They are arguing about this over at MR. Are CEOs paid their value added?
I think this has a lot to do with sample size. When deciding how much a CEO is worth, the board has to make its decision on a relative small amount of evidence. They base their decision on past performance, but the problem is that that people don't have enough years of past performance to be statistically significant. When your conclusions are based on small amounts of evidence, you are going to overestimate the effect of the variable on the results.
Essentially, results vary partly because of randomness. For example a company may have a good quarter or a bad quarter for reasons that have nothing to do with the CEO, and for factors that you can't control for. The shorter time period you look at, the more randomness you are going to see and therefore the quality of CEOs will seem to vary more. If you look at a longer time period you're going to get something called "regression to the mean" also known as "reversion to mediocrity". As in when random variation starts to fade away, everyone starts to look more average.
And when hiring someone, you're paying them for their expected future performance, knowing that a good CEO could well mean a difference of billions of dollars in profits for shareholders. But, that guy who did so well at that other company was probably doing better than his average. Part of it was due to luck. If a CEO has a particularly good quarter, the next one will probably be worse, and vice verse for a bad one. Over time, as you start to control for randomness, people become less exceptional. And you see they aren't worth paying exceptionally large salaries.
The problem is that people aren't around long enough for "reversion to mediocrity" to set in enough. And people routinely fail to take regression to the mean into account. This leads them to overestimate the effect of individuals, whether in business or sports or politics. The man at the top on an organization is less important than people think. And so companies spend too much money attracting top performing CEOs only to watch "reversion to mediocrity" set in.
A CEO that can really improve the company and its stock value would be worth a great deal of money. The problem is you can't tell who that CEO is. And if you pay them for performance, much of that is just randomizing their salary.
I'm not saying that a persons success or failure is not affected by hard work and ability (like a conservative would argue) or on connections and corruption (like a liberal would argue). But lets not forget the importance of Lady Fortune as well.
Wednesday, November 30, 2011
Quotes
Megan McArdle
"The current plan on the table, as I understand it, is for the PIIGS to get bailouts in exchange for letting the more solvent countries step in and run their budgets if they violate budget rules. I can see how this could work, but I can also see how that might be the last straw, and that if the central countries actually tried to execute on this authority, they might find that it doesn't actually exist . . . while their guarantees of that debt very much do. The EU, in fact, has a rather long history of creating toothless institutions that everyone ends up ignoring."
Yeah, Germany can't really force sovereign countries to do anything. It's only lever is its willingness to give them money, and they aren't really very willing anyway. Also, countries don't like surrendering fiscal sovereignty. It can have really bad effects, just ask Suharto.
Karl Smith
"The Eurozone is now a single currency area in name only. Worse, the national central banks do not have the power to control monetary policy. Which means by American or British standards there is no monetary policy in Europe right now. There is regimented chaos."
Karl Smith argues that the ECB can no longer control monetary policy. And that there is no Eurozone-wide monetary policy. The price of Euros in different Euro countries is diverging, and that this is a prelude to the formal break up of the single currency.
From the previous post, Karl Smith
"By that I mean the ECB is no longer controlling the marginal cost of funding and that indeed the cost of such funding is rising much higher than the official 1.25% rate, at least up to 2.25% and perhaps as high as 6 – 7%."
"At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market."
Essentially, if I understand him, and I don't, Europe is so fractured along national lines that households and firms in different European countries are facing radically different interest rates. Also, that the ECB just can't get the liquidity out, let alone out into the real economy, because of a break down in the actual mechanics of trading because you can't find good collateral. People trade sovereign debt mostly as a fairly safe asset to post as collateral for other trades. But sovereign debt in the Eurozone is not the same, and it's not that safe, and there's deep uncertainty as to how unsafe it actually is.
From an IMF working paper by M. Singh, link from MR.
"Post-Lehman, there has been a significant decline in the source collateral for the large
dealers that specialize in intermediating pledgeable collateral. Since collateral can be
reused, the overall effect (i.e., reduced ‘source’ of collateral times the velocity of collateral)
may have been a $4-5 trillion reduction in collateral. This decline in financial lubrication
likely has impact on the conduct of global monetary policy."
