Smithers is quite controversial in many of his views. Brinker actually repeated some of the things he said back to him and asked him to confirm what he was saying. Like me, you may be amazed that Brinker had this man on Moneytalk.
I believe this is very thought-provoking and educational. And if everything Smithers said about the market, economy and inflation is true, it is alarming. You will either love Smither's or "hate" him.
Blog guest-writer, ETF1-Robert has written very complete excerpts from the third-hour Moneytalk last Sunday (emphasis is mine):
3rd Hour: Andrew Smithers
BB: ...... Our guest in this segment is Andrew Smithers. Andrew Smithers is the author of the new book The Road To Recovery--How and Why Economic Policy Must Change. And Andrew is joining us from London. Andrew is on the Advisory Board for The Center for International Macroeconomics and Finance at Cambridge University…….Tell us why you wrote this book
AS: …….I thought it needed writing…….I spend my time advising people on the economic situation and I thought that the more one studies the economic situation, the more it seems clear to me that standard economics was missing very important things that are going on……Economists have their own ways of doing things…….The way they do things tends to produce a similarity of view which is a little dangerous. A very common feature and failing of the economists is to take mathematical models which are elegant too seriously……if you do that……you are in danger of taking a world view of things where world views are not appropriate……..……if you wish to impose mathematical models on everything you will tend to miss some very key developments that go on, and in particular, which is one of the main subjects of my book, when you change the incentives in the way people behave, you will change their behavior. And if you live in a world in which behavior doesn’t change, you will badly miss out on the key things that are going on in the economy. This is one of the main features and theses of my book.………The results of that is economic policy is missing a very important point, both in the US and the UK……and again in Japan……….
BB:……….as you well know, we have just gone through a year that can only be described as an extraordinary level of intervention and initiative on the part of the U.S. Federal Reserve.
We have just gone through a year where the year over year gain in real GDP in the USA came in at 1.9%. So I must ask you, why has this recovery been as weak as it’s been?
AS: ……….We have, in both sides of the Atlantic, had a major change in the way senior management is paid. As the result of that is the incentives of management have changed, and that means they behave in a different way than they were before……..the purpose of incentives is to influence behavior. But what economists have failed to notice is that modern incentives discourage companies from investing and they discourage companies from being aggressive in pricing [??], so what happens is that profit margins are pushed up further than they would normally be at this stage of the economy, and that of course has a negative impact on the real income of the work force. And that of course has a negative impact on consumption, and secondly, of course it would discourage investment and that also has a negative impact on the economy. So what the incentives are doing is that they have a perverse effect which is stopping the normal way in which you would expect an economy to pick up after a severe recession. The normal way is that cheap money, very low interest rates, and you could hardly have them lower than they are today. A booming stock market which of course makes equity cheap to raise. And very low yields on bonds, all of which mean that capital is extremely cheap at the moment and you’d normally expect under these circumstances, that companies would rush out and spend a lot of money, but they’re not. They are borrowing money. But instead of borrowing money to invest, they are borrowing money to buy back shares.
And they are doing that because that is what the incentives encourage management to do. A feature of my book is to show how in the last decade the proportion of corporate cash flow which is spent on investment is the lowest it’s been in the post war world and the proportion of cash flow which is spent on buybacks and dividends, i.e., giving money back to shareholders, which largely benefits management as well as shareholders, has never been higher.
BB: …………Now Andrew, I am not going to put words in your mouth, but I am going to ask you this. There is an implication in what you just said, at least to me, there is an implication that what we’re seeing is an effort by CEOs, and I’ll particularly focus on CEOs, at personal enrichment at the expense of other considerations, is that what you’re seeing?
BB: Well that’s a serious indictment Andrew
AS: Well not entirely. It’s an odd thing, but CEOs did not invent the system which they are seeking to exploit
BB: Well that’s true
AS: …I think this really started in business schools in the 80’s. There was an attempt which said, ‘let us align the interests of management and shareholders more closely’. They said, the business school people, ‘the way to do that is to give them bonuses and options which will be very sensitive to the success of the company’. But unfortunately the people who were thinking about this didn’t know much about option theory. And option theory tells you that the value of an option is not determined by the underlying success of profits but by their volatility. One of the things I show in my book is the amazing increase in the volatility of the way people publish profits today by companies compared with the way the profits are published in the national accounts. This is only one feature but it is very indicative of the behavior. Yes I agree with you that CEOs are exploiting their particular positions to enrich themselves, and this is having a bad effect on the economy. But I don’t think you should say ‘that’s because CEOs are bad people’. CEOs are no different from what they used to be. It’s rather like saying, ‘we’ve suddenly had a vast increase in burglaries. Burglars have become a lot worse than they used to be’. I think that’s the wrong approach. We’ve had a large increase in burglaries, why is that, and the answer probably is the conditions in which burglaries become easy has changed.
It isn’t the nature of CEOs has changed where they have become much wicked-er than they used to be. It’s just that the circumstances which have allowed them to enrich themselves at the expense of the general economy has been changed to their benefit and to the economy’s detriment. You don’t want to go around blaming CEOs. I do think that you want to blame the system which has allowed this to happen.
