Arnold Kling  

Economic Attribution Error

California Energy Crisis Redux... Wesbury on Tax Cuts...

In this essay, I argue that the importance attached to the President or the Fed Chairman in determining economic outcomes may be an instance of what psychologists call the fundamental attribution error.

During the Clinton administration, the projected Budget surplus improved by over one trillion dollars. However, most of this change came as a surprise to the administration. A reasonably non-partisan analysis by Douglas W. Elmendorf, Jeffrey B. Liebman, and David W. Wilcox shows that less than 20 percent of the revision to the Budget outlook came from economic policy. (See figure 4 in the paper).

For Discussion. In the essay, I also suggest that CEO's may be overpaid because people attribute too much of corporation's performance to its CEO and not enough to the overall context. Do you agree with this argument?

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CATEGORIES: Fiscal Policy

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The author at in a related article titled Is CEO compensation in line with CEO value? writes:
    In a post celebrating the (rightful) smackdown of an egregious 'golden parachute' CEO compensation plan at GlaxoSmithKline, Calpundit Kevin Drum noted that in the 90s, run of the mill corporate executives saw their compensation go through the roof: Th... [Tracked on June 2, 2003 3:29 PM]
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"In the essay, I also suggest that CEO's may be overpaid because people attribute too much of corporation's performance to its CEO and not enough to the overall context. Do you agree with this argument?"

Arnold, I agree with you 110%.

Whenever a company does well, it's always because of the CEO's

a) foresight
b) brilliant strategic thinking
c) dazzling leadership
d) shrewd handling of the company
e) all of the above

And because of all these, the company needs to pay the CEO big time --talk about egregious pay packets (check out Computer Associates, for one)

When the company does badly, it's because of

a) the Russian debt default (1998)
b) Y2K fears (1999)
c) recession (2000)
d) the terrorist attacks of 9/11 (2001)
e) global deflation
f) all of the above.

The CEO, of course, has nothing to do with the company's abysmal performance. He/ she may even argue that because of all the aforementioned crises, the company needs his leadership/ strategic planning more than ever [LOL] And of course, the company needs to pay this talented worthy a pay package that matches his "incredible talents", even as thousands of employees are let go. As The Economist once remarked, modern CEOs, especially in the US, have this Pontius Pilate act down pat.

David Thomson writes:

I strongly believe that the role of the CEO is greatly exaggerated. The self serving rhetoric that turns them into heroic figures able to jump over tall buildings and bend steel in their bare hands has much to do with the cooperate elitist buddy-buddy system. Do you remember the old saying: “You scratch my back and I’ll scratch your's?” They mostly all sit on the same boards and award each other huge compensation packages.

Why do the ordinary stockholders let them get away with this nonsense? Previously I mentioned the dilemma of fighting against government waste. You may abstractly disagree with a perceived wasteful spending program, but it is exceedingly difficult to do anything pragmatically about it. The actual cost to your personal pocketbook is only something like .000000001% of your total annual income. You therefore must act altruistically while those advocating for the program are usually well compensated for their efforts. The same thing essentially holds true in the private sector regarding executive compensation.

Gosh darn it, have I turned Marxist? Am I now ready to bring down the system and establish an utopian workers paradise? Heck no, I simply realize that our current system needs some fine tuning.

Jim Glass writes:

Regarding the Clinton's people's claim to have "created the surpluses" here's the budget picture they *thought* they were creating at the time -- the base line budget projection as of March 28, 1996* (well after enactment of the Clinton tax increases and purported spending cutbacks that supposedly created the surplus)....

Year ... projected budget stance
1996 ... $140 billion deficit
1997 ... $169 billion deficit
1998 ... $195 billion deficit
1999 ... $221 billion deficit
2000 ... $246 billion deficit
... rising to a $405 billion deficit in 2006.

Thus, the actual surplus of $236 billion in 2000 arrived as a $482 billion surprise to them. So the next time you hear Clinton's people claim kudos for creating that surplus, without admitting what a big surprise it was to them compared to what they thought they were creating, feel free to let them know how generous they are being to themselves.

