Irrationality in the boardroom

Here’s the finding of a new study of German firms:

Managerial overconfidence is positively related to the probability of failure of planned investment projects.

This corroborates a decent amount of research summed up (pdf) by Ulrike Malmendier:

A large and growing body of evidence suggests that a substantial share of top corporate executives exhibit symptoms of overconfidence in their decisions…Even when managers intend to maximize claimholder value, they can fail to do so because they hold overconfident beliefs.

For example, she shows (pdf) that where bosses are overconfident, firms’ capital spending is unduly sensitive to corporate cash flow: they invest when the firm is flush but not when it isn’t. And Charles Lee and Salman Arif have shown that increases in investment tend to lead to more earnings disappointments and lower growth – which suggests that investment decisions are motivated by sentiment rather than a realistic assessment of potential projects.

You might say that this merely vindicates Keynes’ point that investment is driven by animal spirits. Only partly. His point was that the future was unknowable and so firms had to rely upon animal spirits. This research, however, shows that such spirits are systematically mistaken – which goes beyond Keynes’ point.

This is by no means the only evidence we have. There’s also groupthink in boardrooms, which has contributed to corporate scandals. Bosses can be narcissists and psychopaths, with adverse effects on corporate performance. Richard Roll famously pointed out 31 years ago that takeovers were often motivated by hubris (pdf): RBS’s takeover of ABN Amro, which was one of the most expensive mistakes in British economic history, fits this pattern. And banks took excessive risks in the mid-00s, which led to the financial crisis.  

What we have here, therefore, is abundant evidence that bosses are irrational, and this irrationality is costly for shareholders and the wider economy.

Jeremy Corbyn’s call for a maximum income does not address this. The problem is not just that bosses have too much money, but that they have too much power, which they misuse.

This fact, however, is almost completely effaced from political discourse. The nudge agenda focuses far more upon low-level individual irrationalities than upon boardroom ones; bosses are routinely portrayed in the media as disinterested experts and even heroes rather than biased rent-seekers; and debate about Brexit has stolen almost all the cognitive bandwidth that should be devoted to other matters.

In these ways, politics and the media serve the function of sustaining unjust and inefficient inequalities.

Comments

[acarraro]

It seems pretty pointless to enact a maximum wage policy if I must say. Most stock is owned by the wealthy. I see no reason why lower management income should flow to employees rather than shareholders. You are just moving money from one bunch of rich people to another bunch. Does it really matter?

Plus maximum wages would hit footballers and actors as much as CEOs (or possibly even more), would that really be politically popular?

[Luis Enrique]

I think there has to be more to it than "increases in investment" lead to lower growth, unless the marginal return to capital is negative and we need investment/GDP to fall. Some sort of threshold effect whereby high investment tends to be low quality investment, but on average more investment still good because on average investment is reasonably quality, or something.

I think I agree the underlying problem is organizational structure that gives fallible individuals too much power. Just thinking on the economics of CEO salaries, what would theory predict about wages paid to a group of workers with the following characteristics:

1. one of these workers must be hired (i.e you must have a CEO)
2. average productivity is low (let's say zero)
3. the returns moving from a below average to above average ability is very large (i.e. average is zero but distribution is wide)
4. you have almost zero ex-ante ability to observe ability

would you expect wages to be low, reflecting low average productivity, or high, reflecting gains from recruiting and retaining above average ability workers (CEOs)?

[e]

But Corbyn's audience isn't as knowing as you are Chris. Those that might be have surely already picked their side and are shouting from the sidelines. Is it not sensible for a Labour politician to take an incremental 'populist' approach to these things. He is after all democratically constrained. And with respect to the meat of the issue, damaging power relationships, clearly he isn't effacing the evidence, quite the opposite.

[odeboyz]

Corbyn should worry about the wages that his core(?) are actually getting rather than an elision on the politics of envy.

[aragon]

Full Disclosure: I have advocated in the past and support the policy, of a maximum wage.

It seems an obvious counter part to a minimum wage. CEO's have too uch power and this is expressed.

Whatever the distribution of talents there is a limit to the deviation and therefore the reward.

If CEO's have too much power, then rent seeking (wages) is one aspect of this.

If you use a ratio to the minimum wage, then raising the minimum wage would allow the maximum to be increased by the multiple.

Footballers and actors extract rents from copyright.

The policy is simple to understand and shows concern for the low level of average or minimum wages so provides a political message. It is a shame he has withdrawn from the proposal.

https://www.theguardian.com/commentisfree/2017/jan/10/jeremy-corbyn-pay-ratio-wage-equality-reprieve

http://www.independent.co.uk/news/uk/politics/jeremy-corbyn-wage-caps-u-turn-labour-party-leader-populist-relaunch-climbdown-a7520101.html

http://onlinelibrary.wiley.com/doi/10.1002/smj.2504/abstract

CEO's are important because shareholders think they are important.

Friedman was wrong returns to shareholders are not the only thing that matters. This is about the kind of society you wish to live in.

Shareholders are not the only stakeholders and possibly the least important. Mandating all companies to be co-op's could be problematic.

As for avoidance I have a cunning plan or two make that three).

[Mark Evens]

I think this discussion has touched on an important point that gets little attention in the politics of today, namely what is an appropriate corporate governance model for the complex world we (and companies) live in? Admittedly there has been some political discussion about worker representatives on boards, but that is only part of the matter. Most large corporates (and almost all the global ones) do not have a governance structure that properly takes into account the wide scale of their impacts on society (and the planet) or the breadth of their stakeholders. A model in which management are only accountable to shareholders (if that) cannot hope to achieve a result which society considers appropriate. Arbitrary caps and ratios would be sticking plaster at best. Maybe there is some good research somewhere on corporate governance models that achieve sustainability (social and environmental, as well as financial), but I am not aware of it. There has been a good deal published on the measurement of "multi-capital" performance, but the companies which attempt to practise it do so usually because of enlightened individual managers, not because they have a governance structure that encourages it.
Such a model would need to be flexible to suit the circumstances - what is appropriate for a global bank is not right for a small business. Indeed, to return to the point about CEO pay, I have no problem with entrepreneurs who risk their own money taking commensurate rewards for their success, but I do have a big problem with managers being overpaid to take huge risks with other people's money (or worse).

[gastro george]

"The problem is not just that bosses have too much money, but that they have too much power ..."

This. The problem is always power. Money may be *one* way to exert power, but it's always power.