We're all drunks looking under the lamppost.”
—Aviv Nevo, professor of economics, University of Pennsylvania, speaking at the European Central Bank’s annual gathering of leading economists in Sintra, Portugal.
Today’s New York Times tells us that wages should be rising, since we live in a world in which stock markets are soaring, the global economy is growing and unemployment levels are at record lows. But wages aren’t rising. For most workers around the world, wages continue to stagnate, after decades of minimal growth or decline. The implications are dire for global political stability: resentment among middle- and lower-class workers has already given rise to populist leaders in both the U.S. and parts of Europe. Unless the problem is solved, more trouble lies ahead.
Leading Economists At A Loss
Yet the world’s leading economists aren’t much help in understanding, let alone solving, the problem of stagnant wages:
- It’s “the economy's biggest mystery,” writes CNBC’s Jeff Cox.
- “This is one of the big economic questions of our time,” said Ángel Talavera, lead eurozone economist at Oxford Economics in London.
- “The lack of wage growth at the aggregate level despite the declines in the unemployment rate and strong job gains remains a mystery," Joseph Song, U.S. economist at Bank of America Merrill Lynch, wrote in a note to clients.
- “Economists are stumped,” writes Noah Smith in Bloomberg.
Federal Reserve Chairman Jerome Powell also admits to being troubled. “I wouldn't say it's a mystery,” he said cautiously. “But it is a bit of a puzzle.”
The combination of strong growth and stagnating wages flies in the face of basic economic principle that falling unemployment should lead to higher wages. Employers compete harder for workers. Paychecks rise across the board. Inflation goes up. Ergo, wages increase, as businesses pass on the higher cost of labor to customers.
These indubitable truths are enshrined in what’s known as the Phillips Curve, a staple graphic of introductory economics courses named for its originator, the New Zealand-born economist William Phillips. Most economists no longer use the Phillips curve in its original form because it was shown to be too simplistic and no longer fits the data. Yet the Phillips curve remains the primary framework for understanding and forecasting inflation used in central banks.
Economists have devoted enormous energy trying to explain why inflation and wages remained stuck in neutral,” writes Jack Ewing in the New York Times. But to no avail. “Economists have not been able to agree on why pay for most people in the United States, Europe, Japan and other wealthy countries had long been stagnant even as unemployment plummeted.”
Various reasons have been discussed, none of them particularly plausible, including:
- Shortage of workers in countries like Germany, but there are many other theories.
- The decline of unions in some countries and diminished bargaining power by workers.
- Globalization, outsourcing, the easy flow of money and information across borders that have also forced workers in wealthy countries to compete with those in poorer ones.
- Monopsony, or concentrated market power, which reduced competition
- Increased use of noncompete clauses in worker contracts.
- The gig economy with more freelancers as exemplified by Uber or Airbnb.
- The retirement of highly paid Baby Boomers, dragging down the national wage average.
- Slow productivity growth and technological stagnation, despite the extraordinary possibilities of Artificial Intelligence, the Internet of Things, 3D printing, new materials and a host of other technological possibilities.
Country-specific answers don’t explain why low wage growth is a global phenomenon. For instance, Japan has very different policies and practices on antitrust, non-competes and unions, yet it has the same problem as the U.S.
Moreover, the longevity of the issue is striking. The fact that the phenomenon has been going on for several decades implies that there are deeper forces at work, beyond the simplistic thinking of the Phillips Curve.
The puzzle was the main focus of the European Central Bank’s recent annual gathering of leading economists in Sintra, Portugal.
Aviv Nevo, a professor of economics at the University of Pennsylvania, summed up the conference's mood of uncertainty by referring to the idea of the streetlight effect, where researchers look for information only where it is easiest to find, rather than probing further. Professor Nevo reflected on the discussion of the conference, “We’re all drunks looking under the lamppost.”
