Competition at the top: is managerial compensation really increasing economic inequality?

Bank bonuses have, since the financial crisis, been at the center of the debate on economic inequality. The public has grown tired of such generous compensation, which is seen as underserved, because of the direct role that the banking sector played in the recent—and in many places—still ongoing crisis. The scandals about Libor rate manipulation and the very recent reports on HSBC hidden Swiss accounts are exemplar about the type of behavior that people take—and rightly so—as unacceptable and as incompatible with huge bonuses.

However, finding such behavior reprehensible may turn the conversation towards a question of professional ethics and morality that are context specific and, therefore, cannot be swiftly use to make any assertions of economic inequality, as an issue that goes beyond individual or sectorial behavior.  The real question must be one that takes into account managerial compensation at large (throughout all sectors): should we see super-salaries as equally outrageous across all industries? And, more concretely, are super-salaries really a contributing factor to rising economic inequality?

Are super-salaries really a contributing factor to rising economic inequality?

The French economist Thomas Piketty takes a close look at the actual evidence in his acclaimed work, Capital in the Twenty-First Century. He explores the changes that the highest incomes from labor have had in recent decades and in particular since the 1980s. What he finds is highly insightful and provides persuasive arguments, based on hard evidence, about the true role that exuberant managerial compensations are really playing.

The figures

Piketty provides clarifying figures, from which a detailed image of the labor inequality landscape emerges. It is important to keep in mind that the following figures focus only on the income that results from people’s work, that is, their salaries and other related compensation, such as bonuses. This distinction is key, because income can also be the result of investments, savings and an array of financial instruments—and taking a close look at this second source of income provides impactful conclusions, without a doubt, but not conclusions on how labor income is contributing to economic inequality.

So,

The upper 10% of the labor income distribution (the best-paid 10%) in developed nations, says Piketty, generally receives between 25–30 percent of total labor income. This means that the best-paid 10% of the population takes home around 25% of all the income that results from salaries, bonuses, etc., within a country.

Is the richest 10%—in the US or the UK—made out of the same people that are in the best-paid 10%?

Not exactly, and this is where it gets interesting. The richest 10% is not made out of the same people as the best-paid 10%, because the richest 10% receives most of its income not from their salaries (their work in any shape or form), but from the capital they owe (from income generated mainly in the financial and real estate markets). To understand this difference in income sources and the role it plays in economic inequality Piketty divides that wealthiest 10% even further, between the richest 1% and the rest (the 9% left). What he finds out is that,

The top 1% receives a much lower proportion of their income through their salary and other forms of work-related compensation, than the rest—than the missing 9%.

In fact the higher up you go—so from the richest 1% to the richest 0,1% and then even higher up to the 0,01%—the less important income from labor becomes.

Now, you may be thinking at this point, ‘so the super-rich don’t earn their money like most people, so why is this important?’

I will tell you that it is important for three reasons:

1.    People, who make most or all of their income, through financial instruments alone (capital income alone), are people who inherited their wealth in the first place (Piketty, 2013). Hence, when we are talking about the richest 1% we are not mainly talking about moguls of innovation like Steve Jobs or Richard Branson, but actually of heirs like the Hiltons or the Kennedys, just to name a couple of exemplar cases.

2.    Capital income, in addition, has been increasing as a percentage of GDP in most developed countries, between 1975-2010, from

• 22% of GDP to 27% in the US
• 19% of GDP to 20% in Germany
• 17% of GDP to 30% in the UK

(Piketty, 2013, p. 222)

This means that capital income has become more and more important in our time, than it has been for the past seventy years, and is set to become even more important in the future. This is important because it means that wealth inheritance has likewise become in the recent decades more and more important.

40-year trend in capital income for developed countries

Source: Piketty, Capital in the Twenty-First Century, p. 222

3. The bottom 50% of wage earners is becoming poorer in comparison to the rest.

·      While they make up 50% of the labor force, they get to keep only 30% of the total income generated from labor—they take virtually nothing of the income generated from capital.

·      When we look at general wealth, the bottom 50% owes less than 5% of a country’s total wealth (US figures).

This is a very worrying trend, because it means that the bottom 50% can never expect to earn any income from capital, because their savings are insignificant—plus they have no inheritance at all—and their income from labor does not allow them to be able to buy into even the less-profitable types of financial instruments; too many in the workforce are stuck with at most a savings account, offering a rate of return that is barely above inflation, and is probably lower than inflation today.

Western societies proudly boast that ancient hierarchies, where last names mattered more than personal ability, have been long left behind: if you work hard and persist, society will compensate you in turn, was the mantra that most of us were born repeating. Believing that hard work is the underpinning of economic success motivates many to study, to want to excel at their jobs, to want to become entrepreneurs, etc., as well as to be trustful of corporations and firms at large.