There has been a decline in the velocity of collateral which has a similar effect to a decline in the velocity of money. After Lehman, people want to have as few intermediaries that they might be exposed to as possible. If you post some collateral when I lend you money, I can then pledge your collateral as collateral for someone to lend me money, and so on. And money is created. But this chain has gotten shorter because after Lehman people are less sure about whether everyone in the chain is going to be here tomorrow to repay.
Or it's clear at this point that I don't know what I'm talking about.
"The current plan on the table, as I understand it, is for the PIIGS to get bailouts in exchange for letting the more solvent countries step in and run their budgets if they violate budget rules. I can see how this could work, but I can also see how that might be the last straw, and that if the central countries actually tried to execute on this authority, they might find that it doesn't actually exist . . . while their guarantees of that debt very much do. The EU, in fact, has a rather long history of creating toothless institutions that everyone ends up ignoring."
Yeah, Germany can't really force sovereign countries to do anything. It's only lever is its willingness to give them money, and they aren't really very willing anyway. Also, countries don't like surrendering fiscal sovereignty. It can have really bad effects, just ask Suharto.
Karl Smith
"The Eurozone is now a single currency area in name only. Worse, the national central banks do not have the power to control monetary policy. Which means by American or British standards there is no monetary policy in Europe right now. There is regimented chaos."
Karl Smith argues that the ECB can no longer control monetary policy. And that there is no Eurozone-wide monetary policy. The price of Euros in different Euro countries is diverging, and that this is a prelude to the formal break up of the single currency.
From the previous post, Karl Smith
"By that I mean the ECB is no longer controlling the marginal cost of funding and that indeed the cost of such funding is rising much higher than the official 1.25% rate, at least up to 2.25% and perhaps as high as 6 – 7%."
"At the crux of the problem seems to be the inability to arbitrage away differences in funding costs between institutions and countries because of malfunctioning in the European Repo market."
Essentially, if I understand him, and I don't, Europe is so fractured along national lines that households and firms in different European countries are facing radically different interest rates. Also, that the ECB just can't get the liquidity out, let alone out into the real economy, because of a break down in the actual mechanics of trading because you can't find good collateral. People trade sovereign debt mostly as a fairly safe asset to post as collateral for other trades. But sovereign debt in the Eurozone is not the same, and it's not that safe, and there's deep uncertainty as to how unsafe it actually is.
From an IMF working paper by M. Singh, link from MR.
"Post-Lehman, there has been a significant decline in the source collateral for the large
dealers that specialize in intermediating pledgeable collateral. Since collateral can be
reused, the overall effect (i.e., reduced ‘source’ of collateral times the velocity of collateral)
may have been a $4-5 trillion reduction in collateral. This decline in financial lubrication
likely has impact on the conduct of global monetary policy."
There has been a decline in the velocity of collateral which has a similar effect to a decline in the velocity of money. After Lehman, people want to have as few intermediaries that they might be exposed to as possible. If you post some collateral when I lend you money, I can then pledge your collateral as collateral for someone to lend me money, and so on. And money is created. But this chain has gotten shorter because after Lehman people are less sure about whether everyone in the chain is going to be here tomorrow to repay.
Or it's clear at this point that I don't know what I'm talking about.
Why Was The Default Voluntary?
Essentially, the ECB decided Greece would default, but it wouldn't trigger Credit Default Swaps. As in it's a default but we aren't going to call it a default. Credit Default Swaps, by the way, are simply insurance issued by one private party to another. If Greece defaults, and you have a CDS on Greece, the insurance pays out.
Only this time it didn't. Because when your investment went up in smoke, the ECB redefined the meaning of the word "fire". There really is no direct reason for the ECB should do this. When a sovereign like Greece defaults the people who issued the swaps lose money, and the people who bought them gain. And it's not clear why one should be favored over the other. Presumably the ECB is trying to save some at risk institutions that issued insurance they can't pay out, but there are also many European institutions that bought the swaps.
This is incredibly harmful in that it prevents anyone thinking of buying European debt from hedging against the possibility of default. Demand for European debt will sink, and the interest rates on European debt will go up even more. And when the ECB changes the rules mid-game, it creates uncertainty about investing in Europe and people don't want to play anymore. This lack of trust in European institutions is now a structural problem.
The question here is why would these Eurocrats be so daft? Are they being daft?
