Margareta Pagano: Investment's the key victim of this bonus rampage

It's time for the 'bonus' to be returned to its Latin meaning of 'good' and not 'for the greedy few'

The telephone line was crackling when I caught up with Andrew Smithers at Tokyo's Imperial Hotel last week – but his message was as clear as a bell: the way we pay corporate bosses of quoted companies in the UK and the US, through bonuses and share options, is dangerously distorting the economy and is a major drag on recovery.

But not for the reasons that most people think bonuses are bad – it's far worse than that. As Mr Smithers says, the debate around the issue of pay is appallingly uninformed. Either it's a rant about greedy bankers or one about social justice. Yet the far more important problem is that the incentive schemes designed over the last 20 years to pay top corporate bosses in the UK and US have allowed them to gouge rents from the rest of the economy. This rent extraction, as he calls it, has produced two big problems. First, the UK and US governments have been forced to run big deficits that are unstable in the long run and whose reduction is unstable in the short term. The second problem is even more worrying: these tactics are inhibiting investment, reducing the long-term growth potential of both countries.

It's a view that Mr Smithers sets out with great clarity in his brilliant new book, The Road to Recovery: How and Why Economic Policy Must Change, which should be read by every City fund manager, politician and policymaker before even more damage is done.

Packed with new data, the evidence produced by Mr Smithers is persuasive: in the 1970s, companies invested many times more in the long term than they paid to shareholders. Today business leaders are either sitting on cash or handing it back to shareholders; in 2011 the value of share buybacks in the UK was equal to 3.1 per cent of GDP, and in the US it was 2.7 per cent . That's bad news as buybacks boost earnings per share in the short term, thus boosting the value of management's share options.

So how did this switch come about? Mr Smithers blames the boffins in the business schools, who came up with long-term incentive plans and other such complex share schemes hoping to find a way of aligning shareholder interests with managers to maximise profits.

The opposite happened. Instead of aligning interests, the bosses have turned the bonus culture into a gravy train for their own rewards.

He's right and here's why. For managers whose remuneration is based on short-term profit, the key to maximising their returns is to maximise volatility; if you want volatility, pay bonuses. So the greater use of bonuses has meant that managers are less inclined to take short-term risks – such as cutting profit margins – and more likely to take longer-term risks, meaning reduced investment.

Mr Smithers has an uncanny instinct for getting to the bottom of things. He was right in 2000, when his book Valuing Wall Street highlighted the exuberance of the dot-com era, and he also warned of the asset bubbles bubbling away well before the crash. He reckons there are three ways of tackling these pay distortions: tax bonuses out of existence; abolish them; or reform the way bosses are paid. But most of all he hopes for a proper public debate about how best the interests of management should be aligned with the economy as a whole. And so should we. It's time for "bonus" to be returned to its Latin meaning of "good" and not "for the greedy few".

The banks didn't want to tell Sid

Royal Mail, led by Moya Greene (inset below), was always going to be priced to go – so no one should be surprised at the frothy profit when the shares closed at 455p on Friday. The Government's mistake was not the price but failing to give a bigger slice of shares to private investors.

Much is being made of a 1980s-style revival in Sids. The truth is that only 23 per cent of the £3.3bn issue went to the public; the investment bankers made sure of that as they dislike small investors, preferring to help their friends get enough to stag. If ministers do want to give popular capitalism a shot before the next election, they must stand up to the bankers and demand more shares are made generally available. They can start by ensuring that a much bigger chunk of Lloyds gets to El Sid rather than institutions when the next tranche of shares is sold next year.

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