Diamonds or fool's gold?

Are the rich diamonds or are they fool's gold? I ask because of something Tim says. He responds to George Monbiot's complaint that:

There is an inverse relationship between utility and reward. The most lucrative, prestigious jobs tend to cause the greatest harm. The most useful workers tend to be paid least and treated worst.

This, says Tim, is just an example of the old diamond-water paradox. Diamonds (usually) have a higher price than water because they have a higher marginal utility and are scarcer than water.

This, however, obscures a vital question: what exactly is the source of the high marginal utility of people on mega-salaries to their employers? Is it because such people are genuinely useful, or is it because they are lucky but useless? Hence my question: are they diamonds or fool's gold?

First, we should distinguish between social and private utility. A CEO, for example, might be tremendously useful to his shareholders but not to society if he increases profits by creating externalities - if, for example, a mining company destroys the local environment.

An important set of cases here is risk pollution. Banks, for example, make money for their senior staff (if only rarely shareholders) by taking on extra risk in the knowledge that, if things turn bad, taxpayers will partly bear these risks. Banks, in effect, get a massive subsidy from the taxpayer.

Secondly, perceived marginal utility, and hence demand, is in part an ideological construct. Imagine a society in which remuneration committees thought: "Corporate growth is largely random and bosses have very little foresight into how their strategies will work. There's no point therefore paying CEOs millions. All we need is a competent administrator paid a respectable professional salary." And imagine this belief coexisted with the idea that people must have dignity in old age and that only a few care workers (to take George's example) have the personal skills to enhance that dignity. In such a world, care workers would be more highly prized. Wage differentials between the CEO and care worker would thus be modest.

What's more, there can be lower-level market failures which create big demand and hence high salaries even for failures:

 - Werner Troesken has shown that demand for quack (pdf) remedies in the 19th and early 20th centuries was strong. He says: "Patent medicines proliferated and flourished not despite their dubious medicinal qualities, but because of them”. One reason for this was that quacks invested massively in product differentiation. The failure of one remedy did not therefore discredit the industry but merely shifted demand towards others. I suspect the same thing is true for CEOs and for fund managers: under-performance by one (or many) merely leads to a search for the superstar who can succeed.

 - Marko Tervio has shown that what employers want is not talent but proven talent. This, he says, serves to greatly limit the supply of suitable workers, with the result that mediocrities with some kind of track reord get big money: film stars or CEOs fit this model.

 - Bjorn-Christopher Witte shows how competition between fund managers can sometimes encourage reckless risk-taking with the result that lucky chancers will thrive. For example, in the early 00s bankers who danced to the music and took risks got big bonuses whilst those who sat it out got sacked. And during the tech bubble money flowed to those managers who thought boo.com and Baltimore Technologies were good stocks, whilst sceptical fund managers such as Tony Dye were fired.

 - Hedge fund managers can, in normal times, generate good returns and fees merely by artlessly taking on tail risk - as in Andrew Lo's example (pdf) of Capital Decimation Partners. In fact, non-financial bosses can also "succeed" by taking tail risk - for example by under-investing in R&D, IT or maintenance.

My point here is a simple one. Appealing to demand or marginal utility does not suffice to explain or justify high salaries. Instead, we must ask: what is the source of that marginal utility? Once we ask this, we can see that George's claim that many of them are in fact parasitic kleptocrats might be more consistent with orthodox economics than Tim (or indeed George) appreciates.

Comments

[Luke]

I thought the point of paying bosses lots was to stop them looting the company. (I take no credit for that idea, as I definitely did not think of it and probably read it here.)

And that justifies paying more to the boss of a large company, just as it's more expensive to insure a bigger house. Directors and Officers insurance is (I think) particularly expensive for banks and finance companies. Those are also well paid jobs. Does variation in bosses' pay reflect the ease (and cost) of looting different businesses, as reflected in higher D&O premiums?

[Carol]

Luke, if the high salaries are to prevent looting by the bosses, then maybe there should be no bosses, since their real utility is nil,and probably negative.

[Brett]

Most of what CEOs and management do is invisible to people outside of the company, with it only becoming visible when they screw things up on a massive scale. Even success tends to be invisible - you just see the profits or well-managed company.

