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Salmon: In Praise of Across-the-Board Bonuses

NEW YORK ( Reuters Blogs) -- Quentin Fottrell had a great headline Sunday: "25% of firms give bonuses for incompetence." Which is shocking -- but not in the way that Fottrell intends. Because it's not really incompetence that is being rewarded here. Instead, it's simply employees getting a bonus when their employer does well enough to be able to afford to give out such a thing.

Obviously, if you give out a bonus to all your employees, then you're going to be giving a bonus to your lowest-performing employees. But that's probably as it should be, since trying to measure individual performance is a mug's game, and the performance review is something that deserves to die. Performance-related pay is a nasty, invidious thing, and I'm very glad that an increasing number of companies are doing away with it.

The problem is that people like Fottrell tend to think that bonuses, by their nature, must be performance-related, and that if you're not going to be paying out bigger bonuses to your best performers, then that defeats the purpose of having a bonus system in the first place. And he's completely wrong about that. The reason is that bonuses are a great way of tackling the serious problem of sticky wages -- a problem which causes a significant amount of unemployment in the economy. It shouldn't be 25% of firms giving out what Fottrell calls "bonuses for incompetence," it should be 100%. If that were the case, the unemployment rate would be significantly lower than it is today.

It's basic economics that sticky wages cause unemployment. In any economy, there will be some firms which become less competitive over time; in order to restore their competitiveness, they will need to cut their wages. If they can't do that, they will simply go bust. But cutting nominal wages is very hard. The result is that firms go bust unneccessarily, and their employees get laid off unneccessarily. On top of that, thanks to wage stickiness, there are many firms paying above-market wages to their employees -- that is, wages which are above what an equally-qualified person would require to do the same job. That, too, causes unemployment: if a firm would like to be able to hire 20 people at $15 per hour but instead can hire only 15 people at $20 per hour, that reduces the firm's overall productivity and also means five fewer jobs in total.

When economists talk about the necessity of implementing "structural reforms" in an economy, one of the key reforms they generally have in mind is making it easier for companies to hire, to fire and to reduce wages for workers when times are tough -- those reforms are generally understood to be helpful in reducing unemployment, and countries where doing such things is difficult do indeed, as a rule, have higher unemployment rates than countries where doing such things is easier.

Structural reforms don't need to be handed down from above, by legislatures -- in fact, they're often more effective if they're not. And if you want a structural reform which makes wages less sticky, especially when inflation is very low and you can't count on inflation to do your dirty work for you, then the first place you should look is bonuses.

Think of three people. Anna, who was being paid a salary of $60,000, is told that this year she will be paid only $57,000 -- she's being given a $3,000 pay cut. She gets very angry. Betty, in the country next door, was also being paid a salary of $60,000, and gets no pay rise, despite the fact that there's 5% inflation. She's not happy, but she's not as angry as Anna. Finally there's Carly, who is being paid a salary of $50,000, and who got a $10,000 bonus last year; this year, she's told, she'll get a $7,000 bonus. She's pretty happy.

All three women, of course, end up with effectively the same amount of money both last year and this year. But because of social norms, Carly accepts her 5% pay cut with much more equanimity than Betty, who, in turn, is significantly happier than Anna. An economy with more Carlys and fewer Annas is going to have less sticky wages -- and, as a result, lower unemployment.

There's something quite fair about paying your employees a decent base wage and then giving them a bonus on top which is dependent on how well your company does over the course of the year. It helps align incentives; it also means that when the company makes lots of money, its employees share in the good fortune to a greater degree than they would otherwise. Conversely, it gives the company a certain amount of flexibility to cut annual payroll costs when things get tough. None of this has anything to do with performance reviews, it's just a way to make a large part of a company's expenses a bit more efficient.

Bonuses even make it that much easier to hand out pay rises: If Anna asks for a pay rise she won't like the answer, but if Carly asks for a pay rise it might be possible to work something out. And, of course, pay rises in general are cheaper when they're being applied to a lower base salary.

Finally, bonuses help to encourage saving. Employees tend to spend whatever is in their regular paychecks; if you get a lump-sum windfall, on the other hand, you're more likely to save it. Bonuses are bad for people living paycheck to paycheck, but hourly workers don't tend to get bonuses anyway. So let's hope they catch on. Maybe one day, the minimum size of the company-wide bonus would be a direct function of the size of the bonus given to the CEO. But I'm not going to hold my breath on that one.

-- Written by Felix Salmon in New York.

Read more of Felix's blogs at Reuters.

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