The Road to Recovery Andrew Smithers The Daiwa Anglo-Japanese - - PowerPoint PPT Presentation

The Road to Recovery

Andrew Smithers

The Daiwa Anglo-Japanese Foundation London, 25th September, 2013

Slide 1. The Road to Recovery: How and Why Economic Policy Must Change.

• Poor economics caused the financial crisis.
• It is thwarting a sustainable recovery.
• It is raising the risks of another crisis.

Slide 2. The Need for Change.

• Pre-crisis policy was based on the “Neo-classical Consensus”.
• This has no place for debt or asset prices.
• Financial crises are caused by excessive debt and triggered by

sharp falls in asset prices (US 1929, Japan 1990, World 2008).

• Bad theory – bad consequences.1

1 See “The Economic Consequences of Alan Greenspan.” By Andrew Smithers and

Stephen Wright. World Economics Vol. 3 No. 1 January-March 2002.

Slide 3. After the Financial Crisis.

• When asset prices fall, lenders worry about being repaid and

borrowers worry about access to more debt.

• Plans to invest and consume fall, plans to save rise – i.e. an

attempt to run a surplus of savings over investment.

• But savings must equal investment. To avoid depression,

governments must run large fiscal deficits.

• The bigger the debts and the larger the price falls, the larger

the fiscal deficit needed to avoid depression.

Slide 4. Excess Savings can be Cyclical or Structural.

• To avoid depression (excess ex-ante savings) a fiscal deficit is

essential.

• These excess savings are overwhelmingly found in the

business sector.

• Slide 5 (US), Slide 6 (UK) and Slide 7 (Japan).

• 4
• 2

2 4 6 8 10 12

• 8
• 6
• 4
• 2

2 4 6 8 10 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Fiscal deficit (+) or surplus (-) as % of GDP. Net lending (+) or borrowing (-) as % of GDP. Data Source: Cabinet Office National Income Accounts.

Slide 5. Japan: Fiscal Deficits and Business Cash Flows have moved Together.

Companies Fiscal Deficit

• 6
• 4
• 2

2 4 6 8

• 4
• 2

2 4 6 8 10 12 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Business lending (+) or borrowing (-) as % of GDP. Fiscal deficit (+) or surplus (-) as % of GDP. Data Source: ONS via Ecowin.

Slide 6. UK: Fiscal Deficits and Business Cash Surpluses have moved Together.

Government Business

• 3
• 1

1 3 5 7 9 11 13

• 5
• 4
• 3
• 2
• 1

1 2 3 4 5 6 7 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Fiscal deficit (+) or surplus (-) as % of GDP. Net lending (+) or borrowing (-) as % of GDP by business sector. Data Sources: NIPA Tables 1.1.5 and 5.1.

Slide 7. US: Fiscal Deficits and Business Cash Surpluses have moved Together.

Domestic Business Fiscal Deficit

Slide 8. This Time the Surplus is Structural.

• The Neo-classical consensus assumes the surplus is cyclical.
• Followers await a recovery in the “animal spirits of

entrepreneurs”, leading to “escape velocity”.

• The evidence shows this assumption to be without merit.
• Corporate savings’ surpluses in Japan, the UK and the US

are structural.

Slide 9. Bad Economics Again.

• Having caused the crisis, bad economics is now thwarting

recovery.

• As the savings’ surpluses are structural, they will not be

cured by additional demand.

• The cause of the Japanese surplus is excessive depreciation

allowances.

• Those of the UK and US are due to the change in

management remuneration arising from the bonus culture.

Slide 10. High Depreciation causes Business Cash Surplus.

• Japanese companies can finance their excessive level of

investment entirely from depreciation (Slide 11).

• Unless all profits are paid in dividends, there is bound to be a

business cash surplus.

• Excess depreciation means that companies heavily understate

their “true” profits.

• Japanese quoted non-financials’ depreciation is 1.9 times

profits after tax; the US ratio is 0.6.

10 20 30 40 50 60 70 10 20 30 40 50 60 70 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Depreciation and investment ¥ trn. Data Source: MoF Quarterly Survey of Incorporated Enterprises.

Slide 11. Japan: Non-financial Companies - Depreciation pays for All Investment.

Depreciation Investment in Plant and Equipment

Slide 12. Curing Japan’s Problem.

• Companies will run a savings’ surplus unless investment rises
• r deprecation falls.
• Japanese companies invest more than other G5 countries in

an economy that grows more slowly, because of its declining workforce.