In a word, living in a society that rewards smart, hard working people, is, for the most part, something that defines our identities and our sense of freedom, and a social virtue that provides the kind of political stability and freedom that is but a myth in too many countries around the globe. It is the increasing difficulty to reach this desirable outcome in the West that makes Piketty’s findings especially worrisome: are we set to return to the old-times, where inheritance determined our place in society? Will our kids be talking about dowries again?

Written by Daniel Vargas Gómez

If you like this article read more about economic inequality and Piketty’s ideas on The factish: The Thomas Piketty series.

“Creative people are born not made” and other copouts that keep you from being remarkable

From all the myths on creativity this is, no doubt, one of the most pervasive. Its success in becoming part of our collective imagination is due to a single, yet terribly influential belief that gives an almost mystical role to talent—‘raw talent’. My point is that creativity is neither in the brain nor in the body--also not in  society. In a word, it is not a thing, it is a process.

Spotting the ways in which this deeply held belief in 'raw talent' negatively affects our behavior is actually not diffcult.

Think, for example, about the response that most people give, when asked whether or not they would say that they are creative individuals:

‘No… I have never been the creative type… I never was into any of that artsy stuff’.

But, what do we mean when we say things like 'artsy' or even 'talent'?

Creativity we seem to think is some mysteriously cool stuff that allows people to do even more cool stuff.

Such belief, one quickly realizes, makes of creativity a sort of hovering abstract attribute which would somehow materialize in different activities—sometimes painting, sometimes playing an instrument, and sometimes dancing ballet. For the believer in the powers of 'creative stuff' practice is inconsequential or secondary: Picasso was born a Master painter. Creativity, from this point of view, is supposed to be an energy of sorts that lives in some realm that is prior to the activity itself—perhaps within an individual’s soul, mind, or spirit.

You may at this point be thinking: ‘Ok, maybe the idea lacks sophistication, but is it really such a bad thing? Not everyone is a sociologist or a philosopher you know…’. 

I agree with you, the real question is how this affects people’s ability to be creative, right?

Well, this is where the real damage lies and it comes to light when we pay attention to the effects it has on both, the so called ‘creatives’ and the other ‘square’ or uncreative individuals. Most of the believers fall on the latter category. For them they simply acquire a sense of defeat about creativity, which, fact, works as a powerful resistance against creative work. These are the same people that will tell you, when given the opportunity to be creative: ‘I’m not the person for the task’, ‘I can’t do that’, ‘I am not one of the office’s creative people…’ ‘Maybe he [while pointing to someone with frizzy hair] can help you’.

It is this attitude of insecurity or contempt for creative work what is the real hindrance, no matter what the work or the type of organization at stake. This is not to say that the role of those aspects of our lives we don’t really choose for (education, parents, geography, and luck) is negligible, but rather that thinking and working creatively is most of all a practice or a habit, which comes about through repetition.

Repetition is what allows for mastery to be acquired: an artist, who can draw wonderfully realistic portraits in minutes, is able to do so because of the hundreds if not thousands of portraits she has made in the past. Like with any activity—from driving a car to playing tennis—it is hours of dedication and repetition what truly account for what we normally refer to as talent—the 10,000 hour rule for Gladwell’s Outliers. When it comes to creativity, furthermore, talent is indeed essential but it is not sufficient on its own—not all artists are innovators, and not all are pushing the lines of their disciplines. In the cases of people like Picasso, Matisse, Hopper or Warhol, just to name a few, their true truly experimental and innovative phases came only after they had acquired mastery over the techniques necessary to render a flawless painting (or a flawless design in the case of Warhol). Talent, we must realize, is but the starting point behind creative work; talent is what comes to light after the ten thousands hours. It is what allows for experimentation to be less of a leap of faith and more of an experiment in the scientific sense, hence, more of a discovery that may at first raise more questions than answers, but which in any case allows for progress to be accounted for, to be visible.

This same engrained belief is also responsible in convincing us (namely managers) that creative work is a black-box, which implies that it is a process that cannot be accounted for or properly understood. Instead of recognizing the hard work that is needed to acquire a talent, because it makes us feel insecure about our own sense of dedication and perseverance, we put a black-box in its place. Given that we cannot simply replicate the results of someone who has mastered a technique, we decide—out of frustration—that creativity is a sort of uncontrollable fluke, which cannot be learned or taught, and which cannot be made into a central part of an organization’s way of doing things. If your manager or your CFO tells you that in order to encourage creativity the company must sacrifice on productivity and efficiency, then you can be sure that they are the type of believers I have been talking about.

