Universities challenged

Concerns over ‘fat cat’ salaries have been a recurrent feature in the UK over the years and the issue has been raised again in the context of the earnings of university vice-chancellors. Although it has been going for a long time, my first recollection of the popular outrage associated with excessive pay was in the mid-1990s when Cedric Brown, chief executive of the formerly state-owned British Gas, was criticised for his £500k annual pay packet (equivalent to £900k today). The outrage was not so much the amount he was paid – after all, he was ranked in the middle of the range for FTSE 100 CEOs of the time – as the fact that senior managers in formerly state-owned utilities enjoyed massive increases in pay following privatisation. 

Nonetheless, it struck at the heart of the debate over the nature of market economics. The Conservative government of 1979-1997 turned state monopolies over to the market and a lot of UK households, which bought British Gas shares following its 1986 privatisation, benefited handsomely from the surge in share prices that followed. Yet still there was outrage (manufactured or otherwise) over the fact that world class companies competing in a tough global market should have the temerity to pay their management salaries commensurate with that position.

Fast forward more than 20 years and elements of the same debate are evident in the current furore regarding the salaries paid to vice-chancellors at British universities. These are very senior management positions, equivalent to the post of chief executive who essentially oversee the management of the institution. According to a survey by the University and College Union published in February, university bosses received an average salary package of £278k in the academic year 2015/16 which is “an increase of 2% on the previous year and 6.5 times the average pay of their staff.” Whilst a 2% rise sounds modest, it is double the rate of the average university employee and comes after several years of faster increases: In 2014-15, for instance, average remuneration including pensions jumped by 5.4%.

Some universities rewarded their chief executives exceptionally well: The best paid vice-chancellor was at the University of Bath who received a compensation package of £451k (an 11% increase on the previous year). Even more rapid rates of increase were reported elsewhere, with the vice-chancellor at Bournemouth University getting a 19.6% pay rise whilst Ulster University raised the value of total compensation by 16.6%. Pay increases of this magnitude have raised a lot of political eyebrows. But as has been pointed out in a number of quarters, the current government has gone a long way towards creating a market for education so should they be surprised when market forces operate in the market for talent capable of managing in the cut-throat university sector?

What has changed in UK universities in recent years is that the state provides far less direct funding than previously, with only around a quarter coming from the public purse. University managers have to rely far more heavily on private sector sources to drum up business – in other words, they have to be far more commercially minded than previously. But the main source of funds comes from tuition fees which account for around 45% of university income. UK students now have to pay up to £9,000 per year for tuition, which for most is funded via a student loan. Once we add living costs such as food and accommodation, many students can expect to graduate with up to £50,000 of debt. As monopoly suppliers of higher education, there are those who argue that universities are exploiting their clients and paying their senior management handsomely into the bargain. It certainly is not a satisfactory situation when viewed from the position of a young student who will struggle to get a well-paid job on graduation which comfortably covers their living costs and repayment of student debt (let alone some form of long-term savings plan).

Another often overlooked fact is that UK universities enjoy charitable status. Indeed, English institutions are even exempt from registration with the Charity Commission because “they were considered to be adequately supervised by, or accountable to, some other body or authority, such as Parliament.” Scottish and Welsh universities are required to register for some reason. Nonetheless, all of them are designated as non-profit organisations whose primary purpose is to promote social well-being and serve the common good. This means that the vast majority of university income is exempt from corporation tax though they do pay VAT on certain items and are liable for payroll taxes. To give some perspective, Cambridge University paid £3 million of tax in fiscal 2015-16 on profits of £287 million (including investments) and the University of Manchester paid £2 million on earnings of £61 million, both of which are lower tax rates than paid by the much-maligned Google (20%) and Amazon (41%).

The vice-chancellor of Oxford University recently expressed the view that university managers deserve their pay packages because they operate in the “global marketplace” for talent. I have no doubt that they are good at their job, but given the tax status under which universities operate and the fact that in effect these big packages are being funded by students, this came across as a very self-serving statement (and was indeed disowned by many of her Oxford colleagues).

