Are CEO's Overpaid?

To contact us Click HERE
Are CEO's Overpaid? I confess that my knee-jerk answer to this question is "YES"! But Steve Kaplan makes a strong case for a more nuanced answer in Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges," published in July as Chicago Booth working paper 12-42. Here's a sketch of some of  his arguments and graphs.

 First, just as a matter of getting the facts straight, CEO pay relative to household income did spike back in the go-go days of the dot-com boom in the late 1990s, but since then, it is relatively lower. Kaplan argues that there are two valid ways to measure executive pay. One measure looks at actual pay received, which he argues is useful for seeing whether top executives are paid for performance. The other measure looks at "estimated" pay, which is the amount that financial pay packages would have been expected to be worth at the time were granted. This calculation requires putting a value on stock options, restricted stock grants, and the like, and estimating what these were worth at the time the pay package was given. Kaplan argues that this measure is the appropriate one for looking at what corporate boards meant to do when they agreed on a compensation package.

Here's one figure showing actual average and median pay totals for S&P 500 CEOs from 1993 to 2010. Average pay is above median pay, which tells you that there are some very high-paid execs at the top pulling up the average.  Also, average CEO pay spikes when the stock market is high, as in 2000 and around 2006 an  2007. Median realized pay seems to have crept up over time.  
Here's a figure showing estimated pay--that is, the value of the pay packages when they were granted. But this time, instead of showing dollar amounts, this graph shows average and median CEO pay as a multiple of median household income. Average pay again spikes at the time of the dot-com boom. Kaplan emphasizes that estimated CEO pay is on average lower than in 2000 and that the median hasn't risen much. My eye is drawn to the fact that median pay for CEOs goes from something like 60 times median household income back in 1993 to about 170 times median household income by 2010.

An obvious question is whether these pay levels are distinctive for CEOs, or whether they are just one manifestation of widening income inequality across a range of highly-paid occupations. Kaplan makes a solid case that it is the latter. For example, here's a graph showing the average pay of the top 0.1% of the income distribution compared with the average pay of a large company CEO.Again, the story is that CEO pay really did spike in the 1990s, but by this measure, CEO pay relative to the top 0.1% is now back to the levels common in the the 1950s.

  

Kaplan also points out that the pay of those at the top of other highly-paid occupations has grown dramatically as well, like lawyers, athletes, and hedge fund managers. Here's a figure showing the pay of top hedge fund managers relative to that of CEOs in the last decade. Kaplan writes: "The top 25 hedge fund managers as a group regularly earn more than all 500 CEOs in the S&P 500. In other words, while public company CEOs are highly paid, other groups with similar backgrounds and talents have done at least equally well over the last fifteen years to twenty years. If one uses evidence of higher CEO pay as evidence of managerial power or capture, one must also explain why the other professional groups have had a similar or even higher growth in pay. A more natural interpretation is that the market for talent has driven a meaningful portion of the increase in pay at the top."    

Kaplan also compiles evidence that CEOs of companies with better stock market performance tend to be paid more than those with poor stock market performance, and that CEOs have shorter job tenures. He writes: Turnover levels since 1998 have been higher than in work that has studied previous periods. In any given year, one out of 6 Fortune 500 CEOs lose their jobs. This compares to one out of 10 in the 1970s. CEOs can expect to be CEOs for less time than in the past. If these declines in expected CEO tenures since 1998 are factored in, the effective decline in CEO pay since then is larger than reported above." And the CEO turnover is related to poor firm stock performance ..."

To me, Kaplan makes a couple of especially persuasive points: the run-up in CEO salaries was especially extreme during the 1990s, and less  so since then (depending on how you measure it); and the run-up in CEO salaries reflects the rise in inequality across a wider swath of professions. While I believe the arguments that job tenure can be shorter for the modern CEO, especially if a company isn't performing well, it seems to me that most former CEO's don't plummet too many percentiles down the income distribution in their next job, so my sympathy for them is rather limited on that point.

In this paper, Kaplan doesn't seek to address the deeper question of why the pay for those at the very top, CEOs included, has risen so dramatically.  While the demand for skills at the very top of the income distribution is surely part of the answer, I find it hard to believe that these rewards for skill increased so sharply in the 1990s--just coincidentally during a stock market boom. It seems likely to me that
  cozy institutional arrangements for many of those at the very top of the income distribution--CEOs, hedge fund managers, lawyers, and athletes and entertainers--also plays an important role.  

Labor's Smaller Share

To contact us Click HERE
Margaret Jacobson and Filippo Occhino have been investigating the fact that labor has been receiving a declining share of total economic output over the last few decades. I posted on their work last February in "Labor's Declining Share of Total Income."  Now they have written "Labor’s Declining Share of Income and Rising Inequality," which is "Economic Commentary" 2012-13 published by the Federal Reserve Bank of Cleveland.


The starting point is to look at labor income relative to the size of the economy. The top line in the figure shows labor income as a share of GDP, as measured in the national income and product accounts from the U.S. Bureau of Economic Analysis. The lower line in the figure shows the ratio of compensation to output for the nonfarm business sector, as measured by the U.S. Bureau of Labor Statistics. The measures are not identical, nor would one expect them to be, but they show the same trend: that is, with some ups and downs as the economy has fluctuated, the labor share of income has been falling for decades, and is now at an historically low figure.

 This fact lies behind much of the rise in inequality of incomes over this time. The income that is not being earned by labor is being earned by capital--and capital income is much more concentrated than is labor income. Jacobsen and Occhino offer an intriguing figure that measures the inequality of labor income and the inequality of capital income. The measure used here is a Gini coefficient, which "ranges between 0 and 1, with 0 indicating an equal distribution of income and 1 indicating unequal income." (Here's an earlier post with an explanation of Gini coefficients.)
The figure has two main takeaways. First, labor income has become more unequally distributed over time, but since the early 1990s, the big shift in income inequality is because capital income is more unequally distributed. Second, capital income tends to rise during booms and to fall in recessions. Thus, it seems plausible that the inequality of capital income has dropped in the last few years of the Great Recession and its aftermath, but will rise again as economic growth recovers.

What has caused the long-run decline of the labor share of income? Jacobson and Occhino explain this way: "[W]e begin by looking at what determines the labor share in the long run. The main factor is the technology available to produce goods and services. In competitive markets, labor and
capital are compensated in proportion to their marginal contribution to production, so the most important factor behind the labor and capital shares is the marginal productivities of labor and capital, which are determined by technology. In fact, one important cause of the post-1980 long-run decline in the labor share was a technological change, connected with advances in information and
communication technologies, which made capital more productive relative to labor, and raised the return to capital relative to labor compensation. Other factors that have played a role in the long-run decline in the labor share are increased globalization and trade openness, as well as changes in
labor market institutions and policies."

There is no particular reason to believe that these trends will continue--or that they won't. But the declining share of income going to labor suggests the importance of finding ways to increase the marginal product of labor, especially for workers of low and medium skills, perhaps by focusing on the kind of training and networking that might help them make greater use of the advances in information and communication technology to improve their own productivity.

What's Up With the Dodd-Frank Legislation?

To contact us Click HERE
Back in July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. The difficulty with the law has always been that while it was fairly clear on its goals, it did not specify how to reach those goals--instead turning over that task to current and newly-created regulatory agencies.  If you're looking for an update on how the law is proceeding, a good starting point is the Third Quarter 2012 issue of Economic Perspectives, published by the Federal Reserve Bank of Chicago, which has six articles on the Dodd-Frank legislation.

Douglas D. Evanoff and William F. Moeller offer an overview of the goals and approach of the law in their opening piece (footnotes and citations omitted):

"The stated goals of the act were to provide for financial regulatory reform, to protect consumers
and investors, to put an end to too-big-to-fail, to regulate the over-the-counter (OTC) derivatives markets, to prevent another financial crisis, and for other purposes. ... Implementation of Dodd–Frank requires the development of some 250 new regulatory rules and various mandated studies. There is also the need to introduce and staff a number of new entities (bureaus, offices, and councils) with responsibility to study, evaluate, and  promote consumer protection and financial stability. Additionally, there is a mandate for regulators to identify and increase regulatory scrutiny of systemically important institutions.  ... Two years into the implementation of the act, much has been done, but much remains to be done."

