How the bonus culture caused the financial crisis – and how we can stop it happening again

Most people like to think that overconsumption caused our current crisis. Thanks to Alan Greenspan’s stupid monetary policy – which kept money far too cheap for far too long – we all borrowed too much, spent too much, and ended up with houses we can’t afford filled with tat we don’t need. The solution then is to run down debt – both private and public – and to consume less in the process.

But not everyone agrees. James Livingston certainly doesn’t. In his new book Against Thrift he argues that we have it the wrong way around. The crisis was, he claims, caused not by overconsumption but by underconsumption. And the underconsumption being caused by the deleveraging we are forcing across our economies will, he says, be the thing that prolongs it too.

If we want times to get better, we need to laugh in the face of austerity and get on with spending more. Saving for a rainy day is “a soul crushing emotional trap as well as an economic dead end”.

I can feel the sharp intakes of breath from regular readers here, so let me point out that behind the deliberately provocative prose there is some good stuff in here. The stuff that doesn’t hold up is dealt with in this WSJ review and the comments beneath. 

And the stuff that might? Livingston thinks that rich people have too much money; that bubbles are formed by those with excess capital and nowhere productive for it to go pouring into one nonsense after another; and that the solution is for it to be removed from them and given to lower income groups to spend on stuff.

He points in particular to the period from 1933 to 1973, a period when net investment in the US was low, but consumer spending was on a roll thanks to a fast rise in government jobs (so a transfer of cash from high-earning tax payer to lower-earning tax payer via the middle-man of the state) and when the unions were demanding and getting higher wages by the month.

It was a period of regular high growth – of the kind people now think the US is entitled to have in perpetuity – and one that clearly coincided with rising incomes and falling inequality. 

That makes it very different to the period in the run up to the crisis – one of fast rising inequality with the share of returns allocated to profits rising at speed and that to labour falling at speed.

US profit margins are now at a record high and have even achieved the rather odd feat of rising over the last three years even as output has fallen. If profit margins in the US were now at their long-term average US profits before tax would be approximately half their current level. 

Andrew Smithers of Smithers & Co puts this unhappy trend (unhappy because it isn’t much good to labour) down to modern management: “The huge increase in bonuses linked to short-term measures of performance, such as returns to shareholders and return on equity, has naturally encouraged the observed changes, including an increased willingness to sack labour, combined with a disinclination to lower prices and a preference for share buy-backs over investment.”

Changes in incentives have meant changes in behaviour and hence a rise in the share of output going to profits over workers (as well as a fall in business investment). In the past, margins have tended to widen and narrow with fluctuations in economic output and employment. In the last few years they have moved together. Management keen to keep bonuses up like to keep wages and employee numbers down.

Those benefiting from profits have become progressively richer; those benefiting from rises in output as a whole and from the share of that output going to labour have become relatively poorer.

The former, who have a lower propensity to spend than the latter, then become the bubble creators of Livingston’s book – chucking their ill-gotton cash around the globe in the search for a further return. The latter, scrabbling around for the rent, fail to spend, to consume and hence to prompt the rises in output that benefit us all.

The result? Crisis – in the form of a toxic mixture of bubbles and low growth. The solution? Redistribution. Livingston would have that happen via the state. I’d just hope that shareholders might see sense and that public revulsion might bring an end to the bonus culture.

Everyone’s jumping on the executive pay bandwagon this week. David Cameron is talking about it and by Wednesday even Fidelity, one of the world’s biggest retail fund managers, had started talking about it being time for shareholders to have binding votes on pay.

This is good, but I suspect that most of the people thinking about this subject don’t realise just how important it is. They think it is a matter of dealing with public anger by making things look fair. But it’s actually about more than that: getting this right is one of the key things in making sure that the economies of the West can start to grow again.

• This post is an extended version of Merryn’s
editor’s letter from MoneyWeek magazine issue no 572
.