Nobody denies that the challenges of running a university are far greater today than even ten years ago. But academic institutions are not private sector profit maximising organisations – they are non-profit organisations which still rely on the state for part of their revenue – and to argue that university bosses are poorly paid compared with footballers may be true, but the only way to earn a footballer’s obscenely high salary is to be good at football. Indeed, perhaps universities are just the latest in a line of businesses to demonstrate that the pure application of market forces can result in perverse outcomes which benefit managers at the expense of customers.

How should we remunerate politicians?

Many of us spend a lot of time bashing politicians – sometimes fairly, sometimes not – but it cannot be denied that the job which they do in most democratic societies is a thankless one. They have to subject themselves to electoral approval every four or five years and they get a lot more brickbats than bouquets – when things go wrong, it is politicians who stand in the front line of public criticism. You have to be idealistic enough to believe you can change things; extrovert (some might say narcissistic) enough put yourself forward to the electorate on a regular basis and sufficiently thick-skinned to cope with the criticism. It puzzles me why anyone would ever want to do that – in most developed economies, at least, the rewards do not stack up to the degree of opprobrium heaped upon politicians.

Aside from the prime minister of Singapore, who earns an annual salary of USD 2.2 million, public sector chief executives are paid significantly less than chief execs in the private sector (see chart 1). There are various metrics against which we could measure a country’s performance in order to assess whether the chief executive is worth their pay. One way would simply be the size of the economy – the bigger they are, the more they can afford to pay. But that rather falls at the first hurdle given the size of the Singaporean economy. Indeed, in our sample of 60 countries, the correlation between the ranking of overall economy size (GDP) and the salary of head of government is rather low, at 0.375. Another way to think about it is that the bigger the population, the higher the salary should be given that they are responsible for many more people. But this falls pretty flat with the rankings showing zero correlation – hardly surprising given that President Xi of China earns only USD 22,000 per year and Indian Prime Minister Modi’s official salary is just USD 30,000.

We get more success, however, if we look at incomes per capita with the rankings showing a correlation of 0.55 (rising to 0.57 if we look at PPP adjusted incomes). Societies appear prepared to reward their politicians on the basis of their ability to deliver economic prosperity. Naturally, there are some outliers. The President of the Comoros earns a whopping $408,000 per year (541 times the average income) despite it being one of the poorest countries in the world. Contrast this with Uruguay where the presidential salary is only 80% of the average income. Indeed, the degree of disparity is highest in countries not known for the quality of the democratic process (chart 2). But on the whole there is a decent degree of correlation: For example, Donald Trump is paid the fifth highest salary (USD 400,000) whilst the US ranks sixth in terms of GDP per capita; Theresa May’s salary of USD 215,000 puts her 13^th on the list compared to a GDP per capita ranking of 16 whilst French prime minister Édouard Philippe’s salary of USD 200,000 is placed 16 against a GDP per capita ranking of 17. Perhaps societies are indeed prepared to reward their leaders in proportion to how well they manage the economy.

Even the position in Singapore, where the apparently outlandish salary of PM Lee Hsien Loong is off the charts on an international comparison, does correlate with the fact that standards of living are amongst the world’s highest. Singapore is also safe, clean and ranks second on both the WEF’s global index and the World Bank’s Ease of Doing Business index. At a time when the economic threat posed by China is increasing, that is no mean feat.

But compare this with corporate salaries where the median total compensation for S&P500 CEOs in 2016 was USD 11.5 million whilst the average FTSE100 CEO received remuneration of around USD 6 million. Thus, given the dissatisfaction with politicians around the world, would we improve their quality if we paid them more? The case for paying more is that we attract a higher quality of candidate. But there is also a principal-agent problem: Politicians generally set their own salaries, and aside from the odd burst of outrage, in many countries there is little to stop them from raising their own salaries in excess of inflation or indeed in excess of their deliverable outcome in a way which is detrimental to society.

