run. Owner managers awarding themselves generous pay deals are reducing the profits and the sums available for reinvestment in their business. It is robbing Peter to pay Paul. Similar effects will be seen where shareholders have a close involvement with and understanding of the business activities, even if they are not part of the executive management team. Such shareholders will be able to cast a sufficiently critical eye over executive wage claims that such claims should be moderated according to what can be genuinely justified.

But in the vast majority of our big businesses, shareholders have little direct involvement or understanding of the businesses in which they are invested. The majority of shares will be owned by funds whose professionals are themselves likely to have little direct involvement. They will have a strategic understanding of the industries in which the business is involved, but that is a different matter to day-to-day management issues, on which they will be reliant on the incumbent executives. They will often work for institutions who have other commercial relationships with the managers of the company (accounting, auditing, consultancy etc). And they will usually be strongly risk-averse. In these circumstances, paying too much is very much the lesser of two evils compared to paying too little to get the "right" managers. Their competitors will be doing the same, which will reinforce the impression that they are paying the necessary amount. And excessive settlements will make very much less impact on the accounts of big companies than on their smaller competitors. In a self-feeding process, executive wages will ratchet up naturally, with the appearance of justification, though no one will be asking whether there aren't competent people who would be prepared to do the job for a fraction of the multi-million pound price commanded by the incumbents.

The simple counterargument to the suggestion that executive pay is excessive is that the proof of the pudding is in the eating. The average profits of our major companies are stronger than ever. Executives are cheap, even with multi-million pound price tags, if they are delivering multi-billion pound profits. But that assumes that the executives are single-handedly responsible for delivering those profits. Where profits have tripled at oil companies because of a combination of geo-political events and the failure of those companies to discover sufficient new resources to ward off the threat of a shortage, are the executives at those companies to be congratulated for delivering that windfall? Should supermarket executives be congratulated for the fact that people are funding ever greater consumption off the back of ever greater levels of personal debt? Should the bosses of banks be rewarded for feeding that debt frenzy with irresponsible lending?

The answer to all the above should be: if the shareholders believe so, yes. There are undoubtedly many examples of high-paid executives who are worth every penny. And even if they aren't worth it, it's the shareholders' money to throw away. The long-term result of overpaying for underperforming executives should be the loss of the company's competitive position and its replacement by nimbler, leaner competition. Even if wrong, excessive wage settlements should be self-correcting. Provided, that is, that there are no artificial barriers to entry that protect flabby incumbents from their mistakes. The question is: if executive wages are continuously increasing, are bosses really getting that much better that quickly on average, or is it a sign that the market isn't correcting itself as much as it should, and if so, is there any other explanation than that big businesses sometimes do indeed benefit from artificial barriers to entry?

This matters. It matters because a sense of injustice in the relative pay levels of bosses and workers undermines faith in the whole capitalist system - threatening the survival of the very system that rewards those bosses so generously, and that has been the cause of the great increase in general prosperity in the Western world over the past three centuries. And it matters because, so long as the capitalist system does survive, it can only deliver its benefits most efficiently and broadly (and thereby retain the support of the majority) if competition is encouraged, not thwarted. Those bosses who play the political system to gain unfair commercial advantage for their organisations and then reward themselves generously for their "efforts" are undermining the capitalist system they pretend to support. They are killing the goose that lays the golden egg.

This greed threatens the fulfilment of Schumpeter's prediction that capitalism would be a victim of its own success. Despite his pessimism, there is nothing inevitable about this. Freedom and choice are fundamental to capitalism. Executives have to decide whether they will exercise that freedom and choice purely as selfish profit-maximisers, or whether they will take a broader view of their own and society's interests, and exercise some self-restraint.

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