How are those rules coming along? The law firm of Davis Polk & Wardwell publishes a regular Dodd-Frank report. The September 2012 edition summarizes:

• "As of September 4, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have
  passed. This is 59.5% of the 398 total rulemaking requirements, and 84.6% of the 280
  rulemaking requirements with specified deadlines.
• "Of these 237 passed deadlines, 145 (61.2%) have been missed and 92 (38.8%) have been
  met with finalized rules. Regulators have not yet released proposals for 31 of the 145 missed
  rules.
• "Of the 398 total rulemaking requirements, 131 (32.9%) have been met with finalized rules and
  rules have been proposed that would meet 135 (33.9%) more. Rules have not yet been
  proposed to meet 132 (33.2%) rulemaking requirements.

The July 2010 Davis Polk update--the two-year anniversary of the legislation--offers some additional detail: "The two years since Dodd-Frank’s passage have seen 848 pages of statutory text expand to 8,843 pages of regulations. Already at almost a 1:10 page ratio, this staggering number represents
only 30% of required rulemaking contained within Dodd-Frank, affecting every area of the financial markets and involving over a dozen Federal agencies."

It's important to  recognize that writing a new regulation isn't as simple as, well, just writing it. Instead, there is often first an in-house study, followed by a draft regulation, which then is open to public comments, and then can revised, and eventually at some point a new regulation is created. It's not unusual for a regulation to get dozens or hundreds of detailed public comments.

This blizzard of evolving rules has to create considerable uncertainty in the financial sector. Matthew Richardson discusses the complexities of one particular issue in his contribution to the Chicago Fed publication. He picks one example: the problem that many banks made very low-quality subprime mortgage loans. What does the Dodd-Frank legislation do about this basic issue? As he describes, the act: 1) Sets up a Consumer Finance Protection Bureau in title X to deal with misleading products; 2)
Imposes particular underwriting standards for residential mortgages; 3) Requires firms performing securitization to retain at least 5 percent of the credit risk; and 4) Iincreases regulation of credit rating agencies. Each of these tasks requires detailed rulemaking. And as Richardson points out, "with all of these new provisions, the act does not even address what we at NYU Stern consider to be a primary fault for the poor quality of loans—namely, the mispriced government guarantees in the system that led to price distortions and an excessive buildup of leverage and risky credit."

I'm skeptical of anyone who has strong opinions about the Dodd-Frank legislation, because here we are more than two years later, less than halfway toward figuring out what rules the legislation will actually put in place. Wayne A. Abernethy of the American Bankers Association is one of the authors in the Chicago Fed symposium. Yes, he is speaking for the bankers' point of view. But his judgement about the overall process seems fair to me:

"At least in the financial regulatory history of the United States, there has never been anything like it. I have seen no definitive count of the number of regulations that the Dodd–Frank Act calls forth. The numbers seem to range between 250 and 400—numbers so large that they are numbing. It all defies hyperbole. The Fair and Accurate Credit Transactions Act, adopted in 2003, astonished the financial industry with more than a dozen significant new regulations to be written. ...

"One of the most common criticisms of Dodd–Frank implementation has been a lack of order and coordination in the regulatory process. Instead, the Dodd–Frank Act has succeeded in replacing the financial crisis with a regulatory crisis.  ... As agencies are grappling with impossible rulemaking tasks, most of them are also engaged in major structural reorganizations and shifts in the areas of responsibility. ... Nothing like this has ever been tried before in the history of the United States. Writing 400 financial regulations of the highest significance and the greatest complexity in a couple of years has clearly been too much to expect. ... Getting on with the work to end our self-inflicted regulatory crisis should be among the highest priorities."

 I'm someone who believes that financial regulation needed shaking up. Many of the broad goals of the Dodd-Frank legislation make sense to me: rethinking bank and regulation to deal with macroeconomic risk, not just the risk of an individual institution going broke; figuring out better ways to shut down even large financial institutions when needed; and better regulation of certain financial instruments like credit default swaps and repo agreements; a closer look at technologies that allow ultra-high-speed financial trading; and others.

The Dodd-Frank legislation is almost not a law in the conventional meaning of the term, because it mostly isn't about actual specific activities that are prohibited. Instead, it's about handing over the difficult problems to regulators and telling them to fix it. I'm not sure there was an easy alternative to this regulatory approach: the idea of Congress trying to debate, say, appropriate regulation of the over-the-counter swaps market is not an encouraging thought. But stating a goal is not the same as solving a problem. The passage of Dodd-Frank, in and of  itself, didn't solve any problems.

Are CEO's Overpaid?

To contact us Click HERE
Are CEO's Overpaid? I confess that my knee-jerk answer to this question is "YES"! But Steve Kaplan makes a strong case for a more nuanced answer in Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges," published in July as Chicago Booth working paper 12-42. Here's a sketch of some of  his arguments and graphs.

 First, just as a matter of getting the facts straight, CEO pay relative to household income did spike back in the go-go days of the dot-com boom in the late 1990s, but since then, it is relatively lower. Kaplan argues that there are two valid ways to measure executive pay. One measure looks at actual pay received, which he argues is useful for seeing whether top executives are paid for performance. The other measure looks at "estimated" pay, which is the amount that financial pay packages would have been expected to be worth at the time were granted. This calculation requires putting a value on stock options, restricted stock grants, and the like, and estimating what these were worth at the time the pay package was given. Kaplan argues that this measure is the appropriate one for looking at what corporate boards meant to do when they agreed on a compensation package.

Here's one figure showing actual average and median pay totals for S&P 500 CEOs from 1993 to 2010. Average pay is above median pay, which tells you that there are some very high-paid execs at the top pulling up the average.  Also, average CEO pay spikes when the stock market is high, as in 2000 and around 2006 an  2007. Median realized pay seems to have crept up over time. 
Here's a figure showing estimated pay--that is, the value of the pay packages when they were granted. But this time, instead of showing dollar amounts, this graph shows average and median CEO pay as a multiple of median household income. Average pay again spikes at the time of the dot-com boom. Kaplan emphasizes that estimated CEO pay is on average lower than in 2000 and that the median hasn't risen much. My eye is drawn to the fact that median pay for CEOs goes from something like 60 times median household income back in 1993 to about 170 times median household income by 2010.

An obvious question is whether these pay levels are distinctive for CEOs, or whether they are just one manifestation of widening income inequality across a range of highly-paid occupations. Kaplan makes a solid case that it is the latter. For example, here's a graph showing the average pay of the top 0.1% of the income distribution compared with the average pay of a large company CEO.Again, the story is that CEO pay really did spike in the 1990s, but by this measure, CEO pay relative to the top 0.1% is now back to the levels common in the the 1950s.

  

Kaplan also points out that the pay of those at the top of other highly-paid occupations has grown dramatically as well, like lawyers, athletes, and hedge fund managers. Here's a figure showing the pay of top hedge fund managers relative to that of CEOs in the last decade. Kaplan writes: "The top 25 hedge fund managers as a group regularly earn more than all 500 CEOs in the S&P 500. In other words, while public company CEOs are highly paid, other groups with similar backgrounds and talents have done at least equally well over the last fifteen years to twenty years. If one uses evidence of higher CEO pay as evidence of managerial power or capture, one must also explain why the other professional groups have had a similar or even higher growth in pay. A more natural interpretation is that the market for talent has driven a meaningful portion of the increase in pay at the top."   

Kaplan also compiles evidence that CEOs of companies with better stock market performance tend to be paid more than those with poor stock market performance, and that CEOs have shorter job tenures. He writes: Turnover levels since 1998 have been higher than in work that has studied previous periods. In any given year, one out of 6 Fortune 500 CEOs lose their jobs. This compares to one out of 10 in the 1970s. CEOs can expect to be CEOs for less time than in the past. If these declines in expected CEO tenures since 1998 are factored in, the effective decline in CEO pay since then is larger than reported above."And the CEO turnover is related to poor firm stock performance ..."

To me, Kaplan makes a couple of especially persuasive points: the run-up in CEO salaries was especially extreme during the 1990s, and less  so since then (depending on how you measure it); and the run-up in CEO salaries reflects the rise in inequality across a wider swath of professions. While I believe the arguments that job tenure can be shorter for the modern CEO, especially if a company isn't performing well, it seems to me that most former CEO's don't plummet too many percentiles down the income distribution in their next job, so my sympathy for them is rather limited on that point.

