Can demographics explain why the income shares of high earners have increased?

The increasing concentration of incomes among a small number of high earners has been documented at length here ([1], [2], [3]) and elsewhere. Any sensible response to this development has to be based on at least a partial understanding of how and why this trend began - and we still don't have a theory that seems strong enough to use as a basis for policy.

Here is a story that makes sense to me. Then again, I may be putting one and one together and getting eleven.

The two points I'm mashing together are the following:

1) The hypothesis that the sharp rise in executive compensation was driven by an equally sharp rise in firm values. This study (pdf) concludes that "[t]he sixfold increase of CEO pay between 1980 and 2003 can be fully attributed to the six-fold increase in market capitalization of large US companies during that period." According to this story, the increase in high-earner wages isn't a problem that needs solving: CEOs are being paid their marginal product.

2) The hypothesis that the sharp rise in equity prices was driven by demographics. The story we'd tell here is that as the leading edge of the baby boom reached the age of 40 or so, the demand for financial assets increased, driving up firm values. (See here for a theoretical model that develops the point.) The timing certainly fits: the rise in asset prices began in 1985.

So the claim is that demographic pressures are behind the underlying cause of the increasing concentration of income in the right-hand tail of the income distribution. Clearly, the timing fits this story. The beginning of both the asset price boom and the trend to higher top-end salaries occurred when baby boomers started saving/investing.

As far as policy goes, this is very much a story in which those high executive salaries are best thought of as rents: those CEOs just happened to be at the right place at the right time.

But what happens now as the baby boom ages out of the work force? According to  the second story, the wave of dissaving by retirees would provide downward pressure on asset values. Apparently this has led to talk of an asset price meltdown, but it seems more likely that the decline will be modest. Either way, this conjecture would predict that the trend to high incomes should level off as asset prices reach their plateau. And as asset prices stagnate, shareholders may start asking why they are playing high wages to people who are producing mediocre returns.

There's another point to consider: the fact that high-income concentration is largely a phenomenon of English-speaking countries. The explanation for this would be a claim that the baby boom was more pronounced in the Anglosphere combined with a claim that there is an Anglosphere investor home bias. I don't think either of these claims is clearly wrong, but I'm not sure they are strong enough to explain why we don't see high-income concentration in countries that don't speak English.

I don't recall seeing this conjecture before, so if you are aware of work that has been done on this point, please let me know in the comments.

Comments

[Nick Rowe]

I'm sympathetic to the main focus of your argument -- on demographics. I think (not 100% sure) that current global demographics are historically unprecedented. And (as some of your previous posts showed) the trends in income distribution seem to be showing up across countries.

At the simplest, though, demographics would just lower real interest rates. They would leave the flow of profits unchanged, but simply increase the equilibrium P/E ratio. Assuming this simplest story is the correct one, the flow VMP of a good CEO is unchanged. The capitalised value of that flow VMP would increase, however.

So, (again assuming I am correct so far), there should be no affect on flow salaries. But would there be an effect if the flow VMP of a good CEO outlasted the term in office of that CEO, and they were paid the capitalised value of that flow VMP in stock options??? (My brain has given up at this point).

[Nick Rowe]

Hang on. My brain may be working again. Are CEOs an investment good? Because if demographics lower equilibrium real interest rates, and raise equilibrium P/E ratios, demographics will raise the equilibrium relative price of investment goods to consumption goods, if those investment goods are in relatively inelastic supply. In much the same way demographics will raise land prices.

[Nick Rowe]

Assume there are two sorts of jobs. In both types of jobs, a good worker will have a VMP bigger than a bad worker.

In "consumption jobs", a good worker employed for 1 year increases revenue by $X for 1 year, more than a bad worker. So will earn an extra $X per year over a bad worker.

In "investment jobs", a good worker employed for 1 year increases revenue by $Z forever, more than a bad worker. So will earn an extra $Z/r per year over a bad worker.

If CEOs are investment jobs, and demographics cause r to fall, demographics will increase the earnings of superstars.

[JKH]

Equity compensation (stock options, restricted shares, etc.) only started in earnest 20 years ago, in terms of wider corporate executive distribution. There was relatively little before that, except for the extreme top of the pyramid, perhaps. Most high end compensation has been equity compensation for all of this period. Think of that as a gross addition to rather than a substitute for salary trends up until then.

Leveraged by your points perhaps.

