Growth, CEO Compensation, and Savings

We wish to show, that excessive CEO compensation is deleterious to an economy.  We show that excess savings is also deleterious, the so-called "Paradox of Thrift."

Prove in the case of the Universal Corporation: UC produces everything. Therefore, all it buys is labor. Thus, all revenue goes either to labor compensation or to capital. We include capital’s share in CEO compensation.  Thus, UC’s employee compensation, minus the CEO’s compensation share c, in the n^th cycle, is R_n(1- c), where R_n is UC’s revenue.  Suppose now everything UC’s employees buy is produced by UC, and UC sells nothing to the CEO. Then UC gets all its revenue by selling to its employees, 

( R_n (1- c) ) plus a portion, R_n e, selling to persons outside the corporation.. Therefore,  

R_n+1 = R_n((1- c) + e);  The growth in revenue, for a given period: DR  =  e – c.  So, where c > e, DR is negative, that is, revenue declines. The CEO of the Universal Corporation, regardless of competence, if paid to much,  is adversely effective. Done.

Now we can include the CEO as an employee, ie someone who buys from UC, if we instead interpret c just as what the CEO does not spend, but saves.  Indeed, this gives us the Paradox of Thrift, when c is interpreted instead as the sum of what all employees, CEO included, save. So, if the portion the employees of UC save is more than the portion sold to people outside of UC, ie if c > e, revenues will decline.

If instead we separate savings into components, labor savings and capital savings, (where investment is a capital expenditure,) s_l and s_c, then if s_l + s_c > e, revenues will decline. If s_c > e, then s_l must be negative, and of magnitude greater than s_c –  e, in order for the corporation to grow in revenue.  That is, labor must dissave if capital saves at a rate greater than the rate of selling outside of UC, for UC to grow.  (This can of course be forced by paying labor less than subsistence.)   

Note, if e is negative, eg if the employees also buy from outside UC, at a rate greater than persons outside of UC buy from UC, the employees of UC must dissave, (both  c and e are negative),  |c| > |e|, in order for the revenues of UC to increase.  In components:  we must have |s_l + s_c | > |e|, where if s_c is positive, s_l must be negative of magnitude greater than  s_c + |e| for there to be positive growth of revenue. 

If we include a third component, call it government, and call UC a nation’s economy, then for positive growth we must have:  s_g + s_l + s_c  > e, or  s_g > e – ( s_l + s_c  ).  If we separate e, net exports, into its components x exports and m imports, we require for growth of revenue

s_g   <  x -- m – ( s_l + s_c ). Clearly, where imports are greater than exports, the problem is exacerbated, and there must be extensive dissavings by government if there is savings by labor and capital. 

We observe, for a system with no net trade, ( x = m ),  s_{g  <} – (s_l + s_c ).  That is, for an economy with no net trade to grow, (net closed,) government expenditures must be greater than private sector savings.  In general, that is, the economy as a whole must dissave.  That is:   0 > s_l + ­ s_c + s_g .This may be made explicit:  The share of growth of revenue,

DR =  – (s_l + ­ s_c + s_g ).

What do we mean by dissave? Savings, of course, may mean putting money into mattresses.  Dissaving implies there must be an input of money, such that more money is spent, by the components of an economy, than is earned. This may be money taken out of mattresses.  This may be money lent by an entity outside of the economy. It may be money added to the supply, as with inflation. Where it is lent by an entity inside the economy, (finance, say, thus s_f) we have the same problem:  We have a change in the relative revenue collected by the components, but the revenue for the whole economy necessarily declines.

With monetary input I, as with inflation, say, we have: I > s_l + ­ s_c + s_g + s_f  as the condition for growth of revenue in a net closed economy.  And in general, allowing for imports and exports: 
I + x – m > s_l + ­ s_c + s_g + s_f  Explicitly, the share of growth of revenue is:  
 DR = – ( s_l + ­ s_c + s_g + s_f ) + I +  x –  m.

