Wednesday, January 11, 2017

Irrationality in the boardroom

http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2017/01/irrationality-in-the-boardroom.html

Jan. 10, 2017

Here’s the finding of a new study of German firms:

Managerial overconfidence is positively related to the probability of failure of planned investment projects.

This corroborates a decent amount of research summed up (pdf) by Ulrike Malmendier:

A large and growing body of evidence suggests that a substantial share of top corporate executives exhibit symptoms of overconfidence in their decisions…Even when managers intend to maximize claimholder value, they can fail to do so because they hold overconfident beliefs.

For example, she shows (pdf) that where bosses are overconfident, firms’ capital spending is unduly sensitive to corporate cash flow: they invest when the firm is flush but not when it isn’t. And Charles Lee and Salman Arif have shown that increases in investment tend to lead to more earnings disappointments and lower growth – which suggests that investment decisions are motivated by sentiment rather than a realistic assessment of potential projects.

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This is by no means the only evidence we have. There’s also groupthink in boardrooms, which has contributed to corporate scandals. Bosses can be narcissists and psychopaths, with adverse effects on corporate performance. Richard Roll famously pointed out 31 years ago that takeovers were often motivated by hubris (pdf): RBS’s takeover of ABN Amro, which was one of the most expensive mistakes in British economic history, fits this pattern. And banks took excessive risks in the mid-00s, which led to the financial crisis.

What we have here, therefore, is abundant evidence that bosses are irrational, and this irrationality is costly for shareholders and the wider economy.

Jeremy Corbyn’s call for a maximum income does not address this. The problem is not just that bosses have too much money, but that they have too much power, which they misuse.

This fact, however, is almost completely effaced from political discourse. The nudge agenda focuses far more upon low-level individual irrationalities than upon boardroom ones; bosses are routinely portrayed in the media as disinterested experts and even heroes rather than biased rent-seekers; and debate about Brexit has stolen almost all the cognitive bandwidth that should be devoted to other matters.

In these ways, politics and the media serve the function of sustaining unjust and inefficient inequalities.

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