[Frances Woolley]

Stephen - "high-income concentration is largely a phenomenon of English-speaking countries."

If you were to compare income inequality in 1970 in the former Warsaw Pact (i.e. USSR+Eastern Europe) countries with income inequality in the same region today, you would see a staggering increase. China has gone up and down a bit, but again, similar phenomenon. It's hard to do precisely because the Soviet-era data is poor, but the general trend is clear.

" it seems more likely that the decline [in asset prices] will be modest"

Since someone - I think K - mentioned this phenomenon on the blog, I've been watching the prices for silver plate. At our most recent neighbourhood garage sale, silver plate reached a price of zero. I kid you not. I found a very nice silver plate bowl sitting outside someone's house with a sign saying "free" and took it home. So although some asset prices may decline modestly, others may decline more sharply.

I think demographics could be part of the story, but I think a lot has to do with technological change as well. Do you remember the days when supermarket cashiers had to memorize the price of every product? And so it was a job that involved a certain amount of skill? And supermarket cashiers were unionized and paid o.k.?

[Kyle]

Could be english speaking countries have a far lower percentage of earners with automatic retirement savings that will enable them to retain a comparable standard of living in retirement.

This could lead to policy choices by government to incent investment based retirement savings to try to avoid massive income drops in retirement (RRSPs, 401k, likely UK and Australian equivalents (though I don't know these programs to exist).

Why Canada and the USA brought in income and benefit caps for CPP and Social Security along with incented investment savings (much later for sure) I would guess is due to the programs pay as you go origins, combined with political realities of not wanting to pay high earners what the public may be considered exorbitant pensions while trying not to generate political opposition amongst high earners.

[Jim Rootham]

You are ignoring politics and institutional structure again.

A key trigger to expanding CEO salaries was the arrival of leveraged buyouts. Compounding that was the Reagan/Thatcher greed is good, unions are bad politics. Both of these were focused on English speaking countries and are far more powerful influences than demographics.

[Determinant]

Stephen wrote:

"The explanation for this would be a claim that the baby boom was more pronounced in the Anglosphere combined with a claim that there is an Anglosphere investor home bias. I don't think either of these claims is clearly wrong, but I'm not sure they are strong enough to explain why we don't see high-income concentration in countries that don't speak English."

What? The Post-war baby boom was concentrated in English-speaking countries. It was the United States, Canada, Australia and New Zealand that had massive mobilizations, that sent expeditionary forces overseas for years and that did not suffer any substantial damage to infrastructure and capital stock due to bombing or blockade. That is history.

The United Kingdom's baby boom was much more muted due to wartime damage, deprivation and the fact that rationing and austerity continued until 1955. It is a point of history that rationing in Britain was more restrictive just after WWII than during wartime.

Here are a few studies of the Allied Baby Boom effect:

http://www.voxeu.org/index.php?q=node/1620

http://bulldog2.redlands.edu/fac/diane_macunovich/web/baby_boomers.pdf

It was the United States and Canada, the two largest countries with the largest share of military personnel sent overseas with the best economic performance in the late 1940's and early 1950's that had the largest boom.

In North America the Baby Boom was a thunderclap, in other countries it was a murmur as post-war prosperity came around. In neutral Sweden it was barely noticed.

In many countries fertility increased after WWII, however it was the United States and Canada where mothers were having on average 3.8 children each.

[Too Much Fed]

I suggest:

When will the workers wake up?

http://bilbo.economicoutlook.net/blog/?p=13193

And,

The origins of the economic crisis

http://bilbo.economicoutlook.net/blog/?p=277

[Patrick]

Market cap includes both reality (e.g earnings) and animal spirits. If firms are not price takers in the market for their own shares (thanks to modern marketing and PR), then couldn't the C-suite boost their wages equally well with either higher earnings or a ouija board?

Seriously, I've seen this. I worked for an IT security firm post 9/11. On conference calls the CEO was announcing products that didn't exist but that the market clearly thought should exist. It did wonders for the stock price (and C-suite comp) in the short term. The firm was bankrupt two years later.

[Too Much Fed]

Determinant said: "What? The Post-war baby boom was concentrated in English-speaking countries. It was the United States, Canada, Australia and New Zealand that had massive mobilizations, that sent expeditionary forces overseas for years and that did not suffer any substantial damage to infrastructure and capital stock due to bombing or blockade. That is history."