This is rather tautological.  With a fixed money supply,  total revenue cannot increase, and any quantity of money taken out of the system leads to a decrease in revenue.  Since nominal profit requires an increase in revenue, a fixed money supply will, in the best of circumstances, result in an average nominal corporate profit of zero, unless there is dissavings. Some might argue that the policy of the wealthy for the past 35 years has been a forcing of dissavings on labor, (and government,) from which they have taken their profit. This is manifest by the fact that the share of wealth of the 1% has increased from around 20% of the total economy to around 40%. The share of wealth of the rest of society has correspondingly decreased from around 80% to less than 60%, and all but 10% is concentrated in ownership by the next 19%.  80% of the population of the United States combine to own only 10% of its assets.

PS:  The diagram is actually kind of a joke.  It's really a copy of the backward bending labor supply curve for an individual worker, a janitor say, who, when 'paid to excess,' is expected to produce less, in particular, work fewer hours. (This effect somehow is not thought to apply to CEO's.) While true for the CEO of  the Universal Corporation, in an economy it is only true for the sum of all CEO's.  Any individual corporate CEO, of course, gets nowhere near the compensation necessary to have a deleterious effect on the economy, (though he still might be expected to produce less if overcompensated.)   But that the sum of all CEO compensation, the sum of all compensation to the wealthy, may be harmful lies the problem, which we discuss in my next post.

States Cutting Higher Education and the Future

Here is a nice chart showing the one aspect of the decapitalization of the US, and how we are short changing our future.

http://www.offthechartsblog.org/adding-up-five-years-of-state-higher-ed-cuts/

A case of present wise, future foolish:  Do taxpayers think they are coming out ahead?  Not so:  The people they are depriving of education, first of all, are their own children.  And second of all, their children are the people who will be supporting them in their retirement.

When a person is retired, they live off the labor of the current work force.  They do not somehow save up their labor, and get what they produced all back when they stop working.   The retired are supported by the people who are still working.  It is the labor of the younger generations which supports the elderly.   

Any sensible person would want that workforce to be as prepared and as capable as possible to support them in their retirement. But by reducing, cutting back on their education, the taxpayers are depriving this workforce, on which they will depend, of the resources, the preparation and capabilities, necessary to support them.  They should instead want them to be prepared, to have the capital, the human capital, to produce enough goods and services to support them in a reasonably comfortable retirement. 

And so also that the next generation themselves can be reasonably comfortable, as they work. If they are not reasonably comfortable, they will be resentful, at the least, and may choose to cut their elders off, at the worst, when they come into their power.     

Helping to pay for the higher education of the upcoming generations is one of the most important ways a person saves for their retirement. Seeking instead to secure their labor with debt bondage is counterproductive, since it discourages the investment the young must make in the first place, and also makes them resentful of the imposition of social burdens.   

Money in the bank is useless without a well functioning economy.  And you cannot have a well functioning economy without an educated workforce.

And this is another case of inter-generational warfare, See: http://anamecon.blogspot.com/2012/10/inter-generational-borrowing.html

And it also points up its folly.

There is another interpretation:  Trade. Everything in an economy is connected.  Thus the equalization of factor prices applies to all factors.  Those which are more insulated from the direct effects of trade, such as education, are affected more slowly, but affected still.  The persistent trade deficit will result on downward pressure on all production, on all sectors of the economy, including education and the capitalization of the workforce.   

The increased necessity for the importation of skilled labor, brought about by short-changing domestic investment in higher education, is another aspect, and a case where the feedback is reinforcing and aggravating the trade deficit.

Links to Mansoor Khan

Here are active links to the articles Mansoor Khan refers to in his comment to Debt, Total Debt and by Sector. I encourage the reader to check them out. First:

http://seekingalpha.com/article/209386-modern-monetary-system-there-is-another-way

In Modern Monetary Theory, (as far as I understand it.) the government creates money by printing it, politically easy, once established, preventing inflation, and destroys it through taxation, countering inflation, politically hard. A government of reasonable virtue and principle would be required. A certain amount of inflation is more likely. Indeed, since debtors tend to be numerous, and creditors relatively few, a certain amount of inflation, which favors debtors, might counter natural tendencies toward the concentration of wealth. Compare this to what we see: Creditors have seized control of the government, and seeking to retain what are essentially ill gotten gains, are directing the government toward our common ruin.