So, next time you hear yourself repeating the myth, remember that you can be creative, and that by doing so you are not giving up on structure, accountability or reflection.

Written by Daniel Vargas Gómez

Remember to subscribe to the factish and free yourself from other common myths about Creativity.  

Is technology to blame for economic inequality? 3 ideas in Piketty you need to know to answer this question

Let’s begin with the begging question: Why would technological improvements explain growing economic inequalities in America and elsewhere?

The logic is fairly simple. Technology has a positive impact on the economy as a whole, because it increases productivity, making the production of goods cheaper or more cost effective—workers become more productive and the resources needed to produce goods and services decreases. From this perspective, the issue of income inequality seems foreign and the way it is introduced into the conversation is as follows:

1) By asking about the type of skills needed to be able to use and benefit from technologies—which amounts to asking about the ways in which the presumed gains in productivity come about.

2) By comparing investments in technology with other forms of investment.

How can productivity gains come about if most workers lack the skills to use the available technologies at their disposal?

After raising this question, apologetics of economic inequality hurry to give the following answer: income inequality is the result of having a labor force that is split, between those who possess the right skills and can to take advantage of the technologies available in the 21^st century economies and those who lack such skills and find themselves competing for a decreasing number of jobs that don’t require any such skills. In short, this is the story that tells us there is Silicon Valley, on the one hand, with its high-tech innovations and a growing number of millionaires and billionaires. On the other hand, you have the grey old manufacturing sector, which is inefficient and wasteful and that would be symbolized by cities like Detroit in the US or Birmingham or Liverpool in the UK.

Income inequality would, therefore, be a temporary event, whose solution is to motivate people to choose the right professions (ICT related subjects), for, once they do, they will be able to earn the high salaries that those skilled workers at Google have. Is this a feasible story?  What does the evidence tell us?

Thomas Piketty addresses this argument in his Capital in the Twenty-First Century. The evidence, he tells us does not seem to support this theory.

“Over the long run, education and technology are the decisive determinants of wage levels” (Piketty, 2013, pp. 306, 307).

In the short run, however, differences in labour income (in wages) obey directly to three main factors:

1.    Executives have acquired direct influence on their own remuneration and at times even set their own salaries, through direct control over boards of directors—this is a claim supported by Piketty, but also Nobel price winners’ Joseph Stiglitz and Paul Krugman.

2.    Pay for luck: positive changes in a firm’s external conditions (economic growth, prices of raw materials, exchange rates, competitors’ performance) are rewarded as if generated internally—by the leadership and strategic mind-set of upper echelon employees (Piketty, 2013, p. 335).

3.    Decreases of top marginal income tax rates in English speaking countries since the 1980s, was followed by an explosion of very high incomes, which accelerated the growth rate of economic inequality during the last 30 years (Piketty, 2013, p. 335).

4.    The main source of income of the richest 1% is not their wage, that is, income inequality is NOT primarily explained by disparities in wages (Piketty, 2013, p. 280).

Next to these factors, I said too that in comparing investments in technology with other forms of investment, such as investment in real estate property, the former are presumed to accrue higher rewards, because they entail equally high risks. This means, for instance, that someone like Steve Jobs, who made what was back in the early eighties a very risky investment in an incredible innovation (the personal computer) received an equally high reward, when his innovation proved its merit and became very profitable. In comparison, if you or I, who are fearful of risk, prefer, in turn, a safer investment (a savings account for example), it is only logical that we cannot expect high rewards. Under this light, innovations are taken as the philosopher stone of wealth creation, and to a certain extent long run economic growth does depend on innovation (Piketty, 2013, p. 306).

Yet, is it feasible to put the blame of economic inequality on smart investments (high risk, high reward) against lame investments (low risk, low reward)?

Piketty’s answer is that the historical evidence does not suggest this to be the case, even remotely, for a single, yet quite important reason: the rate of return of portfolios increases not as their investment on innovations increases, but rather as the amount of capital invested increases—on average the largest endowments are able to obtain real returns of close to 10 percent a year, while smaller endowments must make do with 5 percent returns (Piketty, 2013, p. 449).

Technology has, no doubt, been fundamental to the economies of the 19^th, 20^th and 21^st centuries and has, to be sure, been disruptive of the ways we used to do things in the past—and it will probably play the same role in the future. The issue of economic inequality, however, cannot be blamed on technological advancement.