Personally, I hope they are. The idea that the ECB is playing favorites is less worrying than a Europe that can't handle the default of even a relatively minor player. I don't think the ECB worries that a Greek default would be catastrophic, but rather that it might be catastrophic. Its worth remembering how little the people overseeing these financial crises really know about what is going on, and exactly what the result of triggering these Credit Default Swaps would be. It's hard to figure out what the full extent of liabilities across European institutions to a Greek default are, before it happens.
In the back of their minds is the fear that there is another AIG waiting to go off. And Europe may not have the tools to quickly rescue a collapsing bank if the sovereign country lacks either the will or the resources to do so. And I'm sure that in this fear ridden environment, a European bank with exposure in the case of Greece technically defaulting could get out of its commitments by jacking up the doom in private conversations with the central bankers.
Only this time it didn't. Because when your investment went up in smoke, the ECB redefined the meaning of the word "fire". There really is no direct reason for the ECB should do this. When a sovereign like Greece defaults the people who issued the swaps lose money, and the people who bought them gain. And it's not clear why one should be favored over the other. Presumably the ECB is trying to save some at risk institutions that issued insurance they can't pay out, but there are also many European institutions that bought the swaps.
This is incredibly harmful in that it prevents anyone thinking of buying European debt from hedging against the possibility of default. Demand for European debt will sink, and the interest rates on European debt will go up even more. And when the ECB changes the rules mid-game, it creates uncertainty about investing in Europe and people don't want to play anymore. This lack of trust in European institutions is now a structural problem.
The question here is why would these Eurocrats be so daft? Are they being daft?
Personally, I hope they are. The idea that the ECB is playing favorites is less worrying than a Europe that can't handle the default of even a relatively minor player. I don't think the ECB worries that a Greek default would be catastrophic, but rather that it might be catastrophic. Its worth remembering how little the people overseeing these financial crises really know about what is going on, and exactly what the result of triggering these Credit Default Swaps would be. It's hard to figure out what the full extent of liabilities across European institutions to a Greek default are, before it happens.
In the back of their minds is the fear that there is another AIG waiting to go off. And Europe may not have the tools to quickly rescue a collapsing bank if the sovereign country lacks either the will or the resources to do so. And I'm sure that in this fear ridden environment, a European bank with exposure in the case of Greece technically defaulting could get out of its commitments by jacking up the doom in private conversations with the central bankers.
European Federal Oversight, Not Assuring
The proposals being pushed mainly by Germany that involve federal oversight of national budgets for Eurozone members does not strike me as something that should assure anyone thinking of lending money to Europe.
According to the German narrative, a list of various non-German countries that for some reason we have decided does not include France, due to moral weakness, went deeply into debt implicitly guaranteed by Germany. This was not simply because of poor leadership, but rather because of poor decisions by those leaders forced on them by the people of those countries. Democracy should die now that it found the keys to the treasury.
Actually they found the keys to the German treasury, those crafty Greeks. To remedy this, German will oversee the budgets of these creditors to make sure they exhibit proper Germanic temperance.
I'm not really interested in if this narrative makes sense, maybe something on that later. What I am worried about is whether this federal oversight will be constructive, and will it drive down the price of European debt. For several reasons, I think no. Actually, it could be quite harmful.
To start off with, I think that this oversight will amount to shallow austerity rather than deep structural reforms. German and French banks own a lot of debt that they wish they didn't and wish they could get out of. They need to get their money back. The long term, less important. What Europe in general, and the countries like Italy, Greece, and Spain in particular, needs to focus on is increasing competitiveness. For example reforming Europe's two-tier labor market. These are longer term problems, but they need to be addressed. Short term austerity, however, would be down right harmful.
Also, I don't think that Germany will help these countries' competitiveness because they are competitors. Sure, they want to see these countries do well, but not if it means attracting businesses with low taxes or low wages. You can already see this in Franco/German insistence that Ireland raise corporate income taxes. It seems that the word competitive is often preceded by the word unfair in the EU. Just imagine the moral outrage if one of these countries managed to attract a major investment from Opel.
But most importantly, taking away national sovereignty is not going to increase the nation's willingness to pay. And sovereign debt crises are about willingness not ability to pay. Already in Greece we see the social contract under stress. If you are going to ask people to sacrifice through higher taxes or lower benefits, then you need to give them some sense that they are doing it in the interests of their nation. And you need to give them some control as to how.