(For a nice exposition of the problems with the current system, see:

Money as Debt:

http://www.youtube.com/watch?v=Dc3sKwwAaCU&feature=related

Or:

http://video.google.com/videoplay?docid=-2550156453790090544

And:

Money as Debt II:

http://www.youtube.com/watch?v=rCu3fpg83TY )

Next from Mansoor Khan:

http://aquinums-razor.blogspot.com/2011/08/what-is-relationship-of-money-to.html

And:
http://aquinums-razor.blogspot.com/2010/07/why-is-deflation-and-depression.html

http://seekingalpha.com/article/210346-should-newly-created-money-be-a-private-or-a-public-asset

Good. Helicopter money to every citizen. Give citizenship a tangible benefit, rather than the burden implied by the national debt. Negative taxation, which is precisely what the government should do when demand is depressed. And/Or it could guarantee employment, which would work as an automatic stabilizer.

http://seekingalpha.com/article/192375-cause-of-today-s-economic-crises-too-much-thrift

http://seekingalpha.com/article/160269-a-radical-solution-for-america-s-insolvent-financial-system

An orderly bankruptcy of the financial system, with the government as receiver.

http://seekingalpha.com/article/-great-banking-confusion-is-there-a-better-way

Mansoor's proposal for 100% non-lendable equity accounts seems doable. They would carry essentially negative nominal interest. The magnitude of this interest would be minimized by interbank competition for deposits.

A Brief Keynesian Digression

This will help with the next posting. Its not necessary, but if you don’t understand it you will have to take some things on faith.

Over the long run, Consumption and Income (or production) are equal, for economies of all sizes. Everything that is consumed must first be produced. Everything that is produced is pretty quickly consumed. Yes, there are inventories, but they are seldom for more than a few months, and they usually stay more or less stay the same. (Every economy, especially modern ones, is at most, only a few months from disaster) Let’s draw a picture, Diagram 1, with Consumption on the vertical axis and Income on the horizontal axis. Then the line where they are equal, for economies of all sizes, is the 45 degree diagonal. If we draw a point above this 45 degree diagonal, the economy it represents will have Consumption greater than Income. Below this line, Income is greater than Consumption. So any economy we talk about, is in the long run, going to be a point on this 45 degree diagonal. If we talk about a 100 billion economy a, it will lie on this line, where its Income and its Consumption are equal. The same for a 200 billion economy b, or a 500 billion economy c.

Now think about Consumption. If our economy is really little, we are going to want to consume more than we produce. If our economy is bigger, we are going to produce more than we want to consume. (Then we are also going to want to save, or more properly accumulate.) We represent what we want to consume by a line C. Diagram 2. This line is called a curve, by economists, lest they forget, as they sometimes do, that it really doesn’t have to be straight. The distance between this line, and the bottom of the graph, is how much we want to consume, at each level of income y. It slopes upward because the greater people’s income (y), the more they want to

Consume. Now this line C, this curve, crosses our 45 degree diagonal, at point e. Below, to the left of this at point e’’ for instance, our economy is little, and people are going to want to consume more than they produce. (In this simple model they can’t, of course. They have to starve) So the Consumption line is above the 45 degree diagonal, more desire to consume than income. To the right of e, at e’ say, our economy is larger, and people are going to have leftovers from what they want to consume, which they will want to save. As our economy grows bigger, and moves further to the right of e, people will want to save more and more. This is shown by the vertical distance between the 45 degree line, and the Consumption line C. Note they are also consuming more and more.

