Understanding ECB Comments: How Central Bankers (Should) Think

Central Banking should come with a warning: Anything you do, will be the cause of major criticism. When I usually see reactions on comments by ECB officials, it usually of the "they know nothing/understand nothing kind". The job is not easier for the US Federal Reserve either; it has a long been a while since I've heard no reactions to policy changes. When the Fed initiated QE, Cassandras said it would drive inflation rates sky high; it didn't. When tapering started, Cassandras (different ones I hope!) complained that it would have a severe effect on the economy; still nothing. Yet, while the usual aphorisms on Central Bank statements and actions have been going around for a while, what is usually the problem is that do not see things from their point of view: that of a person/institution who have a great effect on the economy.

Whether we like to admit it or not, Central Banks do have a lot on their minds. When times are good they have to be careful to prevent bubbles from forming and when times are bad they have to act in order to make them better and be careful not to make them worse. A clear example of the Central Banker's power and the strong grip he or she has on the economy, are reactions to verbal statements. When Alan Greenspan spoke of irrational exuberance for the first time in 1996, markets tumbled; when Mario Draghi gave the "anything it takes to support the euro" speech in August 2012, this is how the Forex Market reacted:

It is really not a question whether the Central Bank has an effect on the economy, it's about how big it is and the answer is that it's huge. Even if policies do not drastically change market conditions in the short-run  (they usually change them in the medium-run), comments and speeches do have a stronger effect since they affect investor confidence. This is why Central Bankers are very careful of what they say and this is why they should (and do) never speak of bad news.

As we know, the ECB, through its Board, has denied that deflation is a problem. Jens Weidmann has stated that the drop in inflation is nothing but temporal. Whether he actually believes that or not, is something we will never find out. Now, dear reader, imagine what would happen if the ECB or it's board began to talk of deflation being a problem in the Eurozone. As a first reaction, markets would drop and the euro would rise making exports harder. Investment would gradually be reduced and the whole economy would enter a vicious cycle of decreased consumption, drops in wages and less investment. More so, the whole procedure could actually be initiated just by the Central Banker admitting that deflation exists, as most people "know" that deflation is a problem.

Then, with regards to ECB reactions and comments, what would the reader, an ordinary citizen of the Eurozone prefer: a Central Banker denying the existence of deflation thus allowing the markets to continue without paying attention to what he says, or a Central Banker admitting or warning about the dangers of the current deflation and forcing a deflationary cycle on the economy? If you ask me, the former is much better than the latter, if only for employment reasons.

Who knows: maybe the ECB does know something more than we do when it comes to deflation. If not, then measures to counter deflation can be expected at the next meeting. Still, too much truth can actually harm the economy at times. In fact, I would even go as far as claiming that a Central Banker should act like Titanic's orchestra: even when the ship is shipping (s)he should calm everyone down and tell them that it's all going to be all right.

CEO compensation and Worker Job Security

That CEO's are earning big money is nothing we didn't know about. Yet, the size of their paychecks is at times enough to make those who are not earning 6-figure salaries furious. In the list of the top 15 earners for 2013, the lowest CEO compensation is at $36 million. It is true that their earnings fluctuate with the earnings and general performance of their firms. In fact, they have done a wonderful job tracking the S&P 500 especially since the 1990's:

As the reader may observe, CEO compensation was not following stock market development right from the start. In fact, for the first 10-15 years since the 1960's, the upward trend in compensation was not an outcome of a strong stock market; the S&P was on a long downwards trend during that time. Yet, in modern times, CEO's more than made up for their losses. In 1978, the CEO-pay-to-worker ratio was 26.5-to-1; in 1995 it went to 136.8-to-1 and in 2012 it was 202.3 times the typical worker's salary as the EPI reports (the peak of this ratio was in 2000 when it reached 411.3-to-1).