According to the German narrative, a list of various non-German countries that for some reason we have decided does not include France, due to moral weakness, went deeply into debt implicitly guaranteed by Germany. This was not simply because of poor leadership, but rather because of poor decisions by those leaders forced on them by the people of those countries. Democracy should die now that it found the keys to the treasury.
Actually they found the keys to the German treasury, those crafty Greeks. To remedy this, German will oversee the budgets of these creditors to make sure they exhibit proper Germanic temperance.
I'm not really interested in if this narrative makes sense, maybe something on that later. What I am worried about is whether this federal oversight will be constructive, and will it drive down the price of European debt. For several reasons, I think no. Actually, it could be quite harmful.
To start off with, I think that this oversight will amount to shallow austerity rather than deep structural reforms. German and French banks own a lot of debt that they wish they didn't and wish they could get out of. They need to get their money back. The long term, less important. What Europe in general, and the countries like Italy, Greece, and Spain in particular, needs to focus on is increasing competitiveness. For example reforming Europe's two-tier labor market. These are longer term problems, but they need to be addressed. Short term austerity, however, would be down right harmful.
Also, I don't think that Germany will help these countries' competitiveness because they are competitors. Sure, they want to see these countries do well, but not if it means attracting businesses with low taxes or low wages. You can already see this in Franco/German insistence that Ireland raise corporate income taxes. It seems that the word competitive is often preceded by the word unfair in the EU. Just imagine the moral outrage if one of these countries managed to attract a major investment from Opel.
But most importantly, taking away national sovereignty is not going to increase the nation's willingness to pay. And sovereign debt crises are about willingness not ability to pay. Already in Greece we see the social contract under stress. If you are going to ask people to sacrifice through higher taxes or lower benefits, then you need to give them some sense that they are doing it in the interests of their nation. And you need to give them some control as to how.
Tuesday, November 29, 2011
EFSF increasing risk for private creditors
In the wake of the Greek default, has the EFSF lost its ability to drive down bond yields of peripheral members?
When the Eurozone decided to impose loses on private creditors, and private creditors alone, I think it lost any ability to help its member states finance themselves. Because the more bonds the EFSF buys, the more bonds are ring fenced from write offs, and the higher the write offs for private creditors have to be in order to get sovereign debt down to a level that can actually be payed.
Whenever the IMF or the EFSF purchases bonds, it automatically decides its going to be senior to all other creditors. And everyone who already owned the debt suddenly finds themselves in a lower tranche. I don't think people want this kind of "help".
Rather than driving down bond yields, when the EFSF buys bonds of a country, its yields should go up. If Greece owed me money, and it was lent money from Germany, I would worry for the same reason I would worry if Greece was lent money by a loan-shark. If its not going to pay somebody, its the person who won't break their legs.
If the EFSF is going to buy bonds, it should buy them after a default, not before. Or, preferably, it should have accepted the same losses as it forced on private creditors. That would have assured the markets that there would be significant political pressure against defaulting. Or best of all, buy Greek debt and burn it in exchange for reforms.
When the Eurozone decided to impose loses on private creditors, and private creditors alone, I think it lost any ability to help its member states finance themselves. Because the more bonds the EFSF buys, the more bonds are ring fenced from write offs, and the higher the write offs for private creditors have to be in order to get sovereign debt down to a level that can actually be payed.
Whenever the IMF or the EFSF purchases bonds, it automatically decides its going to be senior to all other creditors. And everyone who already owned the debt suddenly finds themselves in a lower tranche. I don't think people want this kind of "help".
Rather than driving down bond yields, when the EFSF buys bonds of a country, its yields should go up. If Greece owed me money, and it was lent money from Germany, I would worry for the same reason I would worry if Greece was lent money by a loan-shark. If its not going to pay somebody, its the person who won't break their legs.
If the EFSF is going to buy bonds, it should buy them after a default, not before. Or, preferably, it should have accepted the same losses as it forced on private creditors. That would have assured the markets that there would be significant political pressure against defaulting. Or best of all, buy Greek debt and burn it in exchange for reforms.
A Lengthy Indictment of Our Century
In a fit of self indulgence, random thoughts on politics and economics. Because I am very important. As for why, I find our politicians interesting for the same reason you can't look away from a car crash. Hopefully, this will remain unread. There are already many places where people can become ill informed. Well, that's all.
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