The empirical evidence is mixed. A 2009 paper based on Brazilian data suggested “that higher wages increases political competition and improves the quality of legislators.” Similarly, a study based on Mexican data  indicated that the quality of civil servants also increases when higher wages are offered. Against that, a study based on the European Parliament found that a salary hike raised the proportion of politicians with lower education levels, perhaps because  it “gave lower-quality MEPs a greater incentive to get into office and, once there, to stay put.”

As Stephen J. Dubner of Freakonomics fame put it, “I am not willing to argue that paying … government officials more would necessarily improve our political system. But, just as it seems a bad idea to pay a schoolteacher less than a commensurately talented person can make in other fields, it is probably a bad idea to expect that enough good politicians and civil servants will fill those jobs even though they can make a lot more money doing something else.” There are no easy answers to the question of how to reward politicians. But we generally know a good one when we see them.

What drives politicians?

Human actions can broadly be understood in the context of three forces which act to offset each other in order to produce balanced outcomes. On the one hand, we are motivated by self-interest which is the driving force propelling individuals forward and helps societies to develop. But this is constrained by the loyalty to the tribe to which we belong, and by the responsibility to the wider society. So it is with politicians in a democratic society: Self-interest is tempered both by party loyalty and a responsibility to represent the people which put them in office.

The actions of someone like President Trump are a bit harder to fathom, particularly since he appears to owe no fealty to the Republican Party. I would venture to suggest, however, that he was motivated to run for the presidency out of ambition but his actions will be constrained by what the American people – or more properly, Congress – allow him to get away with. Trump’s attempt to repeal Obamacare should be seen as a policy of self-interest, designed to ensure that he is seen to be fulfilling his election promises. Equally, Congressional action to block this attempt should be celebrated as an example of how this self-interest can be held in check. (For anyone interested in a more detailed analysis of the difficulties the Trump Administration will face in trying to push through its legislative programme, this article from the New York Times is well worth a read).

On this side of the Atlantic the British political scene offers a number of fascinating insights into the motivations of politicians. The news over the weekend that UKIP’s only sitting MP is to leave the party is a case in point. Douglas Carswell is a former Conservative MP, and a well-known Eurosceptic, who defected to UKIP in 2014. Carswell’s reasons for leaving UKIP are unclear. He obviously did not see eye-to-eye with former leader Nigel Farage (who has never managed to be elected as an MP) but Carswell posted on his blog that “I switched to UKIP because I desperately wanted us to leave the EU. Now we can be certain that that is going to happen, I have decided that I will be leaving UKIP.” A cynic might say that a cause he believed in so strongly has been achieved that, for the second time in three years, he has decided to leave a party which no longer suits his purpose. Or, as the Huffington Post put it,  “He’s just another hypocritical politician. Just another MP motivated by self-interest, who picks and chooses his principles to match whatever he has already decided to do.” 

There again, the same could be said of Winston Churchill who was elected as a Conservative MP in 1900, before defecting to the Liberal Party in 1904 only to rejoin the Conservatives in the 1920s. As the great man put it, “anyone can rat, but it takes a certain ingenuity to re-rat.” With political tribal loyalty these days much stronger than in Churchill’s day, Carswell may not be welcomed back quite so warmly if he were to rejoin his former Conservative colleagues, as has long been rumoured. But whilst one can question Carswell’s personal motivation, he was tapping into a groundswell of anger felt by a large part of the electorate. Like Trump, he was prepared to put other factors ahead of party loyalty and perhaps Carswell really believed that he was acting in the interests of a wider society.

Theresa May, on the other hand, appears to have put the party above all else. She did vote “remain” in the EU referendum (albeit reluctantly, apparently) but has clearly decided that it is more important to keep the party together than allow her personal view on Brexit to determine her course of action. As a result, we appear set for the hard Brexit that many members of the party have long called for. As for her opposite number in parliament, it is hard to know where Jeremy Corbyn stands. It seems that he is not acting in the interests of his party, after his parliamentary colleagues virtually disowned him last year (although he can at least claim that the party’s rank-and-file membership backs him – for now). Most of the polling evidence suggests he is unelectable and as a result he would do his party a favour by stepping aside for someone who is. Arguably, Corbyn is putting personal ambition and his apparently genuine belief in some of the causes he espouses, ahead of party loyalty.