Please tell that to krugman the next time he talks about WWII and more gov't debt being the solution.

[Pdt]

You might want to look at Jack Goldstone's work on Revolution and Rebellion in the Early Modern World. He looks at the way demographic impulses can intensify competition for the top jobs, increasing both rewards and turnover, while also driving (among other things) a scramble for qualifications. But note that this impulse is very much transmitted politically, and also relates to the real resource base.

[jean]

Very interesting interpretation. In other countries, baby boom also occured, but one should notice that in continental Europe, there is usually a Bismarckian welfare system, which lowers the demand for long-term assets. Labour mobility is lower in Europe, which probably lowers the bargaining power of executives. Besides, at least in Germany, the economy is more bank-driven that financial markets driven.

[Mike Moffatt]

Noah Smith's "Great Stagnation...or Great Relocation?" may explain some of this:

http://noahpinionblog.blogspot.com/2011/09/great-stagnationor-great-relocation.html.

[Determinant]

Too Much Fed said:

"Determinant said: "What? The Post-war baby boom was concentrated in English-speaking countries. It was the United States, Canada, Australia and New Zealand that had massive mobilizations, that sent expeditionary forces overseas for years and that did not suffer any substantial damage to infrastructure and capital stock due to bombing or blockade. That is history."

Please tell that to krugman the next time he talks about WWII and more gov't debt being the solution."

What happened during WWII is easy to explain thus:

Take Keynes aggregates and the Cambridge money-demand equation:

Y = C+I+G and M=kPY

Right, so Y = M/kP

then C+I+G = M/kP

We actually care about differentials here, not constants. Due to price controls P was held constant in all countries, as was C due to rationing.

So M = I+G and dM/dt = dI/dt + dG/dt.

If you accept that the Depression economies of Canada and the United States had a money shortage which led to a goods glut and a money-constrained economy, then if following equation holds it is the money-supply increase which will lift the economy out of Depression and transition it to a regular, healthy supply-constrained state with no output gap.

Increased military spending which increased both I and G was a delivery vehicle for more money. Military spending is a particularly efficient way to do this; ordinary infrastructure projects are not. I have worked at a military supply manufacturer, they need everything you can think of. Military spending engages every sector of the economy in a way few other things do. The problem with peacetime stimulus isn't that it isn't large enough, it is that the delivery vehicle, infrastructure, is too narrow in focus. You need something much broader. Military spending is as good as a helicopter drop while actually producing something.

The delivery of money here is important. A depressed economy is in a stable state-space where paying off debt is more advantageous than spending and investing. Stimulus like I just described above has to be large enough and broad enough to shock or transition the economy into another stable state-space where taking on debt and investing is more advantageous than paying off debt for businesses.

Oh, and please tell me who I unconciously cribbed the equations and the interpretation from. I thought of all this myself but I hardly think I'm the first to think this way.

[Robert Bell]

Regarding market cap increases and CEO compensation, are the CEO's compensated on shareholder returns or on market cap?

[Jim Rootham]

CEO's are compensated on whatever they can get the board to approve.

[Stephen Gordon]

You are ignoring politics and institutional structure again.

What changed in the mid-1980s? It's not enough to say 'Reagan did stuff' - what happened so that whatever he did became both feasible and irreversible?

I don't have a problem with institutional arguments. But in order to explain a change, you have to have a story of why the institutional change came about. Otherwise, it has all the explanatory power of "Everything is God's will".

[Jim Rootham]

Ok, here's the story as I see it.

In the 50's and 60's corporations grew and the power of senior management to set compensation arbitrarily started to grow with them. There was still countervailing power in the unions and in politicians who could use the bully pulpit to attack excess. There was also still some social expectations about what was a reasonable compensation.

In the early 70's leveraged buyouts started to happen. One of the consequences of this new activity was a massive increase in compensation to management in the bought out companies.

In the same period unions were attacked and lost much of there power. So a countervailing power was lost.

Reagan/Thatcher moved the Overton window in the political arena. The bully pulpit became much less available on this topic. Another countervailing power was lost.

Public disclosure of executive compensation started to come in here as well, the produced a ratchet effect as executives argued they should make as much as the highest compensated comparable.

By the mid eighties the social restraints had started to break down. The race to the top was on.

To make this a real theory you need to track down the evidence of the events, but this is my memory of the process.