[* "Baseline Total Deficit with Current-Policy Economic Assumptions, capping discretionary spending with inflation after 1998", CBO, 3/28/96]

David Thomson writes:

“The Bush economic policy can be evaluated on its own merits. I would give the administration a bad grade on trade, because of the steel tariffs. I would give the administration a bad grade on fiscal policy, because it is making no attempt to identify and implement spending reductions.”

The Republican Party is indeed merely the lesser of evils. Sooner or later, the Bush administration musk risk angering the voters who wish to hold onto their “entitlements” Identifying and implementing spending reductions will demand enormous political courage---and therefore we can take it for granted that nothing substantially will occur until after the next election.

Jim Glass writes:

"I strongly believe that the role of the CEO is greatly exaggerated..."

I have a memory of a paper finding that high pay for CEOs is justified not because a good CEO will lead his company to do better than the competition, but because a bad CEO can destroy even a major business in short order.

E.g., just look at what Edgar Bronfman Jr. has so quickly accompished with his family's fortune that had been built up over generations. And I can think of *many* other examples.

Hmmm, going back through my e-mail files, I see the paper was "Performance Pay and Top-Management Incentives", by Michael Jensen and Kevin J. Murphy in the April 1990 JPE (and that the reference was mailed to me by an economist friend who noted with a smile that Krugman endorsed it at the time, this being right after PK had gone one of his more recent tirades against CEO compensation.) But I haven't read it myself, so I couldn't really say.

David Thomson writes:

The CEO is a very important person in any company. Often even the most
important. Still, the position does not deserve the outrageous compensation packages seen in recent years. I suspect that most stock holders agree with me.

The harm caused by exaggerating the role of the top executive transcends the small percentage of company profits used to pay their compensation. No, the real damage is the tacit belittlement of others greatly contributing to the business’ fortunes.

Bernard Yomtov writes:

What is interesting about the CEO pay level is that, aside from the board members who authorize the pay, and the CEO's who get it, there are very few people willing to defend it.

Yet there it is.

I partly disagree with you on this, Arnold. I do think, as you say, that the importance of CEO' s is overrated, but I think the absurd pay scales are more a result of the kind of cronyism David Thomson describes than of this misjudgment.

It is virtually impossible for small shareholders to do much about this, but I wonder about the big institutional holders. Are mutual funds, pension funds, etc. fulfilling their fiduciary responsibilities when they remain silent on this issue?

dsquared writes:

Jim, those are CBO projections based on restrictive assumptions about the macroeconomic effect of deficit reduction. You don't have to be a dynamic scoring maven to think that it's pretty misleading to call them "what the Clinton administration thought they were doing". Brad DeLong has said on a number of occasions that they were working off a model under which just getting the deficit moving in the right direction (the "20%" figure) would help to reduce long term real interest rates, with a strong positive effect on the economy. I happen to regard that argument as barking, but I think it's very unfair to call the 1990s boom "unpredictable" when Rubin & Summers did in fact predict it.

Mcwop writes:

CEO pay is outrageous in some cases, but the problem is not necessarily as bad as some would lead people to believe. Fortune 100 execs median salary in 2002 was $13.2 million. That means we are talking about 50 people that may have Eisner-like salaries (which I think is outrageous), but I don’t think $13.2 million (which may be half that after taxes) is outrageous. Steve Jobs earned $1 for a few years while turning around Apple. Now he gets paid handsomely. Regulation of pay is not the answer (even though high marginal tax rates remove a lot of pay from a CEO’s hands). The evidence can be seen in these excerpts from Fortune Magazine:

(1) In 1989, Congress tries to cap golden parachutes by imposing an excise tax on payments above 2.99 times base salary. Result: Companies make 2.99 the new minimum and cover any excise tax for execs.
(2) In 1992, Congress tries to shame CEOs by requiring better disclosure of their pay. Result: CEOs see how much everyone else is making, and then try to get more.
(3) In 1993, Congress declares salaries over $1 million to be non-tax-exempt. Result: Companies opt for huge stock option grants while upping most salaries to $1 million.