Written by Daniel Vargas Gómez

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3 ways companies forget about consumer experience and how it affects their business

Marketing professionals love talking about consumer experience. Terms like engaging, responsive, and targeted make up the usual jargon when we take part in any conversation on consumer experience. My interest here is not to double down on the jargon. Rather than convincing you that I have the formula that will make your consumer experience ‘engaging’ I will take a step back.... 

If I want to convince you of something is perhaps of re-thinking the value of consumer experience: the term is not esoteric or ambiguous. It is, simply put, the way in which your clients, regulars or buyers relate and think about your product. There are a myriad of ways in which this can be done. However, in order to be engaging and awesome companies must first understand what their consumers want and expect. It is at this stage where we tend to simplify and assume too much about what our customers want and what our product delivers. 

There are in particular three aspects that deserve our attention: 1) numbers are wonderful, but they can trick us into making unjustified generalizations—acting in fact like a blindfold on our strategic objectives, 2) qualitative data is many times overestimated and we sometimes exaggerate the value of their conclusions—this is what I call the focus group confusion, and 3) many B2B companies tend to dismiss the whole consumer experience discussion as not applicable to them—the truth of the matter is that, if they do, they are missing out on a valuable opportunity to get to know their clients and to leverage the value of their offering.

1.      The numbers blindfold

Scholars like Deirdre McCloskey have blamed economists of being gullible when it comes to the use of mathematical sophistication: the more complex the mathematics the more people will take an economic argument seriously. Her point is simple: numbers are not relevant in and of themselves and thinking otherwise is foolish.

Consumer and market research can be plagued with numbers, which usually tend to confirm most of the intuitions that motivated it from the start. Numbers will allow you to define boundaries for your overall strategic goals. Numbers, however, are often used to make generalizations about consumer behavior. As Nicolas Taleb’s argued in his Black Swan: be always cautious with generalizations and relying too much on predictions. In particular avoid simplifying your product’s audience. People may naturally share opinions, but if you truly want to understand your customers then segmentation and qualitative analysis cannot be ignored. To learn and eventually create a consumer for your product—think IPod or Walkman—simplifying is not the way to go.  Instead, learn, gather and synthesize consumer information, in order to create memorable experiences.

2.      The focus group confusion:

Many research companies and a few agencies love making focus groups. Some even sneer on the quantitative researchers who are unable to grasp the richness of analysis of a focus group. The truth however is that focus groups are anything but absolute truths. There results can never be taken as a last word and comparison with other sources is always desirable.

Malcolm Gladwell’s Blink is a must read in this respect. He discusses in detail the, perhaps now exemplary case, of what can happen when a company is too complacent with conclusions on consumer behavior product of focus groups and of controlled psychological experiments in general. The case in point was the 1980’s Pepsi challenge, which asserted that if faced with a blind test, consumers would always choose Pepsi over Coke. What happened next is what is truly remarkable. Coca Cola conducted blind test replicating the Pepsi challenge and actually concluded that the results were correct: people preferred Pepsi to Coke. Coke’s move was to bring to the market New Coke, which in a word proved to be a marketing disaster.

The lesson then is: never use focus groups! ... I’m kidding of course or half kidding. The reason is that controlled experiments are truly that: controlled circumstances. These circumstances are almost never identical or even similar to the normal circumstances under which a product is consumed. Take the Pepsi challenge, for instance. When does a cola (or soda/pop) consumer will buy a coke, take a sip of it and then proceed to discuss its taste, in lecture fashion, with a third party?

3.      The B2B deception

For many companies the issue of customer experience is completely pushed aside by appealing to their B2B nature: ‘we don’t have customers, we have clients and they are companies so consumer experience is not relevant for us’. Right (?) Well, wrong actually. B2B changes but does not eliminate the importance of understanding and creating the right customer experience. There are two aspects that must be taken into account in the case of B2B: 1) who are the final users of your product or service and 2) what is the relationship between users and partner managers. If your user’s opinion is unknown then your company is missing out on a huge opportunity to learn about what works and doesn’t with your user experience. If, however, your relationship with your client is mediated by a partner manager or simply by someone other than the actual user, this does raise a challenge, which is, in any case, worthwhile taking head on. The strategic goal is to get your client to understand the merits of the unique user experience that your product or your service delivers. Once she gets how important this is for your company, she will be interested in, either allowing you to have direct contact with your final user, or she will be more than willing to relay valuable information coming from your final user to you. The goal is that both parties understand that doing so entails a win-win situation for both.

There are, to be sure, plenty of ways to reconfigure the way you look at consumer experience. The lesson, if there is one, is not to forget it nor think you can do without knowing it. Keep an eye on this second season of writing in the factish—subscription is completely free and you will not be getting any unsolicited emails. Just remember: sharing is caring.

Written by Daniel Vargas Gómez