In this paper, Kaplan doesn't seek to address the deeper question of why the pay for those at the very top, CEOs included, has risen so dramatically.  While the demand for skills at the very top of the income distribution is surely part of the answer, I find it hard to believe that these rewards for skill increased so sharply in the 1990s--just coincidentally during a stock market boom. It seems likely to me that
  cozy institutional arrangements for many of those at the very top of the income distribution--CEOs, hedge fund managers, lawyers, and athletes and entertainers--also plays an important role.  

Labor's Smaller Share

To contact us Click HERE
Margaret Jacobson and Filippo Occhino have been investigating the fact that labor has been receiving a declining share of total economic output over the last few decades. I posted on their work last February in "Labor's Declining Share of Total Income."  Now they have written "Labor’s Declining Share of Income and Rising Inequality," which is "Economic Commentary" 2012-13 published by the Federal Reserve Bank of Cleveland.


The starting point is to look at labor income relative to the size of the economy. The top line in the figure shows labor income as a share of GDP, as measured in the national income and product accounts from the U.S. Bureau of Economic Analysis. The lower line in the figure shows the ratio of compensation to output for the nonfarm business sector, as measured by the U.S. Bureau of Labor Statistics. The measures are not identical, nor would one expect them to be, but they show the same trend: that is, with some ups and downs as the economy has fluctuated, the labor share of income has been falling for decades, and is now at an historically low figure.

 This fact lies behind much of the rise in inequality of incomes over this time. The income that is not being earned by labor is being earned by capital--and capital income is much more concentrated than is labor income. Jacobsen and Occhino offer an intriguing figure that measures the inequality of labor income and the inequality of capital income. The measure used here is a Gini coefficient, which "ranges between 0 and 1, with 0 indicating an equal distribution of income and 1 indicating unequal income." (Here's an earlier post with an explanation of Gini coefficients.)
The figure has two main takeaways. First, labor income has become more unequally distributed over time, but since the early 1990s, the big shift in income inequality is because capital income is more unequally distributed. Second, capital income tends to rise during booms and to fall in recessions. Thus, it seems plausible that the inequality of capital income has dropped in the last few years of the Great Recession and its aftermath, but will rise again as economic growth recovers.

What has caused the long-run decline of the labor share of income? Jacobson and Occhino explain this way: "[W]e begin by looking at what determines the labor share in the long run. The main factor is the technology available to produce goods and services. In competitive markets, labor and
capital are compensated in proportion to their marginal contribution to production, so the most important factor behind the labor and capital shares is the marginal productivities of labor and capital, which are determined by technology. In fact, one important cause of the post-1980 long-run decline in the labor share was a technological change, connected with advances in information and
communication technologies, which made capital more productive relative to labor, and raised the return to capital relative to labor compensation. Other factors that have played a role in the long-run decline in the labor share are increased globalization and trade openness, as well as changes in
labor market institutions and policies."

There is no particular reason to believe that these trends will continue--or that they won't. But the declining share of income going to labor suggests the importance of finding ways to increase the marginal product of labor, especially for workers of low and medium skills, perhaps by focusing on the kind of training and networking that might help them make greater use of the advances in information and communication technology to improve their own productivity.

What's Up With the Dodd-Frank Legislation?

To contact us Click HERE
Back in July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. The difficulty with the law has always been that while it was fairly clear on its goals, it did not specify how to reach those goals--instead turning over that task to current and newly-created regulatory agencies.  If you're looking for an update on how the law is proceeding, a good starting point is the Third Quarter 2012 issue of Economic Perspectives, published by the Federal Reserve Bank of Chicago, which has six articles on the Dodd-Frank legislation.

Douglas D. Evanoff and William F. Moeller offer an overview of the goals and approach of the law in their opening piece (footnotes and citations omitted):

"The stated goals of the act were to provide for financial regulatory reform, to protect consumers
and investors, to put an end to too-big-to-fail, to regulate the over-the-counter (OTC) derivatives markets, to prevent another financial crisis, and for other purposes. ... Implementation of Dodd–Frank requires the development of some 250 new regulatory rules and various mandated studies. There is also the need to introduce and staff a number of new entities (bureaus, offices, and councils) with responsibility to study, evaluate, and  promote consumer protection and financial stability. Additionally, there is a mandate for regulators to identify and increase regulatory scrutiny of systemically important institutions.  ... Two years into the implementation of the act, much has been done, but much remains to be done."

How are those rules coming along? The law firm of Davis Polk & Wardwell publishes a regular Dodd-Frank report. The September 2012 edition summarizes:

• "As of September 4, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have
  passed. This is 59.5% of the 398 total rulemaking requirements, and 84.6% of the 280
  rulemaking requirements with specified deadlines.
• "Of these 237 passed deadlines, 145 (61.2%) have been missed and 92 (38.8%) have been
  met with finalized rules. Regulators have not yet released proposals for 31 of the 145 missed
  rules.
• "Of the 398 total rulemaking requirements, 131 (32.9%) have been met with finalized rules and
  rules have been proposed that would meet 135 (33.9%) more. Rules have not yet been
  proposed to meet 132 (33.2%) rulemaking requirements.

The July 2010 Davis Polk update--the two-year anniversary of the legislation--offers some additional detail: "The two years since Dodd-Frank’s passage have seen 848 pages of statutory text expand to 8,843 pages of regulations. Already at almost a 1:10 page ratio, this staggering number represents
only 30% of required rulemaking contained within Dodd-Frank, affecting every area of the financial markets and involving over a dozen Federal agencies."

It's important to  recognize that writing a new regulation isn't as simple as, well, just writing it. Instead, there is often first an in-house study, followed by a draft regulation, which then is open to public comments, and then can revised, and eventually at some point a new regulation is created. It's not unusual for a regulation to get dozens or hundreds of detailed public comments.

This blizzard of evolving rules has to create considerable uncertainty in the financial sector. Matthew Richardson discusses the complexities of one particular issue in his contribution to the Chicago Fed publication. He picks one example: the problem that many banks made very low-quality subprime mortgage loans. What does the Dodd-Frank legislation do about this basic issue? As he describes, the act: 1) Sets up a Consumer Finance Protection Bureau in title X to deal with misleading products; 2)
Imposes particular underwriting standards for residential mortgages; 3) Requires firms performing securitization to retain at least 5 percent of the credit risk; and 4) Iincreases regulation of credit rating agencies. Each of these tasks requires detailed rulemaking. And as Richardson points out, "with all of these new provisions, the act does not even address what we at NYU Stern consider to be a primary fault for the poor quality of loans—namely, the mispriced government guarantees in the system that led to price distortions and an excessive buildup of leverage and risky credit."

I'm skeptical of anyone who has strong opinions about the Dodd-Frank legislation, because here we are more than two years later, less than halfway toward figuring out what rules the legislation will actually put in place. Wayne A. Abernethy of the American Bankers Association is one of the authors in the Chicago Fed symposium. Yes, he is speaking for the bankers' point of view. But his judgement about the overall process seems fair to me:

"At least in the financial regulatory history of the United States, there has never been anything like it. I have seen no definitive count of the number of regulations that the Dodd–Frank Act calls forth. The numbers seem to range between 250 and 400—numbers so large that they are numbing. It all defies hyperbole. The Fair and Accurate Credit Transactions Act, adopted in 2003, astonished the financial industry with more than a dozen significant new regulations to be written. ...

"One of the most common criticisms of Dodd–Frank implementation has been a lack of order and coordination in the regulatory process. Instead, the Dodd–Frank Act has succeeded in replacing the financial crisis with a regulatory crisis.  ... As agencies are grappling with impossible rulemaking tasks, most of them are also engaged in major structural reorganizations and shifts in the areas of responsibility. ... Nothing like this has ever been tried before in the history of the United States. Writing 400 financial regulations of the highest significance and the greatest complexity in a couple of years has clearly been too much to expect. ... Getting on with the work to end our self-inflicted regulatory crisis should be among the highest priorities."