Looking Beyond The Lamppost
Economists love to study economic data and seek answers in hard numbers amid the relationships among standard variables. The possibility that answers may lie beyond the economic variables is not an idea that easily gains traction. The possibility of looking at things written by non-economists is almost unthinkable.
But when companies start acting differently from the way they have always acted, and the way they should act as predicted by economic theory, it may be time for economists to emerge from their professional retreats and start asking some basic questions, like: what do the companies say they are doing? Has that changed? If so, why? With what consequences?
The Advent Of The World’s Dumbest Idea
The fact is that in the 1980s and beyond, public companies began embracing a very different idea as to the purpose of a firm: the idea that the sole purpose of a corporation is to maximize shareholder value. Then, as executives were compensated massively with stock options to sharpen their focus on increasing shareholder value at the expense of everything else, and activist hedge funds began reinforcing the focus with corporate raids on firms that didn’t buy into the doctrine, public companies began to focus totally on maximizing shareholder as reflected in current the stock price.
Previously, firms had sought to balance the needs of all the stakeholders—customers, employees, shareholders and the community. Workers were valued both as contributors to the gains that had already been made and as the creators of future growth. But once shareholder value thinking took over, workers came to be seen as expendable commodities, whose training for the future and career development were simply not their problem. No responsibility was felt to those employees who had helped create the wealth of the company. Instead, corporate raiders, who had played no role in creating that wealth, extracted much of the gains, which they then used to conduct more raids.
"Fifty years ago,” writer Lynn Stout, the late distinguished professor of corporate and business law at Cornell Law School, in her book, The Shareholder Value Myth, wrote, “if you had asked the directors or CEO of a large public company what the company's purpose was, you might have been told the corporation had many purposes: to provide equity investors with solid returns, but also to build great products, to provide decent livelihoods for employees, and to contribute to the community and nation. The concept was to focus on long-term performance, not maximizing short-term profits."
"All this changed in the 1980s. Economists began arguing, confidently, if incorrectly, that shareholders 'own' corporations and that stock price always captures a firm's true economic value. Thus shareholders should have more power over corporate boards, and executive pay should be tied to shareholder returns. These academic arguments were embraced by activist investors seeking to buy shares, pump up price, and sell for a quick profit. They also appealed to CEOs hoping to enrich themselves by boosting share price by any means possible (including, at Enron, outright fraud). The result is today's world, where 'shareholder value' is king."
Containing wages and benefits became key elements of corporate strategy of most public companies, while shareholders and executives were rewarded beyond their wildest dreams. But there was a cost: stagnant wages through downsizing and layoffs, and widening income inequality.
“It's alarming,” writes Paul F. Cole, executive director of the American Labor Studies Center, “that the chairman of the Federal Reserve is ‘puzzled’ why raises are ‘elusive.’” Cole suggests that the Fed chairman should “read Lynn Stout's book.”
Other notable books that the Fed chairman might read include:
The Fed chairman might also look at the many management studies that have denounced shareholder value theory. For instance, two distinguished Harvard Business School professors–Joseph L. Bower and Lynn S. Paine—recently declared in Harvard Business Review that maximizing shareholder value is “the error at the heart of corporate leadership.” It is “flawed in its assumptions, confused as a matter of law, and damaging in practice.”
He might also listen to Jack Welch, who in his tenure as CEO of GE from 1981 to 2001 was seen as the uber-hero of maximizing shareholder value. In 2009, he famously declared that shareholder value is “the dumbest idea in the world. Shareholder value is a result, not a strategy... your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal… Short-term profits should be allied with an increase in the long-term value of a company.”
He might also pay attention to the CEOs who have spoken out against it. Vinci Group Chairman and CEO Xavier Huillard called it “totally idiotic.” Alibaba CEO Jack Ma said that “customers are number one; employees are number two and shareholders are number three.” Paul Polman, CEO of Unilever, denounced shareholder value thinking as “a cult.” Marc Benioff, chairman and CEO of Salesforce, has declared it to be “wrong.”