• The efficiency of capital in other G5 countries (Slide 13) has

been twice to four times better than Japan’s.

• Japan already invests too much, so depreciation must fall.

2 4 6 8 10 12 14 16 18 0.5 1 1.5 2 2.5 3 France Germany Japan UK US Business ICOR (business investment as % of GDP divided by growth of GDP at constant prices). % p.a change in GDP at constant prices 1992 - 2012. Data Sources: National Accounts via Ecowin.

Slide 13. G5: Growth and Capital Efficiency.

Business ICOR Growth

Slide 14. Depreciation Allowances are too High.

• Depreciation is largely determined by the growth of real

wages.

• Productivity and real wages grew at 4% p.a. in the 1980s and

are now around 1.5% p.a.

• The ratio of depreciation to profits after tax in Japan for non-

financial companies is 1.9:1 and in the US 0.6:1.

• The failure to reduce depreciation allowances with the fall in

productivity means that Japanese profits are heavily understated.

Slide 15. The Need to Rebalance.

• Japan needs to shift from investment to consumption. Labour

incomes need to rise as a proportion of output.

• Without a change in depreciation, this would cause profits

before or after tax to fall. Wages and employment fall when profits fall. (Bonuses and “Shunto” respond to profits).

• Lower depreciation would allow the labour share of output to

rise and profits to increase.

Slide 16. The Boost to Consumption.

• Lower depreciation would increase consumer incomes, both

through wages and dividends.

• As household savings are low, the rise in incomes would be

almost all spent on consumption.

• Higher dividends and wages would increase tax revenue from

both income and expenditure taxes.

• As profits would be stable to rising, there would be no loss of

revenue from corporation tax.

Slide 17. The UK and US Problem is Different from Japan’s.

• There has been a recent and dramatic change in how

management is paid.

• Basic

salaries amounted in the US to 40%

• f

total management remuneration in 2000 – 2005, but only 17% in 2008.2

• If you change incentives, you change behaviour.
• This

is

• bvious

but ignored by most economists and policymakers.

2 “CEO Compensation.” by C. Frydman and D. Jenter, Annual Review of Financial

Economics (2010).

Slide 18. Short-termism.

• The interests of management have increasingly diverged from

those of the company and its shareholders.

• The long-term risks to companies are losing market share

and having higher costs than competitors.

• The short-term risks to management are lower EPS and RoE

due to lower margins and investment in equipment rather than buy-backs.

• Bonuses encourage (i) high profit margins, (ii) low investment

and (iii) volatile profits.

Slide 19. The Bonus Impact is as Expected.

• Profit margins are high compared to output gaps (UK Slide

20 and US Slide 21).

• Investment is low relative to profit margins (UK Slide 22 and

US Slide 23).

• Published profits have become hugely volatile relative to

national account profits (Slide 24).

• 3
• 2
• 1

1 2 3 4 5 30 31 32 33 34 35 36 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Difference between actual and potential GDP in percentage points. Profits, before depreciation, interest and tax, as % of

• utput.

Data Sources: OECD Economic Outlooks and ONS via Ecowin.

Slide 20. UK: Unchanged Margins despite Rise in Output Gap.

Non-financial Profit Margins Output Gap

28 29 30 31 32 33 34 35 36 37 38

• 4.5
• 3.5
• 2.5
• 1.5
• 0.5

0.5 1.5 2.5 3.5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Profits, before depreciation, interest and tax, as % of

• utput.

Difference between actual and potential GDP in percentage points. Data Sources: OECD Economic Outlooks and NIPA Table 1.14.

Slide 21. US: Rise in Margins despite Rise in Output Gap.

Output Gap Non-financial Profit Margins

7.5 8.0 8.5 9.0 9.5 10.0 10.5 11.0 11.5 32.5 33.0 33.5 34.0 34.5 35.0 35.5 36.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Business investment as % of GDP. Profits, before depreciation, interest and tax, as % of

• utput.

Data Sources: OECD Economic Outlook and ONS via Ecowin.

Slide 22. UK: Business Investment has Fallen Heavily while Profit Margins are Unchanged.

Non-financial Profit Margins Business Investment as % of GDP

11.0 11.5 12.0 12.5 13.0 13.5 14.0 28.5 29.5 30.5 31.5 32.5 33.5 34.5 35.5 36.5 37.5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Business investment as % of GDP. Profits, before depreciation, interest and tax, as % of

• utput.

Data Sources: NIPA Tables 1.1.5 and 1.14.