 I'm someone who believes that financial regulation needed shaking up. Many of the broad goals of the Dodd-Frank legislation make sense to me: rethinking bank and regulation to deal with macroeconomic risk, not just the risk of an individual institution going broke; figuring out better ways to shut down even large financial institutions when needed; and better regulation of certain financial instruments like credit default swaps and repo agreements; a closer look at technologies that allow ultra-high-speed financial trading; and others.

The Dodd-Frank legislation is almost not a law in the conventional meaning of the term, because it mostly isn't about actual specific activities that are prohibited. Instead, it's about handing over the difficult problems to regulators and telling them to fix it. I'm not sure there was an easy alternative to this regulatory approach: the idea of Congress trying to debate, say, appropriate regulation of the over-the-counter swaps market is not an encouraging thought. But stating a goal is not the same as solving a problem. The passage of Dodd-Frank, in and of  itself, didn't solve any problems.

When Tradeable Pollution Permits Fall Short

To contact us Click HERE
Like a lot of economists, I occasionally break into a semi-spontaneous song-and-dance about how tradeable pollution permits have all sorts of advantages. In an old-fashioned command-and-control system, every firm needs to reduce pollution emissions to a given standard, even though for some firms meeting that standard will be cheap and easy and for other firms it will be costly and difficult. In a system of tradeable pollution permits, firms that can reduce pollution less expensively can do so, and sell their extra pollution permits to other firms. As a result, the goal of limiting emissions can be reached more cheaply. Even better, firms can make money by seeking out innovative ways to cut emissions, because when pollution permits can be sold or need to be bought, there is a clear financial incentive to do so.

 Dallas Burtraw has preached this gospel of tradeable pollution permits many times himself, which is part of why I was intrigued by his recent paper "The Institutional Blind Spot in Environmental Economics" (Resources for the Future Discussion Paper 12-41, August 2012). He argues that systems of tradeable pollution permits have one severe flaw:  when they set the level of pollution that is allowed to be emitted in future years, they cannot foresee future development that may cause that level to be implausibly high.

For example, the 1990 Clean Air Act set up a framework for using tradable pollution permits that sought to reduce emissions of sulfur dioxide by half from 1980 levels. The program was a success, reducing emissions at cost that were probably 40% or so below the cost of a command-and-control pollution rules. My own Journal of Economic Perspectives ran a couple of articles on the program (here and here) back in the Summer 1998 issue.

Burtraw offers an updated view. As the costs of reducing SO2 emissions and the benefits of doing so became better understood, it seemed clear that SO2 emissions should be reduced much farther and faster. Congress proved unable to make such a chance legislatively, but regulators pushed forward in various ways. The result is that the program for trading SO2 pollution permits worked for a time in the 1990s but since then became irrelevant, with additional declines in S02 trading being driven by old-fashioned regulatory actions. Here's Burtraw (footnotes omitted):

 "The trading program was statutorily created in the Clean Air Act Amendments of 1990 and led to cost reductions of roughly 40 percent compared to traditional approaches under the Clean Air Act. However, the program had what literally became a fatal flaw: namely, an inability to adjust to new scientific or economic information. Though information current in 1990 suggested that benefits of the program would be nearly equal to costs, by 1995 there was strong evidence that benefits were an order of magnitude greater than costs. Today the Environmental Protection Agency would argue that benefits are more than thirty times the costs. Unfortunately, to change the stringency of the program requires an act of Congress, at least according to the D.C. Circuit Court. The Act locked in the emissions cap, and despite several legislative initiatives to change the stringency of the trading program, none have been successful. ...

"If the nation’s fate with respect to sulfur dioxide emissions were left to Congress, tens of billions of dollars in additional environmental and public health costs would have been incurred in the last few years and into the future. Fortunately, the inability of Congress to act was backstopped by the regulatory ratchet of the Clean Air Act that triggers a procession of regulatory initiatives based on scientific findings that have been effective in shaping investment and environmental behavior in the electricity sector."

"The sulfur dioxide cap-and-trade program was intended to reduce sulfur dioxide emissions from power plants from anticipated levels of 16 million tons per year to 8.95 million tons per year by 2010. However, evidence based on integrated assessment suggests an efficient level would be just over 1 million tons per year. In the absence of legislative action, regulatory initiatives have taken effect and driven emissions from power plants to 5.157 million tons, as measured in 2010. By 2015, the Clean Air Interstate Rule and the Mercury and Air Toxics Standard will further reduce emissions to 2.3 million tons per year. In doing so, the emissions constraint under the 1990 Clean Air Act amendment has become irrelevant, and the price of those tradable emissions allowances has fallen from several hundred dollars a ton to near zero."

"The sulfur dioxide cap-and-trade program is the flagship example of the use of economic instruments in environmental policy. However, since its adoption in 1990, although the sulfur dioxide trading program gets most of the credit in textbooks, more than half of the emissions reductions that have and will occur are due to regulation."

 In short, a scheme for trading pollution permits only works because it sets a firm limit on how much pollution can be emitted--often a limit that is declining over time--and then allows trading of permits within that limit. But if faster reductions in the level of pollution seem useful or cost-effective, perhaps because of changes in the market or in scientific information, the pollution quota often can't be changed. Moreover, the idea that the pollution limit might be adjusted up or down in the future would make it hard for a market of pollution permits to operate.

Burtraw points out  that a similar dynamic applies to reducing carbon emissions. Back in 2009, the Waxman-Markey bill that would have set up a cap-and-trade system for carbon emissions passed the House of Representatives but failed in the Senate. At the time, supporters of the bill made some dire predictions about how carbon emissions would increase as a result. But here's the unexpected aftermath. Back at the time of Waxman-Markey, the goal was to reduce carbon emissions by about 10% by 2020, relative to 2005 levels.

However, when Waxman-Markey failed, other events happened. California has imposed rules to limit carbon emissions, along with some other states. The Environmental Protection Agency has looked for ways under existing rules to reduce carbon emissions. The new rules requiring higher fuel economy will reduce carbon emissions. And the advent of more plentiful and cheaper natural gas will reduce carbon emissions. Thus, Burtraw writes: "Total reductions [in carbon dioxide emissions] by 2020—accounting for changes due to subnational policy, regulatory actions under the Clean Air Act, and advantageous secular trends—are on track to yield emissions reductions of 16.7 percent relative to 2005 levels. The anticipated emissions reductions under the Clean Air Act regime exceed those reductions within the United States that would have occurred under cap and trade."

Again, if cap-and-trade legislation had passed back in 2009, it would have set an overall limit on carbon emissions. With that limit in place, any other changes--like cheaper natural gas or higher fuel efficiency standards for cars--would have just made it easier to meet the pollution limit in the cap-and-trade standard. Those unexpected gains in reducing carbon emissions would probably just have led to less need to reduce carbon emissions in any other way.

None of this means that tradeable pollution permits are a bad idea. After all, they were effective in reducing S02 emissions in a cost-effective manner in the 1990s, as well as reducing lead emissions in the 1980s. But when there are ongoing changes in the economic factors affecting the magnitude of emissions, the technology for reducing emissions, and the scientific evidence about the cost of emissions, setting a specific limit on the quantity of pollution allowed may be even harder than it looks.

Are CEO's Overpaid?

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Are CEO's Overpaid? I confess that my knee-jerk answer to this question is "YES"! But Steve Kaplan makes a strong case for a more nuanced answer in Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges," published in July as Chicago Booth working paper 12-42. Here's a sketch of some of  his arguments and graphs.

 First, just as a matter of getting the facts straight, CEO pay relative to household income did spike back in the go-go days of the dot-com boom in the late 1990s, but since then, it is relatively lower. Kaplan argues that there are two valid ways to measure executive pay. One measure looks at actual pay received, which he argues is useful for seeing whether top executives are paid for performance. The other measure looks at "estimated" pay, which is the amount that financial pay packages would have been expected to be worth at the time were granted. This calculation requires putting a value on stock options, restricted stock grants, and the like, and estimating what these were worth at the time the pay package was given. Kaplan argues that this measure is the appropriate one for looking at what corporate boards meant to do when they agreed on a compensation package.