Shareholders should be the ones upset about pay, and performance. So I would be ok with regulations that allow shareholders a bigger say. The funny part is among all the outrageous- pay-whiners, they almost never offer comprehensive guidelines to what is acceptable pay.

RE: Clinton and budget surpluses. Budget “surpluses” during Clinton’s term can be attributed to the following:
-Strong economy, which expanded income subject to taxation.
-Strong payroll tax revenues from higher salaries and low unemployment
-Lower interest rates (the treasury issued only short-term debt at lower interest rates saving money).
-Cuts in defense spending and keeping spending increases slightly above inflation.
-Stock market boom, which generated massive capital gains subject to taxes

The tax increases are often cited as the main contributor, but I have seen little evidence that this contributed much. At least those that state this case can credit Bush I a little. He raised taxes before Clinton did.

dsquared writes:

When you make the claim that the deficit reduction was the result of the "strong economy", rather than that the economic strength was due to the investment boom kicked off by falling real long term interest rates as a result of the deficit reduction program, you are assuming what you ought to prove.

mcwop writes:

D2 - Are you referring to the interest rates that Alan Greenspan lowered before Clinton took office. Chicken and egg? Did Greenspan lower rates as a result of Clinton policies. Does not appear to be the case, as interest rates have been trending down since the early 80's.

dsquared writes:

No, I'm referring to long bond yields, which are not directly controlled by Greenspan.

Eric Krieg writes:

D2, the comment still stands. Interest rates of all types have been trending downward since about 1982 or so. During that time, US federal defecits have been all over the place.

Just recently, federal defecits have been growing due to the recession. However, the long bond interest rate is the lowest it has been in two generations.

Mcwop writes:

D2 Writes: "No, I'm referring to long bond yields, which are not directly controlled by Greenspan."

I would argue that LB yields are heavily dependant on Greenspan’s (Federal Reserve’s) interest rate actions. The second factor is inflation expectations.

Example: Money Yields are 6% and Long bonds are yielding 10%. If the FR lowers rates by 300bps and Money yields drop from 6% to around 3%, people will scoop up the long bonds driving their prices up and driving yield down. The treasury will auction new bonds to reflect the current market rates.

Inflation expectations: There has not been much to worry about over the years. OPEC seems to be keeping oil prices reasonable; there are too many goods in the market (except in the healthcare area), and domestic/global competition seem to be keeping prices in check. Either way the Fed Reserve considers this when setting rates.

David Thomson writes:

"OPEC seems to be keeping oil prices reasonable"

More importantly, Iraq will soon be dramatically increasing its oil sales. I suspect that alone may guarantee inflation will be held in check.

dsquared writes:

"Trending down since 1982" perhaps, but rising pretty sharply in 1993 and 1994 which is the period when the policies were actually being formulated.

Eric Krieg writes:

D2, have you read Greenspan's account of the 1994 period? He freely admits that he jacked up rates too aggresively, in contrast to 1999, when he decided that technology allowed much more non-inflationary growth.

I think that there is causation between deficits and interest rates, just not the way that Robert Rubin thinks that there is. It's a secondary effect, economic growth being the real driver of government revenue, and thus deficits. And obviously there is a connection between interest rates and economic growth.

Mcwop writes:

In 1994 Greenspan was raising interest rates. Interest rates did not go straight down since 1982. The Federal Reserve raised rates during some years and lowered during others. Usually the rate hikes were to cool the economy. Greenspan raised rates at the end of Clinton's term from 4 3/4% to 6%.

Here is a history of rate changes:

Eric Krieg writes:

Trending down doesn't mean straight down. It means generally going down. In 1982, interest rates were in the double digits. Today, they are the lowest they have ever been in our lifetimes. That's generally down.

And the real point is that the rates don't follow the deficits. The federal deficit has been rising recently. Rates across the board have been going down.

And in '99 and '00, the rates were rising, yet there was a surplus. I wonder how Rubin explains that?

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