The difference is astonishing. Most of us would (rightly) think that we have overemphasized the importance of a CEO: she/he may be worth a lot and have much more worries than the average worker, but try working a day without him and another without 200 typical employees and see which is more important for the firm. Still, what is more interesting is not that, since the 2000 peak, the ratio of CEO pay to average worker has decreased, but the timing and reason behind that. For example, look at the following table from the same publication:

Note the two highlighted numbers: CEO compensation has actually decreased in 2011-2012, by approximately 7.1% while the decrease for workers has been a much lower 0.6%; the ratio of earnings during that period narrowed by about 6%. The problem here is worker wages are also falling during a crisis. Thus, even though CEO compensation is falling, the fall is reduced from the worker wage reduction (this is the same as debt-to-GDP ratio analysis where if GDP falls even when debt falls the ratio may remain unchanged). This isn't just the case for the US mind you; the same gap (albeit not so exacerbated) also exists in Spain (where higher salaries continued to grow through the crisis, with 2009 being the only exception) and most likely every other EU nation. As the article on Spain notes, there are two possible explanations: either CEO salaries were the first to go down so the first to go up, or firms are focusing on people who, in their opinion are bringing the greatest value in the organization.

Defendants of CEO pay might argue that since their compensation varies widely through time, indicating more risk, it makes sense that these people get more money in return. Yet, when there is mostly an upwards trend, a few points indicating a decrease hardly matter. In fact, Kaplan notes that the historical average of CEO compensation is in the mid 1990's: the figure for 1995 is 6,303 and the ratio at 141.1-to-1. Thus, even though CEO compensation has been falling since 2000 the fact remains that at its peak it was much higher than expected. Just like the dot-coms at the time, it was a bubble itself.

A more important point is that their compensation, although decreased at times of recession (contemporaneously as the data show; see 2007-2009), the value of their money was not reduced by as much, given the deflationary pressures of the time. Yet, the defendant might comment that worker wages increased during that time. This is the most interesting part of the analysis: it appears that, in 2007-2010, worker wage was increasing (a total increase of 5.6%), while CEO compensation fell by 11.8%. In contrast to what many might believe, it appears that worker compensation declines only long after the event, indicating that wages are sticky (for details see this). The bad part here is that unemployment isn't.

In fact, unemployment in the US soared to 10% from less than 5.5%, in 2008-2010. It was only after unemployment peaked, at the start of 2010, that firms decreased wages. This brings out a more important topic: that after all, worker wage is not only volatile, but workers also face the extra uncertainty of becoming unemployed. For the CEO's higher pay means that the cost of being replaced is accommodated, as is the cost of higher volatility. The problem is that the cost of being replaced isn't covered by the wage increases of the average worker.

This doesn't just happen in the US though; it is also the case in Spain, and Greece and other countries. The point is that we compensate CEO's for the higher risk of getting fired or higher volatility in earnings. Still, the wages they earn are sufficient enough for their children to live in luxury. The average worker not only does not earn that much, but also faces the increased probability of being fired at a time when it is most difficult to encounter another occupation, just because of wage stickiness.

What we have been arguing basically reduces to one of two options: either we start thinking that we are overpaying CEOs or that we are underpaying workers. I'll leave it up to you to decide. But if you ask me, lowering the ratio to the early 1990's levels would be much better.

Too much benefits?

After viewing Eurostat's "Government Finance Statistics" publication for 1/2012 in which all data concerning income, expenditure, debt, deficit, and much more were visible, what amazed me was the size of social benefits paid by each country in the EU. Take a look at the following:

What is obvious from the above statistics is that all crisis-ridden nations have seen their social benefits rise over the past 15 years. Greece, Portugal and Cyprus are the top three in increases with 8.4%, 9.5% and 7% respectively. On the other hand, Germany and Finland have reduced the social benefits they pay by 1.5% and 2.6% respectively. It is noteworthy that the nations whose social benefits rose substantially over the last 15 years were the ones which in 1996 had the lowest percentages (Cyprus: 8.3%, Ireland: 12.5%, Portugal: 12.6%, Greece: 13.5%) This phenomenon is rather strange as citizens of most of the aforementioned countries will indicate that they were better off in 1996 than 2012. As politicians and policymakers increases social benefits