Here's one figure showing actual average and median pay totals for S&P 500 CEOs from 1993 to 2010. Average pay is above median pay, which tells you that there are some very high-paid execs at the top pulling up the average.  Also, average CEO pay spikes when the stock market is high, as in 2000 and around 2006 an  2007. Median realized pay seems to have crept up over time. 
Here's a figure showing estimated pay--that is, the value of the pay packages when they were granted. But this time, instead of showing dollar amounts, this graph shows average and median CEO pay as a multiple of median household income. Average pay again spikes at the time of the dot-com boom. Kaplan emphasizes that estimated CEO pay is on average lower than in 2000 and that the median hasn't risen much. My eye is drawn to the fact that median pay for CEOs goes from something like 60 times median household income back in 1993 to about 170 times median household income by 2010.

An obvious question is whether these pay levels are distinctive for CEOs, or whether they are just one manifestation of widening income inequality across a range of highly-paid occupations. Kaplan makes a solid case that it is the latter. For example, here's a graph showing the average pay of the top 0.1% of the income distribution compared with the average pay of a large company CEO.Again, the story is that CEO pay really did spike in the 1990s, but by this measure, CEO pay relative to the top 0.1% is now back to the levels common in the the 1950s.

  

Kaplan also points out that the pay of those at the top of other highly-paid occupations has grown dramatically as well, like lawyers, athletes, and hedge fund managers. Here's a figure showing the pay of top hedge fund managers relative to that of CEOs in the last decade. Kaplan writes: "The top 25 hedge fund managers as a group regularly earn more than all 500 CEOs in the S&P 500. In other words, while public company CEOs are highly paid, other groups with similar backgrounds and talents have done at least equally well over the last fifteen years to twenty years. If one uses evidence of higher CEO pay as evidence of managerial power or capture, one must also explain why the other professional groups have had a similar or even higher growth in pay. A more natural interpretation is that the market for talent has driven a meaningful portion of the increase in pay at the top."   

Kaplan also compiles evidence that CEOs of companies with better stock market performance tend to be paid more than those with poor stock market performance, and that CEOs have shorter job tenures. He writes: Turnover levels since 1998 have been higher than in work that has studied previous periods. In any given year, one out of 6 Fortune 500 CEOs lose their jobs. This compares to one out of 10 in the 1970s. CEOs can expect to be CEOs for less time than in the past. If these declines in expected CEO tenures since 1998 are factored in, the effective decline in CEO pay since then is larger than reported above."And the CEO turnover is related to poor firm stock performance ..."

To me, Kaplan makes a couple of especially persuasive points: the run-up in CEO salaries was especially extreme during the 1990s, and less  so since then (depending on how you measure it); and the run-up in CEO salaries reflects the rise in inequality across a wider swath of professions. While I believe the arguments that job tenure can be shorter for the modern CEO, especially if a company isn't performing well, it seems to me that most former CEO's don't plummet too many percentiles down the income distribution in their next job, so my sympathy for them is rather limited on that point.

In this paper, Kaplan doesn't seek to address the deeper question of why the pay for those at the very top, CEOs included, has risen so dramatically.  While the demand for skills at the very top of the income distribution is surely part of the answer, I find it hard to believe that these rewards for skill increased so sharply in the 1990s--just coincidentally during a stock market boom. It seems likely to me that
  cozy institutional arrangements for many of those at the very top of the income distribution--CEOs, hedge fund managers, lawyers, and athletes and entertainers--also plays an important role.  

Labor's Smaller Share

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Margaret Jacobson and Filippo Occhino have been investigating the fact that labor has been receiving a declining share of total economic output over the last few decades. I posted on their work last February in "Labor's Declining Share of Total Income."  Now they have written "Labor’s Declining Share of Income and Rising Inequality," which is "Economic Commentary" 2012-13 published by the Federal Reserve Bank of Cleveland.


The starting point is to look at labor income relative to the size of the economy. The top line in the figure shows labor income as a share of GDP, as measured in the national income and product accounts from the U.S. Bureau of Economic Analysis. The lower line in the figure shows the ratio of compensation to output for the nonfarm business sector, as measured by the U.S. Bureau of Labor Statistics. The measures are not identical, nor would one expect them to be, but they show the same trend: that is, with some ups and downs as the economy has fluctuated, the labor share of income has been falling for decades, and is now at an historically low figure.

 This fact lies behind much of the rise in inequality of incomes over this time. The income that is not being earned by labor is being earned by capital--and capital income is much more concentrated than is labor income. Jacobsen and Occhino offer an intriguing figure that measures the inequality of labor income and the inequality of capital income. The measure used here is a Gini coefficient, which "ranges between 0 and 1, with 0 indicating an equal distribution of income and 1 indicating unequal income." (Here's an earlier post with an explanation of Gini coefficients.)
The figure has two main takeaways. First, labor income has become more unequally distributed over time, but since the early 1990s, the big shift in income inequality is because capital income is more unequally distributed. Second, capital income tends to rise during booms and to fall in recessions. Thus, it seems plausible that the inequality of capital income has dropped in the last few years of the Great Recession and its aftermath, but will rise again as economic growth recovers.

What has caused the long-run decline of the labor share of income? Jacobson and Occhino explain this way: "[W]e begin by looking at what determines the labor share in the long run. The main factor is the technology available to produce goods and services. In competitive markets, labor and
capital are compensated in proportion to their marginal contribution to production, so the most important factor behind the labor and capital shares is the marginal productivities of labor and capital, which are determined by technology. In fact, one important cause of the post-1980 long-run decline in the labor share was a technological change, connected with advances in information and
communication technologies, which made capital more productive relative to labor, and raised the return to capital relative to labor compensation. Other factors that have played a role in the long-run decline in the labor share are increased globalization and trade openness, as well as changes in
labor market institutions and policies."

There is no particular reason to believe that these trends will continue--or that they won't. But the declining share of income going to labor suggests the importance of finding ways to increase the marginal product of labor, especially for workers of low and medium skills, perhaps by focusing on the kind of training and networking that might help them make greater use of the advances in information and communication technology to improve their own productivity.

What's Up With the Dodd-Frank Legislation?

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Back in July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. The difficulty with the law has always been that while it was fairly clear on its goals, it did not specify how to reach those goals--instead turning over that task to current and newly-created regulatory agencies.  If you're looking for an update on how the law is proceeding, a good starting point is the Third Quarter 2012 issue of Economic Perspectives, published by the Federal Reserve Bank of Chicago, which has six articles on the Dodd-Frank legislation.

Douglas D. Evanoff and William F. Moeller offer an overview of the goals and approach of the law in their opening piece (footnotes and citations omitted):

"The stated goals of the act were to provide for financial regulatory reform, to protect consumers
and investors, to put an end to too-big-to-fail, to regulate the over-the-counter (OTC) derivatives markets, to prevent another financial crisis, and for other purposes. ... Implementation of Dodd–Frank requires the development of some 250 new regulatory rules and various mandated studies. There is also the need to introduce and staff a number of new entities (bureaus, offices, and councils) with responsibility to study, evaluate, and  promote consumer protection and financial stability. Additionally, there is a mandate for regulators to identify and increase regulatory scrutiny of systemically important institutions.  ... Two years into the implementation of the act, much has been done, but much remains to be done."

How are those rules coming along? The law firm of Davis Polk & Wardwell publishes a regular Dodd-Frank report. The September 2012 edition summarizes:

• "As of September 4, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have
  passed. This is 59.5% of the 398 total rulemaking requirements, and 84.6% of the 280
  rulemaking requirements with specified deadlines.
• "Of these 237 passed deadlines, 145 (61.2%) have been missed and 92 (38.8%) have been
  met with finalized rules. Regulators have not yet released proposals for 31 of the 145 missed
  rules.
• "Of the 398 total rulemaking requirements, 131 (32.9%) have been met with finalized rules and
  rules have been proposed that would meet 135 (33.9%) more. Rules have not yet been
  proposed to meet 132 (33.2%) rulemaking requirements.

The July 2010 Davis Polk update--the two-year anniversary of the legislation--offers some additional detail: "The two years since Dodd-Frank’s passage have seen 848 pages of statutory text expand to 8,843 pages of regulations. Already at almost a 1:10 page ratio, this staggering number represents
only 30% of required rulemaking contained within Dodd-Frank, affecting every area of the financial markets and involving over a dozen Federal agencies."