In a world where many of us express irritation at the actions of politicians, it is important to be aware of the forces which drive them. On the one hand, doing so might help to narrow the chasm which has emerged between politicians and the electorate, which is an important factor driving the populist movement and is driving us towards a resurgence of economic nationalism. In addition, it may help counter the more extreme positions adopted by some of the populists. The prejudice of the Brexiteers, for example, could have been fought far more effectively if their opponents had tried to engage with the electorate’s fears rather than dismiss them. Sun Tzu’s The Art of War recommends that we know our enemy.  What was true in the 5th century BC still holds today: Good ideas never die – they just get recycled.

The haze of regulation

Having posted previously on the subject of incentives (here), and how important it is to ensure they are set correctly in order to avoid unintended consequences, the recent spate of warnings regarding pollution levels in London over the winter months brought the issue to mind once again. There are many contributory factors to high pollution levels in urban areas with climatic conditions exacerbating the problems caused by central heating systems and wood burners (one of the recent scapegoats). But one of the factors rising up the worry list in London is the problem caused by emissions from diesel engines (see chart).

Ironically, it is not long ago since diesel engines were hailed as the great new clean technology which would save us from the choking carbon dioxide emissions of petrol engines. Beginning in the early-1980s, UK excise duties on diesel were set lower than those on petrol, though since the late-1990s they have remained the same as those on unleaded fuel. From a fuel consumption perspective diesel engines are more efficient than their petrol equivalents, so even if the duty per litre is the same, the tax paid per mile (or kilometre) travelled is lower for diesel than for petrol. Successive governments were happy to encourage the switch to diesel engines because – we were told – they emit less carbon dioxide than petrol, and this switch was seen as one of the arrows in the quiver designed to reduce CO₂ emissions in line with international agreements. Unfortunately, diesel engines emit more nitrogen oxides and small particulate matter, which is even worse for human health than CO₂. Moreover, the evidence appears to suggest that their average CO₂ emissions are no better than petrol engines.

The chemistry associated with the burning of diesel is not new. So how is it that governments across Europe have encouraged this trend? According to the academics Cames and Helmers (here) one argument is that “the European oil industry co-initiated the shift to diesel cars in the 1980s and 1990s in order to find outlets for middle distillates” which had collapsed as natural gas displaced heating oil as a fuel used in electricity generation. In addition, the increased use of nuclear power for generating purposes further increased the downward pressure on distillate demand.  Whatever the reason, across most European countries, diesel cars received favourable tax treatment at the expense of petrol-engined cars. If governments were indeed using the switch as a cover to promote the need to reduce CO₂ emissions it was at best misleading, and if the claims advanced by Cames and Helmers are true, it points to collusion between the interests of the oil industry and government.

This goes back to the point I made recently (here) about how there is evidence to suggest that interest groups can have undue influence over government policy which may not always be in the best interests of voters. Perhaps the most egregious example of this is the policy towards obesity in the western world. It has become accepted wisdom that the problem is caused by too much fat in the diet. However, as long ago as 1972, a scientist called John Yudkin wrote a book claiming that there is a clear correlation between the rise in heart disease and a rise in the consumption of sugar, and questioned whether there was any causal link between fat and heart disease. But the food industry struck back, led by a scientist called Ancel Keys who – aided and abetted by the sugar industry – proceeded to discredit Yudkin’s work. However, the work spearheaded in recent years by prominent scientists such as Robert Lustig, suggest that Yudkin had been right all along.

This was not a simple academic spat: It was an issue of fundamental scientific importance with implications for human health. It also highlights the problem that if a particular interest group funds research which is unequivocally accepted by government, and is used as the basis for public policy, there is an incentive to distort the research to ensure the desired outcome. I am not endorsing the claims of Cames and Helmers with regard to the influence of the oil industry. But the very fact that it has been hinted at indicates that the line between genuine scientific research and that conducted for ulterior motives is at best blurred.