Slide 23: US: Business Investment has Fallen while Profit Margins have Widened Sharply.

Non-financial Profit Margins Business Investment as % of GDP

0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007 2012 Standard deviation over previous 10 years in NIPA profits after tax and EPS on S&P 500 measured at constant prices. Data Sources: Standard & Poor's and NIPA Table 1.14.

Slide 24. US: S&P EPS and NIPA Profits Similar 1952 - 2000, S&P now 4.5 Times More Volatile.

EPS NIPA Profits after Tax

Slide 25. Experience accords with Theory.

• Theoretical analysis also sees the bonus culture as damaging to

the economy.

• Remunerations which depend heavily on bonuses rather than

salaries are “convex contracts”.

• These induce “investment policies that drive firms’ equilibrium

(equity) capital stock to zero”.3

• Managements therefore prefer buy-backs to investment in plant

(Slide 26).

3 “Some Unpleasant General Equilibrium Implications for Executive Incentive

Compensation Contracts” by John B. Donaldson, Natalia Gershun and Marc Giannoni, published in December 2011 by the Federal Reserve Bank of New York as Staff Report

• No. 531.

10 15 20 25 30 35 40 45 50 68 70 72 74 76 78 80 82 84 86 88 1961 1966 1971 1976 1981 1986 1991 1996 2001 2006 2011 % of cash generated from domestic operations paid to shareholders. % of cash generated from domestic operations invested. Data Source: Z1 Table F.102.

Slide 26. US: Companies prefer Buy-backs to Investment.

Investment Share % % to Shareholders

Slide 27. New Evidence.

• Since I wrote the book, new supportive evidence has been

published.

• The distortions from the bonus culture will apply mostly to

quoted companies.

• US unquoted companies invest twice as much as quoted
• nes and appear to have lower margins.4

4 “Corporate Investment and Stock Market Listing: A Puzzle?” By John Asker, Joan

Farre-Mensa and Alexander Ljungqvist, April 2013.

Slide 28. Official Misforecasting – Additional Support.

• Official forecasts have persistently erred in ways that support

the case that management behaviour has changed.

• Higher margins boost inflation, which has been persistently

higher than expected in both the UK and the US.

• The perceived cost of capital to management has risen, thus

favouring the employment of more labour rather than more capital.

• Productivity has therefore been poor (Slide 29).

• 1.5
• 1
• 0.5

0.5 1 1.5 2 2.5 Germany Japan UK US % p.a. change in GDP at constant prices per hour worked.

Slide 29. Collapse of UK and US Productivity.

Q1 2010 - Q1 2013 1992-2012 Data Sources: BLS and BEA websites for US, National Accounts via Ecowin for Others.

Slide 30. The Common Problem – Bad Economics.

• Academics are using economic models which don’t work.
• This applies both to the financial crisis and to the current

malaise.

• One key error is using a model without a finance sector.
• Another

error is ignoring the changed incentives for management which have made business cash surpluses structural not cyclical.

Slide 31. Debt and Asset Prices.

• Debt levels remain very high (Slide 32).
• QE has driven up asset prices to bubble levels (Slide 33).
• While well short of the peaks of 1929 and 2000, valuations

equal those of 1906, 1937 and 1968, all of which were followed by serious economic downturns.

50 100 150 200 250 300 350 400 1929 1939 1949 1959 1969 1979 1989 1999 2009 Debt as % of GDP. Data Sources: Bureau of the Census, NIPA Table 1.1.5 and Z1 Table D3.

Slide 32. US: Debt as % of GDP.

Public Private

• 1.2
• 1
• 0.8
• 0.6
• 0.4
• 0.2

0.2 0.4 0.6 0.8 1 1.2

• 1.2
• 1
• 0.8
• 0.6
• 0.4
• 0.2

0.2 0.4 0.6 0.8 1 1.2 1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 q and C PAE to their own averages (log numbers). Data Sources: Stephen Wright (1900 - 1947) and Federal Reserve (1947 - Q1 2013) for q and Robert Shiller for CAPE.

Slide 33. The Overvaluation of the US Stock Market.

q to its Own Average CAPE to its Own Average

Slide 34. Conclusion: Economic Policy must Change.

• Debt and asset prices need to be reduced slowly. QE must

end slowly.

• Fiscal deficits must shrink by reducing the structural

savings’ surpluses of the corporate sector.

• These

must be achieved before “escape velocity” is achieved.

• So that inflationary expectations don’t pick up and rising

interest rates then set off the next financial crisis.