It's important to  recognize that writing a new regulation isn't as simple as, well, just writing it. Instead, there is often first an in-house study, followed by a draft regulation, which then is open to public comments, and then can revised, and eventually at some point a new regulation is created. It's not unusual for a regulation to get dozens or hundreds of detailed public comments.

This blizzard of evolving rules has to create considerable uncertainty in the financial sector. Matthew Richardson discusses the complexities of one particular issue in his contribution to the Chicago Fed publication. He picks one example: the problem that many banks made very low-quality subprime mortgage loans. What does the Dodd-Frank legislation do about this basic issue? As he describes, the act: 1) Sets up a Consumer Finance Protection Bureau in title X to deal with misleading products; 2)
Imposes particular underwriting standards for residential mortgages; 3) Requires firms performing securitization to retain at least 5 percent of the credit risk; and 4) Iincreases regulation of credit rating agencies. Each of these tasks requires detailed rulemaking. And as Richardson points out, "with all of these new provisions, the act does not even address what we at NYU Stern consider to be a primary fault for the poor quality of loans—namely, the mispriced government guarantees in the system that led to price distortions and an excessive buildup of leverage and risky credit."

I'm skeptical of anyone who has strong opinions about the Dodd-Frank legislation, because here we are more than two years later, less than halfway toward figuring out what rules the legislation will actually put in place. Wayne A. Abernethy of the American Bankers Association is one of the authors in the Chicago Fed symposium. Yes, he is speaking for the bankers' point of view. But his judgement about the overall process seems fair to me:

"At least in the financial regulatory history of the United States, there has never been anything like it. I have seen no definitive count of the number of regulations that the Dodd–Frank Act calls forth. The numbers seem to range between 250 and 400—numbers so large that they are numbing. It all defies hyperbole. The Fair and Accurate Credit Transactions Act, adopted in 2003, astonished the financial industry with more than a dozen significant new regulations to be written. ...

"One of the most common criticisms of Dodd–Frank implementation has been a lack of order and coordination in the regulatory process. Instead, the Dodd–Frank Act has succeeded in replacing the financial crisis with a regulatory crisis.  ... As agencies are grappling with impossible rulemaking tasks, most of them are also engaged in major structural reorganizations and shifts in the areas of responsibility. ... Nothing like this has ever been tried before in the history of the United States. Writing 400 financial regulations of the highest significance and the greatest complexity in a couple of years has clearly been too much to expect. ... Getting on with the work to end our self-inflicted regulatory crisis should be among the highest priorities."

 I'm someone who believes that financial regulation needed shaking up. Many of the broad goals of the Dodd-Frank legislation make sense to me: rethinking bank and regulation to deal with macroeconomic risk, not just the risk of an individual institution going broke; figuring out better ways to shut down even large financial institutions when needed; and better regulation of certain financial instruments like credit default swaps and repo agreements; a closer look at technologies that allow ultra-high-speed financial trading; and others.

The Dodd-Frank legislation is almost not a law in the conventional meaning of the term, because it mostly isn't about actual specific activities that are prohibited. Instead, it's about handing over the difficult problems to regulators and telling them to fix it. I'm not sure there was an easy alternative to this regulatory approach: the idea of Congress trying to debate, say, appropriate regulation of the over-the-counter swaps market is not an encouraging thought. But stating a goal is not the same as solving a problem. The passage of Dodd-Frank, in and of  itself, didn't solve any problems.

Why GDP Growth is Good

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Most teachers of economics at some point have to address the existential question from students: Is more output always good? Nicholas Oulton does has a nice punchy essay called "Hooray for GDP!", written as an "Occasional paper" for the Centre for Economic Performance at the London School of Economics and Political Science. Oulton summarizes the main arguments against focusing on GDP in this way:

1.  GDP is hopelessly flawed as a measure of welfare. It ignores leisure and women’s
   work in the home. It takes no account of pollution and carbon emissions.
2. GDP ignores distribution. In the richest country in the world, the United States, the
   typical person or family has seen little or no benefit from economic growth since the
   1970s. But over the same period inequality has risen sharply.
3. Happiness should be the grand aim of policy. But the evidence is that, above a certain level, a higher material standard of living does not make people any happier. ...
4. Even if higher GDP were a good idea on other grounds, it’s not feasible because the
   environmental damage would be too great.

Oulton then addresses each question, not attempting any kind of exhaustive review, but by providing a selective sampling of the arguments and evidence. Here are some of  his answers, mixed with my own.

1. GDP is flawed as a measure of welfare. 


 Yes, GDP leaves out a lot that matters, and a lot that should matter. There's no surprise in this: Every intro econ textbook for decades has taught this point. My favorite quotation on this point from a 1968 speech by Robert Kennedy.

 Oulton makes the useful distinction that GDP is a measure of output that is not and was never intended to be a measure of welfare, but that per capita GDP is clearly a component of welfare--that is, when one makes a list of all the factors that benefit people, a higher level of consumption of a wide range of goods and services is an item on that list. In addition, per capita GDP is a broader indicator of welfare because looking around the world, GDP is clearly broadly correlated with health, education, democracy, and the rule of law.

For thinking about social welfare, it is often useful to look at statistics other than GDP. For example, here's one of my earlier posts about economists attempting to estimate "Household Production: Levels and Trends."

My own favorite comment on this point is from a 1986 essay by Robert Solow ("James Meade at Eighty," Economic Journal,December 1986, 986-988), where he wrote: "Ifyou have to be obsessed by something, maximizing real National Income is not abad choice." At least to me, the clear implication is that it's perhaps better not to be obsessed by one number, and instead to cultivate a broader and multidimensional perspective. But yes, if you need to pick one number, real per capita GDP isn't a bad choice. To put it another way, a high or rising GDP certainly doesn't assure a high level of social welfare, but it makes it easier to accomplish those goals than a low and falling GDP.
2) GDP ignores distribution. 

Yes, it does. Again, GDP is a measure of output, not of everything that can and should matter in thinking about society. I've often noted on this website that inequality of wages and household incomes has been rising in recent decades, and that I believe this trend is a genuine problem.

But even though high and rising inequality is (I believe) a problem, that doesn't mean that high or rising GDP is the cause of the problem It's not at all clear that being in an economy with a higher level of GDP leads to more inequality. From a global perspective, many economies with the greatest level of inequality are in Latin America or in Africa. Many high-income countries in western Europe have much greater equality of incomes than the U.S. economy. Periods of rapid economic growth in the U.S. economy--say, back in much of the 1950s and the 1960s--were not associated with rising inequality.

Oulton writes: "Inequality concerns are real but there is still a case in my view for separating questions of growth from questions of distribution." In my own mind, this analytical distinction started in earnest (although I'm sure there were predecessors) with John Stuart Mill's classic 1848 text, Principles of Political Economy, where the first major section of the book is about "Production" and the second major section is about "Distribution." In Mill's "Autobiography," he writes that  he came to appreciate this distinction, and indeed to view it as one of the central distinguishing features of his book, as a result of discussions with his wife, Harriet Taylor Mill. Mill wrote:

"The purely scientific part of the Political Economy I did not learn from her; but it was chiefly her influence that gave to the book that general tone by which it is distinguished from all previous expositions of political economy that had any pretension to being scientific.... This tone consisted chiefly in making the proper distinction between the laws of the Production of wealth—which are real laws of nature, dependent on the properties of objects—and the modes of its Distribution, which, subject to certain conditions, depend on human will."


3) Happiness should be the grand aim of policy. 

The question here, of course, is how "happiness" is judged. It's true that on surveys which ask people to rank how happy they are on a scale from 1-10, the happiness level of people in high-income countries isn't much higher than a few decades ago. There is an ongoing argument over how to interpret these results. Is happiness really "positional"--that is, I judge my happiness relative to others at the same time, and so if everyone has more consumption, happiness doesn't rise? Are these kinds of survey results an artefact of the survey itself: that is, someone who answers that they are "7" on the happiness scale in 2010 isn't saying that they would also be a "7" on the happiness scale if they had a 1970 level of income. Here's a post from last May on the connections from economic growth to survey questions about happiness, with some emphasis on how it applies in China.