As it happens, European countries have a pretty good track record in preventing dodgy research from slipping through the net – think of the good work done by the drug regulatory authorities. However, it is crucial that these high standards are maintained, which is something else for the UK government to think about as it embarks upon Brexit. And as the diesel and sugar episodes remind us, it is also important to think about the longer-term effects of today's policy choices. Failure to think long-term can - quite literally - be fatal.

Setting the right incentives for high flyers

I have always thought that the word “incentivise” is one of the more unnecessary words in the English language as it takes a perfectly ordinary noun and transforms it into an ugly verb. Call me old fashioned, but I always thought that incentives were designed to motivate people to behave in particular ways. The verb “incentivise” first made an appearance in the US in 1968 but it did not gain currency on this side of the Atlantic until the early 1990s. Indeed, its entry into everyday language in the UK coincided with a shift to a more market-oriented economy in the post-Thatcher era. Aside from linguistic considerations, the study of incentives is one of the most important areas in economics. Setting the correct incentives to ensure the desired outcomes is crucial.

Incentives can either take a monetary or non-monetary form. Monetary incentives are well understood – people often get paid a bonus for hitting their targets, which in the case of company executives can run into the millions. But a common problem in all organisations is that people may prefer to pursue their own interest instead of the firm’s common goals which potentially leads to a conflict of interest. One resolution to this problem is to align the interests of the firm and the workers by appealing to their intellectual engagement. For example, Google is a highly innovative hi-tech company which allows its engineers to develop new ideas off their own bat because they may turn out to be game changing ideas. In other environments it may not be so easy to generate such intellectual development. Many US companies instituted employee of the month programmes to recognise particularly outstanding workers. For all the scepticism which these awards may generate, there is evidence to suggest that recognition by the management for a job well done goes a long way.

In this vein, I was struck by a neat little paper recently published on the CEPR’s Vox website which attempts to quantify this effect. The example in this instance looks at the behaviour of Luftwaffe pilots in World War II in response to the public praise lavished on high-performing pilots (i.e. those who shot down many enemy aircraft, here). Careful analysis of 5000 individual records, which looks at the impact the recognition accorded to indviduals had on their former colleagues, shows that this led to an improvement in the performance of all pilots who were known to have served with him. However, the good pilots (the “aces”) performed significantly better without taking more risks, but average pilots performed only slightly better but with a higher risk of being killed. The conclusion of this analysis is that singling out one worker for individual praise acts as an incentive for others to try harder.

The analogy is extended to suggest that such praise which encourages risk taking is a major problem in the financial services industry if it encourages traders to take ever bigger bets without understanding the risks they are running. Whilst there is some merit in the conclusion, it is not the whole story because traders received monetary rewards for the results which they generated. Indeed, most good traders I have ever known may be susceptible to a bit of flattery but they were very clear-eyed about the monetary rewards flowing from the actions they were taking (economists on the other hand are suckers for flattery). Nonetheless, the paper does provide a neat insight into the statistical analysis of the risk-taking business.

But if you get the incentives wrong, the consequences can be catastrophic. During Mao’s Great Leap Forward in late-1950s China, the government aimed to transform a largely agrarian economy into an industrial powerhouse. But in the dash for modernisation too many resources were diverted away from farming, which resulted in a catastrophic collapse in agricultural output and a famine which killed at least 20 million people. One of the reasons why provincial governments continued with their disastrous policy, despite evidence that it was not working, was because Mao himself lavished great praise on those who followed his instructions.

It is often claimed that monetary incentives can distort the behaviour of firms, so that they follow policies which maximise the utility function of those receiving the incentives rather than the wider constituency of shareholders. There is a substantial amount of evidence to show that companies have pursued short-term policies to inflate share prices, which benefits senior management who are paid in stock options, but which tend to have serious adverse longer-term effects. But as the Chinese example shows, it is important to ensure that we align non-monetary incentive structures too, for they can potentially inflict even more damage.