Contrast that with non-management employees. What a cashier, or a janitor, or many civil servants do is extremely visible, including the utility of it.

[Oakchair]

The USSR showed that more hierarchy, centralization, and management can fail. Turns out having a select few people making all the decisions for the many in most cases does not work out. So the question is how do we eliminate the bad qualities of those things in smaller units such as corporations. I'd say more unionization, worker control and more worker input in decisions is a step towards the right direction.

[Luis Enrique]

I think the proven talent thing is very important, it is what limits the supply to look more like diamonds than water. And I think it's a mistake - too much weight is placed on prior experience.

But on the value side, suppose the average CEO is only slightly more capable than the average manager. In that case it would be really hard to see their ability, and yet in expectation terms it would be 'worth' paying them a lot simply because when are are in charge of $$$bn enterprises then slightly less bad decisions than the alternative are worth a lot.

before shit for brains turns up to accuse me of shilling for capitalism again, just does not justify the system it merely, I think, helps explains what happens in the system.

[Socialism in One Bedroom]

In the city of London the banks and financial institutions paid lots of money to entice the best mathematical brains to their company, in the belief that the models they devised would make them a sack load of money. Turns out that the models of these 'high achievers' bankrupted the whole system and nearly brought it to its knees.

Has this changed the way banks view talent?

Not at all, because it is fundamentally ingrained in how the system operates, not only with people living off the backs of others (the old boys network) but also with competition.

There was a statistic that showed France had twice the number of doctors as Britain but the total cost was the same. This shows that their are no economic laws behind this but cultural/political and ideological human conscious activity. Conscious human activity is also the solution to this problem.

There are many a well paid hard working accountant who does nothing but thinking u p ways of defrauding the tax payer and ensuring their client gets another yacht to water ski behind. Utility is the least of the issue here.

I would expect managerial roles to be remunerated slightly better than their workers, in Mondragin it is around 6:1 between highest and lowest paid, this is a fair reflection. When that ratio becomes 100/1 or 200/1 or 50/1 and when 1% of the worlds population owns over 50% of global wealth we ain't in the land of marginal utility and scarcity but systematic thievery. We live in a kleptocracy.

[Luke]

Luis,

"before shit for brains turns up to accuse me of shilling for capitalism"

Isn't that a nice change from being called a communist on Tim Worstall's blog?

[An Alien Visitor]

Luis Enrique, that computer generated apologist of capitalism, tells us how knowledgeable he is but he plays all dumb when a piece of simple knowledge contradicts something he says. For example he was unaware that financial deregulation debates of the 1980's. He his Mr shit for brains when his programming calls for it.

He reminds me of Rebekah Brooks and other such high level managers who when faced with questioning about endemic cultural and illegal practices within the corporation they are meant to be managing night and day play all stupid and clam they didn't know anything about it! They are probably telling the truth and simply revealing their general uselessness.

[Ironman]

Luis, you don't know your born if 'shit for brains' is the worst iy gets on this blog.

[Luis Enrique]

Hang on minute, am I tactically feigning ignorance or inadvertently revealing that I am not in fact omniscient? (Generally useless)

I think when these debates about financial deregulation were taking place, I was busy suffering embarrassment at school discos and experimenting with ill advised haircuts.

Actually, true fact, I won the disco dancing prize at my primary school two years in a row. Where did I go wrong.

Luke, yes I am otherwise employed as an apologist for stalinism.

Chris sorry for polluting your blog with this nonsense I shall put an end to it.

[An Alien Visitor]

In the case of financial deregulation I think you just made up anything that suited your apologism, so you built up a straw man. While you were probably not aware of the intricacies of the debates you simply took the plunge and assumed there wouldn't have been any, because that suited your apologism at that moment in time. You made a positive statement that claimed to be true, which you must have known you were guessing at, which turned out to be positively false and luckily I was around to say so.

So you remind me of Rebekah Brooks, who told us how she burnt the midnight oil and was worth the shitloads of cash she got but then revealed she actually knew nothing beyond where the best restaurants were, because like her type you say whatever seems convenient at the time.