My sense is that most people actually get a lot of happiness from the goods and services of a modern economy, and they would not be equally happy if those goods and services were unavailable. Oulton makes an interesting argument here that there is a battle between process innovation and product innovation.  If both process innovation and product innovation rise together, then people have higher productivity and incomes, and happily spend those incomes on the new products that are available. If process innovation rises quickly, but product innovation does not, then people would have higher productivity and incomes, but nothing extra to spend them on--and thus might opt for much more leisure. Oulton has a nice thought experiment here:

"Imagine that over the 220 or so years since the Industrial Revolution began in Britain process innovation has taken place at the historically observed rate but that there has been no product innovation in consumer goods (though I allow product innovation in capital goods). UK GDP per capita has risen by a factor of about 12 since 1800. So people today would have potentially vastly higher incomes than they did then. But they can only spend these incomes on the consumer goods and services that were available in 1800. In those days most consumer expenditure was on food (at least 60% of the typical family budget), heat (wood or coal), lighting (candles) and clothing (mostly made from wool or leather). Luxuries like horse-drawn carriages were available to the rich and would now in this imaginary world be available to everyone. But there would be no cars, refrigerators, washing machines or dishwashers, no radio, cinema, TV or Internet, no rail or air travel, and no modern health care (e.g. no antibiotics or antiseptics). How many hours a week, how many weeks a year and how many years out of the expected lifetime would the average person be willing to work? My guess is that in this imaginary world people would work a lot less and take a lot more leisure than do real people today. After all, most consumer expenditure nowadays goes on products which were not available in 1800 and a lot on products not invented even by 1950."

Of course, over the last century or so workweeks have gotten considerably shorter, and in that sense, people have chosen to take some of the rewards of process innovation in the form of more leisure. But most people prefer to follow a path where they can earn sufficient income to enjoy the results of product innovation. As I like to point out, the modern economy offers a fair amount of freedom in terms of work choices.  Throughout their lives, people often have a choice about whether they will choose to follow a job path that is less demanding in time and energy, but also provides lower income. Some people seek out such choices, but most do not.


4) GDP and the costs of environmental damage. 

Oulton quotes from a 2012 Royal Society report that is concerned about overpopulation and a sustainable environment. He writes: "In its preferred scenario GDP per capita is equalised across the world at $20,000 in 2005 PPP terms by 2050 (Report, page 81). The UK’s GDP per capita in 2005 was $31,580 in 2005 PPPs so this would imply a 37% cut. When they think about economic growth natural scientists tend to think about biological processes, say the growth of bacteria in a Petri dish. Seed the dish with a few bacteria and what follows looks like exponential growth for a while. But eventually as the bacteria cover most of the dish growth slows down. When the dish is completely covered growth stops. End of story."

 Of course, the world economy isn't a petri dish, and people aren't bacteria. Economist have been drawing up models of economic growth with fixed amounts of land or minerals, or where economic activities emit pollution, for some decades now. Oulton summarizes the basic lesson: "These models all have in common the result that perpetual exponential growth is possible provided that technical progress is sufficiently rapid."

In other words, it's certainly possible to draw up a disaster scenario where resource or environmental limitations lead to grief at a global level. It's also possible that with a combination of investments in technology and human capital, economic growth can at least for a considerable time overcome such limitations. For an example of analysis along these lines, the United Nations has put out the first of what is intended to be a series of reports on how changes in different types of capital can offset each other (or not), which I posted about in "Sustainability and the Inclusive Wealth of Nations."

As Oulton notes, the practical question here is not whether resource and environment limits must eventually bind at some distant point in the future, "but only whether it makes sense to advocate growth over the next 5, 10, 25, 50 or 100 years." 

In the U.S. economy, 15% of the population is below what we call the "poverty line," and their life prospects are diminished as a result. About 2.5 billion people in the world live on less than $2/day. 
 I do not see a practical way of raising the standard of living for these people, or for their children, unless rising GDP plays a central role.

Are CEO's Overpaid?

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Are CEO's Overpaid? I confess that my knee-jerk answer to this question is "YES"! But Steve Kaplan makes a strong case for a more nuanced answer in Executive Compensation and Corporate Governance in the U.S.: Perceptions, Facts and Challenges," published in July as Chicago Booth working paper 12-42. Here's a sketch of some of  his arguments and graphs.

 First, just as a matter of getting the facts straight, CEO pay relative to household income did spike back in the go-go days of the dot-com boom in the late 1990s, but since then, it is relatively lower. Kaplan argues that there are two valid ways to measure executive pay. One measure looks at actual pay received, which he argues is useful for seeing whether top executives are paid for performance. The other measure looks at "estimated" pay, which is the amount that financial pay packages would have been expected to be worth at the time were granted. This calculation requires putting a value on stock options, restricted stock grants, and the like, and estimating what these were worth at the time the pay package was given. Kaplan argues that this measure is the appropriate one for looking at what corporate boards meant to do when they agreed on a compensation package.

Here's one figure showing actual average and median pay totals for S&P 500 CEOs from 1993 to 2010. Average pay is above median pay, which tells you that there are some very high-paid execs at the top pulling up the average.  Also, average CEO pay spikes when the stock market is high, as in 2000 and around 2006 an  2007. Median realized pay seems to have crept up over time. 
Here's a figure showing estimated pay--that is, the value of the pay packages when they were granted. But this time, instead of showing dollar amounts, this graph shows average and median CEO pay as a multiple of median household income. Average pay again spikes at the time of the dot-com boom. Kaplan emphasizes that estimated CEO pay is on average lower than in 2000 and that the median hasn't risen much. My eye is drawn to the fact that median pay for CEOs goes from something like 60 times median household income back in 1993 to about 170 times median household income by 2010.

An obvious question is whether these pay levels are distinctive for CEOs, or whether they are just one manifestation of widening income inequality across a range of highly-paid occupations. Kaplan makes a solid case that it is the latter. For example, here's a graph showing the average pay of the top 0.1% of the income distribution compared with the average pay of a large company CEO.Again, the story is that CEO pay really did spike in the 1990s, but by this measure, CEO pay relative to the top 0.1% is now back to the levels common in the the 1950s.

  

Kaplan also points out that the pay of those at the top of other highly-paid occupations has grown dramatically as well, like lawyers, athletes, and hedge fund managers. Here's a figure showing the pay of top hedge fund managers relative to that of CEOs in the last decade. Kaplan writes: "The top 25 hedge fund managers as a group regularly earn more than all 500 CEOs in the S&P 500. In other words, while public company CEOs are highly paid, other groups with similar backgrounds and talents have done at least equally well over the last fifteen years to twenty years. If one uses evidence of higher CEO pay as evidence of managerial power or capture, one must also explain why the other professional groups have had a similar or even higher growth in pay. A more natural interpretation is that the market for talent has driven a meaningful portion of the increase in pay at the top."   

Kaplan also compiles evidence that CEOs of companies with better stock market performance tend to be paid more than those with poor stock market performance, and that CEOs have shorter job tenures. He writes: Turnover levels since 1998 have been higher than in work that has studied previous periods. In any given year, one out of 6 Fortune 500 CEOs lose their jobs. This compares to one out of 10 in the 1970s. CEOs can expect to be CEOs for less time than in the past. If these declines in expected CEO tenures since 1998 are factored in, the effective decline in CEO pay since then is larger than reported above."And the CEO turnover is related to poor firm stock performance ..."

To me, Kaplan makes a couple of especially persuasive points: the run-up in CEO salaries was especially extreme during the 1990s, and less  so since then (depending on how you measure it); and the run-up in CEO salaries reflects the rise in inequality across a wider swath of professions. While I believe the arguments that job tenure can be shorter for the modern CEO, especially if a company isn't performing well, it seems to me that most former CEO's don't plummet too many percentiles down the income distribution in their next job, so my sympathy for them is rather limited on that point.

In this paper, Kaplan doesn't seek to address the deeper question of why the pay for those at the very top, CEOs included, has risen so dramatically.  While the demand for skills at the very top of the income distribution is surely part of the answer, I find it hard to believe that these rewards for skill increased so sharply in the 1990s--just coincidentally during a stock market boom. It seems likely to me that
  cozy institutional arrangements for many of those at the very top of the income distribution--CEOs, hedge fund managers, lawyers, and athletes and entertainers--also plays an important role.  