Now this Consumption line is sort of a matter of attitude. (And other things. In fact, this whole argument, is a matter of attitude. As is the diagram, except for the fact that the economy is on the 45 degree diagonal. Notice we’re also ignoring little things like taxes and government and exports and imports.) If people feel like consuming a greater proportion of their income, for a given size of their income, the Consumption line would be higher. This is shown by curve C’ in Diagram 3. At the size of income marked by y, though people are neither saving or dissaving at C, at C’ they want to consume so much they would be dissaving.

Back to the C curve, and Diagram 4. At income y, C is below the 45 degree diagonal, and the difference is how much the people in the economy want to save. (Want to consume + want to save = what is produced.) Now, where can this savings go? It has to go somewhere, because in the long run, economies cannot accumulate stuff. Economies do not save. (This is particularly true of market economies. A company that ‘saves’ too much of its product ends up going under. Well, maybe except for banks. But saving money is not saving stuff.) Nobody is going to make 50 million dishwashers, or 50 million cars, so that 5 or 10 years down the road, they will have them to sell. (Inventories that are accumulated are for at most a few months, and we’re talking about longer than that. Also, note that services cannot be saved.) No. They’re going to want to build a factory to make these things. They’re going to want to invest in a factory. That’s where all the savings goes, investment, and so savings is equal to Investment. (Remember, we’re talking about real savings. Right now, people are money savings like crazy, or trying to. But it is not being invested. So really, they are not saving anything. THey are redistributing demand, both in the present, and the future.)

Now Investment uses resources and is therefore like Consumption. Desired Investment also depends on the Income of the economy, so it can also be represented by a curve, and if we take this curve for desired Investment and add it to the (desired) Consumption curve, we end up with a total, the sum of Consumption and Investment, which economists call Aggregate Expenditures, or AE curve. Actually, what we have here is Aggregate desired Expenditures. Now where wishes, that is the AE curve, meet with reality, that is with income, or production,(y) on the 45 degree line, at e, we have the size of the real economy. This is also where desired savings is equal to desired investment. (We cheated and used a different argument, that real investment and real savings really have to be the same. The Keynesian argument with desired savings and desired investment is more complicated: Suppose the economy produced more than at e, at e’ say. Then the economy would be really producing more than people wanted to expend (at the AE curve.) So with all this extra production, inventories will expand, producers will want to cut back, they will invest less, and the economy will fall back to e. Suppose instead, the economy produced less than at e, at e’’, say. Then the economy will really be producing less than what people want to expend. Inventories will shrink, producers will see this and want to produce more, so they will invest more, and the economy will grow, back to e.)

Now this diagram doesn’t explain very well how economies grow, and move up the 45 degree line as both income, that is production, and consumption grow. Apparently, the AE curve has to keep shifting upward, which means either desire to Consume, or desire to Investment, or both must also keep shifting upward.

In the diagram, though, the economy is kind of stuck at e, because we can’t save more than we invest, and we can’t invest more than we save.

From this diagram, we can draw a simpler diagram of just the relationship between desired Savings and desired Investment. We do this by simply subtracting the Consumption curve in the diagram. If we subtract the C curve, that is shift the C curve down to the horizontal axis (down the orange arrow) and keep the other lines in the same relationship to each other, we have a diagram of the relation between desired savings and desired investment. Diagram 5.

As in Diagram 4, the economy we are talking about is really where the lines cross, at e, where desired Savings equals desired Investment. This is the diagram we will be discussing in the next posting.

Savings and Investment

There is some illusion about people saving, for retirement, for example. People do not save for retirement. They may think they do. But the reality is society invests to support its people, of whom the retired are (will be) a part.

What do we mean? We mean that it is only in the present that society supports its members. It doesn’t ‘save up’ present production to support them in the future. It doesn’t take past production to support them in the present. In terms of what is being produced, it only has what is currently being produced, to support its economy. Yes it has inventories, but usually these are at most a few months. Society doesn’t accumulate (save) a 20 year supply of dishwashers, so it will have them when they are needed ‘down the road.’ Society doesn’t do this with anything.