[Determinant]

Leveraged Buy-outs and Hostile Takeovers are also part of the re-emergence of "Raider Capitalism". Until the 1929 this was common. The Van Sweringen Brothers of Cleveland were prime examples. Their Allegany Corporation held interlocking directorships and ownership stakes in numerous railroads. Their structure and methods would not be out of place today.

1929 removed the financing for these structure and ventures; numerous constituent companies went bankrupt. Many of these conglomerates fell apart.

The financial drought of the 1930's and then the captial controls of WWII made corporate raiders obsolete for a time. In WWII it is a matter of recorded history that stock traders on the NYSE would throw paper airplanes around to amuse themselves, the place was so quiet.

CEO's during this time were remodelled to be the "Manager-in-Chief". The CEO came from within the company, was frequently its chief technocrat and his tenure was the crowning moment of a long career of service. Shareholders value consisted of simply reinvesting in the business and making sure it expanded in a healthy way. CEO's were expected to be the Chief Technocrat. AT&T was the poster-child for this kind of business.

However corporate raiders re-emerged at the end of the 1950's. Robert Young gained control of the aforementioned Allegany Corporation and proceeded to mount a hostile takeover and proxy fight for the New York Central Railroad, one of the grandest old corporations in the US and still a very large debt issuer. The Vanderbilts (yes, them) still had a large interest in it. He succeeded but the New York Central was on its way to bankruptcy in 1972 anyway.

By the late 1970's the Manager-in-Chief was no longer enough. CEO's had to be traders who protected their company from takeovers, enhanced shareholder value through trimming costs and hopefully mounted takeovers of their own. CEO's were no longer technocrats in the actual business but drawn from the finance world and paid to be raiders for five years. They were no longer paid to incrementally improve the business, they were paid to win the lottery.

With the risks of takeover mounting and the high stakes it involved CEO pay started to climb. Shareholder value was no longer simply growth, it was also expense trimming. The link and common interest between the CEO and workers was severed.

[Too Much Fed]

Determinant said: "Increased military spending which increased both I and G was a delivery vehicle for more money."

I believe that "more money" is actually debt. Some people believed the U.S. economy would go back to recession or near recession after the war. IMO, it did not because supply was destroyed in other parts of the world and that allowed the USA to net export more. IMO, if it wasn't for that, the USA would have went back to recession or near recession (see Japan).

[Too Much Fed]

Determinant said: "Leveraged Buy-outs and Hostile Takeovers are also part of the re-emergence of "Raider Capitalism". Until the 1929 this was common. The Van Sweringen Brothers of Cleveland were prime examples. Their Allegany Corporation held interlocking directorships and ownership stakes in numerous railroads. Their structure and methods would not be out of place today.

1929 removed the financing for these structure and ventures; numerous constituent companies went bankrupt. Many of these conglomerates fell apart."

So would that cause the amount of medium of exchange to go down?

[Too Much Fed]

Determinant said: "If you accept that the Depression economies of Canada and the United States had a money shortage which led to a goods glut and a money-constrained economy, then if following equation holds it is the money-supply increase which will lift the economy out of Depression and transition it to a regular, healthy supply-constrained state with no output gap."

First, I like to use medium of exchange because there are too many definitions of "money". Skip that for now.

I don't see why healthy supply-constrained state with no output gap should be considered regular or normal.

Here is what I mean. If real AD grows by 1% (population growth), real AS grows by 2.5% (productivity growth), and there is already enough supply, then real GDP grows by 1% and employment can fall allowing for more retirees. Yes, I'm assuming real AD is NOT unlimited.

[Determinant]

What I mean is that the economy, a "monetary" or unit of account/unit of exchange economy is not constrained by its money supply. The noose of "medium of exchange" is not acting as a noose.

In a supply-constrained economy additional investment in more productive capacity is desired and will be used. Abstaining from consumption and investing the funds in additional productive capacity will result in more actual consumption and hence will produce a return on investment.

I'm curious Fed as so how you say real AD is not unlimited when you say your posited position allows for more retirees. Are the retirees consuming things? I would think they are. That is not an AD problem, it's is a reapportionment of supply amongst unlimited demand including retirees. Your situation does not mean that workers are cast into involuntary unemployment.

An exchange-constrained economy with an output gap does mean that there is involuntary unemployment.

Involuntary unemployment is the hallmark of an exchange-constrained economy.

