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, 25 th 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). •

Slide 5. Japan: Fiscal Deficits and Business Cash Flows have moved Together. 10 12 Fiscal deficit (+) or surplus (-) as % of GDP. Net lending (+) or borrowing (-) as % of GDP. 8 10 Companies Fiscal Deficit 6 8 4 6 2 4 0 2 -2 0 -4 -2 -6 -8 -4 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 2010 Data Source: Cabinet Office National Income Accounts.

Slide 6. UK: Fiscal Deficits and Business Cash Surpluses have moved Together. Business lending (+) or borrowing (-) as % of GDP. 12 8 Fiscal deficit (+) or surplus (-) as % of GDP. Government Business 10 6 8 4 6 2 4 0 2 -2 0 -4 -2 -4 -6 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 Data Source: ONS via Ecowin.

Slide 7. US: Fiscal Deficits and Business Cash Surpluses have moved Together. Net lending (+) or borrowing (-) as % of GDP by business 7 13 Fiscal deficit (+) or surplus (-) as % of GDP. 6 11 5 Domestic Business Fiscal Deficit 4 9 3 7 2 sector. 1 5 0 3 -1 -2 1 -3 -1 -4 -5 -3 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Data Sources: NIPA Tables 1.1.5 and 5.1.

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.

Slide 11. Japan: Non-financial Companies - Depreciation pays for All Investment. 70 70 Depreciation 60 60 Depreciation and investment ¥ trn. Investment in Plant and Equipment 50 50 40 40 30 30 20 20 10 10 0 0 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Data Source: MoF Quarterly Survey of Incorporated Enterprises.

Slide 12. Curing Japan’s Problem. Companies will run a savings’ surplus unless investment rises • or 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. •

Slide 13. G5: Growth and Capital Efficiency. Business ICOR (business investment as % of GDP divided 3 18 % p.a change in GDP at constant prices 1992 - 2012. Business ICOR 16 2.5 by growth of GDP at constant prices). Growth 14 2 12 10 1.5 8 1 6 4 0.5 2 0 0 France Germany Japan UK US Data Sources: National Accounts via Ecowin.

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% of total • management remuneration in 2000 – 2005, but only 17% in 2008. 2 If you change incentives, you change behaviour. • This is obvious 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).

Slide 20. UK: Unchanged Margins despite Rise in Output Gap. Profits, before depreciation, interest and tax, as % of 36 5 Difference between actual and potential GDP in 4 35 3 34 percentage points. 2 output. 33 1 0 32 -1 Non-financial Profit Margins Output Gap 31 -2 30 -3 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Data Sources: OECD Economic Outlooks and ONS via Ecowin.

Slide 21. US: Rise in Margins despite Rise in Output Gap. 3.5 38 Profits, before depreciation, interest and tax, as % of Difference between actual and potential GDP in 37 2.5 36 1.5 35 percentage points. 0.5 34 -0.5 33 output. 32 -1.5 31 -2.5 Output Gap 30 Non-financial Profit Margins -3.5 29 -4.5 28 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Data Sources: OECD Economic Outlooks and NIPA Table 1.14.

Slide 22. UK: Business Investment has Fallen Heavily while Profit Margins are Unchanged. 36.0 11.5 Profits, before depreciation, interest and tax, as % of 11.0 35.5 Business investment as % of GDP. 10.5 35.0 10.0 34.5 output. 9.5 34.0 9.0 33.5 8.5 Non-financial Profit Margins 33.0 8.0 Business Investment as % of GDP 32.5 7.5 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Data Sources: OECD Economic Outlook and ONS via Ecowin.

Slide 23: US: Business Investment has Fallen while Profit Margins have Widened Sharply. Profits, before depreciation, interest and tax, as % of 37.5 14.0 Non-financial Profit Margins 36.5 Business investment as % of GDP. Business Investment as % of GDP 13.5 35.5 34.5 13.0 33.5 output. 12.5 32.5 31.5 12.0 30.5 11.5 29.5 28.5 11.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Data Sources: NIPA Tables 1.1.5 and 1.14.