The closest society does to this is invest in its productive structure. Roads, structures and machinery last a fair length of time. It builds these things in the present, so it will have their productive capacity in the future. It has built these things in the past, so that we have them now. This is physical capital. A society builds capital in the present, so it will have the productive facilities to support its people in the future. In order to do this, it takes away some of its current production from direct consumption, and invests it.

Now the more society builds these things in the present, the more productive capacity we will have in the future. The more productive capacity we will have in the future, the better off, materially, we will be. Assuming, of course, we have the energy to power it. And the labor to direct it.

In particular, the greater comfort we will be able to support our retirees, and the rest of the idle class. And of course, everyone else. And everything else. Because production must also be supported.

Now the way we decide how to divvy up this production is with money. Those who spend the most money get the most goods and services. Those who spend the most, in the long run, are those who have the most. So if you save money in the present, in the future you will have more money to spend.

Now the theory is that the banks will take this money and loan it to someone who will invest it. That is, take current production, and use it to build more productive capacity, so there will be more goods and services to divvy up in the future. This isn’t the only money that does this. Corporations make profits, which they may spend to increase their productive capacity. Some of government spending may go to increase productive capacity, as with some of the ’stimulus.‘

So what happens instead when the banks take your money and squirrel it away?
Well, you’re still saving, but society is not investing in its future. Its capital is not expanding. So the pie is not growing any bigger. So down the road, when you retire and spend your savings, you may have a bigger share of the pie. But since the pie will not be any bigger, everyone else will, on the average, have a smaller share. This includes other retirees, say those on social security, and those who still work, who are supporting you with their labor. It also includes those other things, the productive facilities which must be supported to maintain present production and expand production in the future. So your individual savings, when you spend it in the future, takes away from everything else, including supporting the production on which it depends.

Now, if this were just you, this would not be very significant. But if there is a substantial share of savers, and the banks are not investing the money, (or investing it badly, say in housing or commercial real estate) then all the other people will have a significantly smaller share. And so will production.

What does this mean? Well, under these circumstances, savings is deflationary in the present, and inflationary in the future. In the present, money is being taken out of the economy, and since it is not being invested, (spent on capital) and put back in the economy, there is continually less money, chasing a constant supply of goods. And since the money was not invested, but merely saved, productive capacity is not expanded, so the quantity of goods will not increase.

So when in the future the money is taken out of savings and spent, along with the money that was there before, we will have inflation. Over time, these two effects could be expected to cancel out. What won’t cancel out is a big increase in money supply caused by deficit spending. If this is invested to expand the pie, well and good. If squandered, so the pie still does not expand, much the worse for inflation. What also won’t cancel out is the contraction caused by the deflation, which is that the decreasing amount of money chases a quantity of goods which is also decreasing., though not as fast., which does tend to mitigate the deflation, at the expense of the destruction of productive capacity. The pie actually shrinks.

So this is what is caused by the financial industry doing its retrenchment thing. Now we have already pointed out that the financial ‘industry’ is much too big, so its hoarding of money (rather than investing it in real industry) can be expected to go on for a while. To the detriment of the rest of the economy, since it means that the money supply in the rest of the economy can be expected to decrease, thus robbing productive industries of their nominal profits. Since these industries are losing money, they are not investing, they are cutting back. Still. (Add to this the contraction brought about by the trade imbalance! See: April 2010 The Effects of Unbalanced Trade)

The problem, of course, is that as long as these banks are in business, they’re going to be sucking the money out of the economy, so destroying the economy on which they depend. The government with its stimulus tried to counteract this action. It didn’t, much. It can’t. The banks are sucking too much, too fast.

So. In Economics, savings and investment are equal. At equilibrium. But not in the economy we are experiencing, where savings and investment are not equal.

Just by the way, elementary Keynesian theory predicts a reduction in a nation’s income with an increase in its ‘thrift.’ It assumes savings increases with income, but investment is relatively independent of income, or flat. How to explain the Chinese, though, eh? Next time.