[Too Much Fed]

"Are the retirees consuming things? I would think they are."

Under my scenario, they are consuming about the same amount as when they were working.

Back to this, if real AD grows by 1% (population growth), real AS can grow by 2.5% (productivity growth), and there is already enough supply, will companies grow real AS 1% and use the "extra" productivity to reduce employment?

[Determinant]

That productivity increase came from investment. If demand is not increasing to realize a return on that investment, no further investments in productivity will be made until the population increases to consume that excess supply.

At worst you will be a 1.5 year recession. In the future the market will turn against such excess investments.

Or if you wish to increase the number of retirees, as you said, then you can reduce employment and increase retirees *if* you have an acceptable method to redistribute consumption power from workers to retirees. If you won't have a workable method then you will have a recession. That's a political problem, fundamentally.

[Too Much Fed]

"That productivity increase came from investment. If demand is not increasing to realize a return on that investment, no further investments in productivity will be made until the population increases to consume that excess supply."

That could depend on how the return on investment is measured. Let's go to the company level and assume a company is profitable enough to fund itself from earnings. Under my scenario, Q (quantities) grows by 1% for the company, and price inflation is 2% leading to about 3% revenue growth. The productivity increase should increase earnings by more than 3% (fewer workers but the ones remaining need to make more). Some of the earnings can then be used to increase the dividend and/or buyback stock. Hopefully, that will increase the stock price. That only leaves making sure the productivity increase is distributed evenly between the workers and the company so the workers can have real wage growth and the company can have "real earnings" growth.

[Determinant]

I agree you've worked up a distribution problem. Maldistribution can lead to a money-constrained economy. The logical end of your problem is that the company takes all the gains and the workers get nothing. There are three possibilities here: The workers and the company make a fair split so that demand and supply grow equally. Or the company channels the money to retirees (in general) through a the pass through of profits into a pension plan (any pension fund). Or it goes into the hands of the already rich who don't spend the money and you get a demand problem because supply increases without an additional way to pay for it and hence demand will fall.

[Too Much Fed]

"The workers and the company make a fair split so that demand and supply grow equally."

Right. I believe the amount of medium of exchange and its composition need to be correct also.

"Or it goes into the hands of the already rich who don't spend the money and you get a demand problem because supply increases without an additional way to pay for it and hence demand will fall."

Unless you can "trick" the lower and middle class into debt to make up the difference, so they work more in the present and most likely in the future so they retire later so an economy is not "running out of workers". The problem is when you can't "trick" them into debt anymore, the ones who are able start paying the debt down and/or debt defaults. All three of those can allow the amount of medium of exchange to fall when the amount of medium of exchange needs to be at least the same and probably increase.

[Determinant]

Ok, that I agree with. I call that a money-constrained economy and it bears a startling resemblance to our current predicament.

[Too Much Fed]

First, yes it does, and I like to use medium of exchange because there are too many definitions of "money".

Now to make it interesting.

The way the system is set up now is all NEW medium of exchange the demand deposits created from currency denominated debt from a bank or something bank-like?

Now on to possibilities. If an economy needs more medium of exchange, how should that happen, and what are the possibilities even if they don't exist or aren't allowed now?

[Russil Wvong]

An interesting conjecture. Have you looked at market capitalization and executive pay prior to 1980? A recent Washington Post article suggests that US businesses were generally more successful in the 1950s and 1960s, when executive pay was lower.

Roger L. Martin suggests that executive pay is an example of Keynes' comment about the power of economic ideas. In his recent book Fixing the Game, Martin (dean of the Rotman School of Management) describes how current compensation practices can be traced back to the influence of a 1976 paper by Jensen and Meckling in the Journal of Financial Economics, which made the case for equity-based compensation.

Martin thinks this was a major mistake:

"In the face of expectations that can run wild, CEOs have increasingly focused on what they can control: managing share price over the short run. Shareholders, on the other hand, should want CEOs to focus on the long term, on increasing share price more or less forever. So it turns out that rather than aligning the interests of shareholders and executives, stock-based compensation has reinforced the agency problem it was created to solve. What's more, it has destroyed long-term shareholder value by driving shorter horizons of decision making and contributing to shorter CEO tenure. CEOs know that expectations are likely to fall, so they have incentive to leave or retire in order to cash in stock-based compensation instruments while expectations are high."