Labor's Smaller Share

To contact us Click HERE
Margaret Jacobson and Filippo Occhino have been investigating the fact that labor has been receiving a declining share of total economic output over the last few decades. I posted on their work last February in "Labor's Declining Share of Total Income."  Now they have written "Labor’s Declining Share of Income and Rising Inequality," which is "Economic Commentary" 2012-13 published by the Federal Reserve Bank of Cleveland.


The starting point is to look at labor income relative to the size of the economy. The top line in the figure shows labor income as a share of GDP, as measured in the national income and product accounts from the U.S. Bureau of Economic Analysis. The lower line in the figure shows the ratio of compensation to output for the nonfarm business sector, as measured by the U.S. Bureau of Labor Statistics. The measures are not identical, nor would one expect them to be, but they show the same trend: that is, with some ups and downs as the economy has fluctuated, the labor share of income has been falling for decades, and is now at an historically low figure.

 This fact lies behind much of the rise in inequality of incomes over this time. The income that is not being earned by labor is being earned by capital--and capital income is much more concentrated than is labor income. Jacobsen and Occhino offer an intriguing figure that measures the inequality of labor income and the inequality of capital income. The measure used here is a Gini coefficient, which "ranges between 0 and 1, with 0 indicating an equal distribution of income and 1 indicating unequal income." (Here's an earlier post with an explanation of Gini coefficients.)
The figure has two main takeaways. First, labor income has become more unequally distributed over time, but since the early 1990s, the big shift in income inequality is because capital income is more unequally distributed. Second, capital income tends to rise during booms and to fall in recessions. Thus, it seems plausible that the inequality of capital income has dropped in the last few years of the Great Recession and its aftermath, but will rise again as economic growth recovers.

What has caused the long-run decline of the labor share of income? Jacobson and Occhino explain this way: "[W]e begin by looking at what determines the labor share in the long run. The main factor is the technology available to produce goods and services. In competitive markets, labor and
capital are compensated in proportion to their marginal contribution to production, so the most important factor behind the labor and capital shares is the marginal productivities of labor and capital, which are determined by technology. In fact, one important cause of the post-1980 long-run decline in the labor share was a technological change, connected with advances in information and
communication technologies, which made capital more productive relative to labor, and raised the return to capital relative to labor compensation. Other factors that have played a role in the long-run decline in the labor share are increased globalization and trade openness, as well as changes in
labor market institutions and policies."

There is no particular reason to believe that these trends will continue--or that they won't. But the declining share of income going to labor suggests the importance of finding ways to increase the marginal product of labor, especially for workers of low and medium skills, perhaps by focusing on the kind of training and networking that might help them make greater use of the advances in information and communication technology to improve their own productivity.

What's Up With the Dodd-Frank Legislation?

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Back in July 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. The difficulty with the law has always been that while it was fairly clear on its goals, it did not specify how to reach those goals--instead turning over that task to current and newly-created regulatory agencies.  If you're looking for an update on how the law is proceeding, a good starting point is the Third Quarter 2012 issue of Economic Perspectives, published by the Federal Reserve Bank of Chicago, which has six articles on the Dodd-Frank legislation.

Douglas D. Evanoff and William F. Moeller offer an overview of the goals and approach of the law in their opening piece (footnotes and citations omitted):

"The stated goals of the act were to provide for financial regulatory reform, to protect consumers
and investors, to put an end to too-big-to-fail, to regulate the over-the-counter (OTC) derivatives markets, to prevent another financial crisis, and for other purposes. ... Implementation of Dodd–Frank requires the development of some 250 new regulatory rules and various mandated studies. There is also the need to introduce and staff a number of new entities (bureaus, offices, and councils) with responsibility to study, evaluate, and  promote consumer protection and financial stability. Additionally, there is a mandate for regulators to identify and increase regulatory scrutiny of systemically important institutions.  ... Two years into the implementation of the act, much has been done, but much remains to be done."

How are those rules coming along? The law firm of Davis Polk & Wardwell publishes a regular Dodd-Frank report. The September 2012 edition summarizes:

• "As of September 4, 2012, a total of 237 Dodd-Frank rulemaking requirement deadlines have
  passed. This is 59.5% of the 398 total rulemaking requirements, and 84.6% of the 280
  rulemaking requirements with specified deadlines.
• "Of these 237 passed deadlines, 145 (61.2%) have been missed and 92 (38.8%) have been
  met with finalized rules. Regulators have not yet released proposals for 31 of the 145 missed
  rules.
• "Of the 398 total rulemaking requirements, 131 (32.9%) have been met with finalized rules and
  rules have been proposed that would meet 135 (33.9%) more. Rules have not yet been
  proposed to meet 132 (33.2%) rulemaking requirements.

The July 2010 Davis Polk update--the two-year anniversary of the legislation--offers some additional detail: "The two years since Dodd-Frank’s passage have seen 848 pages of statutory text expand to 8,843 pages of regulations. Already at almost a 1:10 page ratio, this staggering number represents
only 30% of required rulemaking contained within Dodd-Frank, affecting every area of the financial markets and involving over a dozen Federal agencies."

It's important to  recognize that writing a new regulation isn't as simple as, well, just writing it. Instead, there is often first an in-house study, followed by a draft regulation, which then is open to public comments, and then can revised, and eventually at some point a new regulation is created. It's not unusual for a regulation to get dozens or hundreds of detailed public comments.

This blizzard of evolving rules has to create considerable uncertainty in the financial sector. Matthew Richardson discusses the complexities of one particular issue in his contribution to the Chicago Fed publication. He picks one example: the problem that many banks made very low-quality subprime mortgage loans. What does the Dodd-Frank legislation do about this basic issue? As he describes, the act: 1) Sets up a Consumer Finance Protection Bureau in title X to deal with misleading products; 2)
Imposes particular underwriting standards for residential mortgages; 3) Requires firms performing securitization to retain at least 5 percent of the credit risk; and 4) Iincreases regulation of credit rating agencies. Each of these tasks requires detailed rulemaking. And as Richardson points out, "with all of these new provisions, the act does not even address what we at NYU Stern consider to be a primary fault for the poor quality of loans—namely, the mispriced government guarantees in the system that led to price distortions and an excessive buildup of leverage and risky credit."

I'm skeptical of anyone who has strong opinions about the Dodd-Frank legislation, because here we are more than two years later, less than halfway toward figuring out what rules the legislation will actually put in place. Wayne A. Abernethy of the American Bankers Association is one of the authors in the Chicago Fed symposium. Yes, he is speaking for the bankers' point of view. But his judgement about the overall process seems fair to me:

"At least in the financial regulatory history of the United States, there has never been anything like it. I have seen no definitive count of the number of regulations that the Dodd–Frank Act calls forth. The numbers seem to range between 250 and 400—numbers so large that they are numbing. It all defies hyperbole. The Fair and Accurate Credit Transactions Act, adopted in 2003, astonished the financial industry with more than a dozen significant new regulations to be written. ...

"One of the most common criticisms of Dodd–Frank implementation has been a lack of order and coordination in the regulatory process. Instead, the Dodd–Frank Act has succeeded in replacing the financial crisis with a regulatory crisis.  ... As agencies are grappling with impossible rulemaking tasks, most of them are also engaged in major structural reorganizations and shifts in the areas of responsibility. ... Nothing like this has ever been tried before in the history of the United States. Writing 400 financial regulations of the highest significance and the greatest complexity in a couple of years has clearly been too much to expect. ... Getting on with the work to end our self-inflicted regulatory crisis should be among the highest priorities."

 I'm someone who believes that financial regulation needed shaking up. Many of the broad goals of the Dodd-Frank legislation make sense to me: rethinking bank and regulation to deal with macroeconomic risk, not just the risk of an individual institution going broke; figuring out better ways to shut down even large financial institutions when needed; and better regulation of certain financial instruments like credit default swaps and repo agreements; a closer look at technologies that allow ultra-high-speed financial trading; and others.

The Dodd-Frank legislation is almost not a law in the conventional meaning of the term, because it mostly isn't about actual specific activities that are prohibited. Instead, it's about handing over the difficult problems to regulators and telling them to fix it. I'm not sure there was an easy alternative to this regulatory approach: the idea of Congress trying to debate, say, appropriate regulation of the over-the-counter swaps market is not an encouraging thought. But stating a goal is not the same as solving a problem. The passage of Dodd-Frank, in and of  itself, didn't solve any problems.