But despite these denunciations, the “pernicious nonsense” of shareholder value has spread. Shareholder value thinking, say Bower and Paine, “is now pervasive in the financial community and much of the business world. It has led to a set of behaviors by many actors on a wide range of topics, from performance measurement and executive compensation to shareholder rights, the role of directors, and corporate responsibility.”
Stagnant worker salaries thus aren’t a bug in the current economy: they’re a feature. Holding worker salaries as low as possible is a key to securing short-term quarterly profits, executive bonuses and rising share prices. Seemingly unnoticed by the world’s leading economists, shareholder value is not only the gospel of the global economy. It’s also the root cause of stagnant worker salaries.
New Reading For Mainstream Economists
It isn’t likely that mainstream economists will read any of the books and articles mentioned above, because they’re not written by members of the economic priesthood and so won’t be taken seriously.
However, help is in the way. A new book by a mainstream economist makes the same arguments in terminology that even macro-economists can understand. The book, The Value of Everything: Making and Taking in the Global Economy, goes on sale September 11, 2018 and offers a fundamental re-think of what constitutes real value in the economy. It traces the origins of current economic thinking from its origins in the seventeenth century to the growth of the financial sector and the financialization of the 21st-century economy. It explains how the economy steadily shifted from creating value for the benefit of all to the extraction of value for the owners of assets, and the consequences in terms of steady economic decline and worsening income inequality.
The author, Mariana Mazzucato, is the 2018 winner of the Leontief Prize for Advancing Economic Thought—a prize that some economists have won prior to receiving the Nobel Prize in Economics. As the author of the critically acclaimed book The Entrepreneurial State, she is also professor of the Economics of Innovation at University College London, and Founder and director of the Institute for Innovation and Public Purpose.
A Paradigm Shift In Management
Thus, for anyone who opens their eyes to what’s happening in the real world, it’s no mystery why salaries are stagnant. Firms are simply following the dictates of the stock market and the anachronistic management practices of shareholder value theory.
Firms have failed to make the paradigm shift in management that would generate the growth and profits that would enable them to pay higher wages. We know how to do this. Dazzling examples of the new way of running organizations are everywhere apparent. Firms like Apple and Samsung offer devices that can be tailored to meet the individual wants and whims of hundreds of millions of users. Firms like Tesla, Saab and Ericsson are upgrading cars, planes and networks, not by physically installing new items, but by delivering new software to the products via the Web. Amazon has demonstrated what can be accomplished when customer value is pursued ahead of short-term profits: it’s not just the world’s biggest retailer—it’s bigger than all the other retailers put together. Google has become big and rich very quickly, by providing search capabilities that are offered free. Airbnb, Uber and Lyft are showing how to unlock the value in existing assets that were previously lying idle. And so on.
At the same time, what is lifting some companies is killing those that focus only on shareholder value. The examples here are also abundant. “Market-leading companies,” as analyst Alan Murray has written in the Wall Street Journal, “have missed game-changing transformations in industry after industry—computers (mainframes to PCs), telephony (landline to mobile), photography (film to digital), stock markets (floor to online)—not because of ‘bad’ management, but because they followed the dictates of ‘good’ management.” In effect, the “good management” that these firms were practicing had become anachronistic. It simply didn’t work anymore.
Two Different Worlds
There are thus two worlds are on very different trajectories. The emerging world of customer value is prospering, growing, and thriving in real terms while inspiring and energizing those involved in it, and continuing to evolve and reinvent itself.
The world of shareholder value is declining in real terms, and dispiriting those involved in it, even those few who are enjoying its large but ephemeral financial fruits. The true measures of its progress are not the booming stock market or the short-term benefits to shareholders but rather the sputtering real economy, the despair of large segments of the population who experience stagnating wages, the unraveling social fabric, and the political stalemate in the face of grave issues.
Isn’t it time that mainstream economists caught up with what’s happening in the real world, as opposed to their make-believe world of economic models?
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