BB: So what you are saying Andrew is that CEOs have exploited a system which they basically fell into, they did not create, they fell into, they inherited a system which they have found a way to exploit, and as a result they should not be blamed for exploiting it
AS: I think that is exactly right
BB: ………..In your book Andrew, you write about cyclical versus structural impacts on the economy, in fact you write that this is a key issue for economic policy, tell us more about that
AS: We’ve had a recession, an exceedingly bad one, the worst probably post war, in 2008, and the standard economic response to that is when you get a recession, you have to run large fiscal deficits, because what you’ve got is a lack of willingness to invest compared with the wish to save money. And the standard Keynesian answer says ‘that will cure itself because after a while you’ll get a recovery in what Keynes called, the animal spirits of entrepreneurs.’ And what we’ve been seeing recently is that we had the recession we’ve had a huge increase in fiscal deficits, budget deficits, and very low interest rates, but the animal spirits of entrepreneurs have not recovered in the way that the Keynesians would have predicted and would wish……..that is a structural problem not a cyclical one. Instead of finding that we’ve got the medicine which was going to get us out of the recession, we’ve got medicine which has is a stop gap giving in to catastrophe. We haven’t had a big depression. So I’m not saying that the action initially to stop the situation getting into terrible bad ways like it did in the 1930’s was wrong. I’m saying we’ve now got a problem which has not been addressed because most of the governments don’t realize that the cyclical nature of this which they have dealt with is no longer the problem, we’ve now got a structural problem, i.e. we’ve got a tendency for companies to continue to save more than they invest because they are paid to do so at senior management level. ….To change it, so that they invest more and are less aggressive in their pricing so they don’t save as much, then we must change the system whereby we encourage management to behave in a way which is perverse for the interest of the economy.
BB: Our guest from London is Andrew Smithers. For 25 years, Andrew was in charge of the investment management division at SJ Warburg and Company. He also is a member of the advisory board for the Center For International Macroeconomics and Finance at Cambridge University. But the reason he is with us today is in connection with his new book………………………
BB: …………you talk in your book about the need for change in economic theory. Tell us about that.
AS:…….there is a tendency for economists as a whole to want to fit the world into standard packages which don’t apply in outside changes, i.e., they have a model they’d like to apply all over the world, but countries differ and in countries themselves differ over time. So you need to be more flexible, you need to study the data more than economists are unfortunately unwilling to do very often, that’s one problem………The other problem is that the standard model, which is called the Neoclassical Synthesis, has got us into the present trouble……….…The Neoclassical Synthesis is a model of the world in which there is no financial sector, no banks, no asset prices, and no debt. And unfortunately financial crises occur historically, like the one in 1929 in America, the one in 1990 in Japan or the recent one worldwide, when you get an excess of debt and a sudden fall of asset prices. So unless we can change the way in which economists judge and plan and see the way the world will behave, we are going to run into another financial crisis because unfortunately….the conditions which are needed to bring a financial crisis are with us today again. We have a world which is awash with debt, and we have a world in which asset prices are in many instances are at very very dangerously high levels, and two examples of that would be equity prices in America, bond prices nearly everywhere, and oddly enough, house prices here in the UK
BB: Now when we take a look at the US economy and we see the slow growth that we have seen despite the extraordinary efforts by the Federal Reserve to try to stimulate more economic activity…….Why is it do you think that the Fed has had, now we don’t know what the growth rate would have been positive or negative without the intervention of the Fed, and that’s a great unknown, but why do you think it is that using every tool they have in their arsenal, and inventing some new ones like Quantitative Easing, they’ve been unable to do more to stimulate economic growth in the United States?
AS: …..They failed to identify the major drawback to economic growth, which is the incentives that exist for management not to go for growth. If management is paid not to invest then you will have a big drawback to growth, and that is the situation of the moment.
BB: I hear you loud and clear on that point and it certainly makes sense, but I must ask you, if you’re a CEO and you do not see the sustainable incremental demand developing for your products, why on earth would you build plants and hire people?
AS: Clearly, you would not. However, what you are saying to me is that this is the reason why CEOs are not investing. And I would say to you the evidence is against that……..The type of incentives which I’m saying have such a bad effect on the economy are far and away more obvious in quoted companies where the ownership and the management are very separate. It doesn’t apply nearly to the same extent in unquoted companies. And since I published my book, a remarkable piece of evidence has come which gives huge support to the thesis my book has. There is a paper here, which I’m looking at at the moment, called Corporate Investment and Stock Market Listing: A Puzzle. It’s by John Asker and others. And what it says is there is a remarkable divergence in the last few years, between the way in which quoted and unquoted companies behave……….The US Economy, corporate economy, is half quoted and half unquoted, and they say that the unquoted part has been for the last few years, investing twice as much as the quoted part. And if it was just uncertainty about the future, nothing to do, we can’t do it, then you would expect this to have the same impact on both the quoted and the unquoted sector. But if, as I am claiming, it is the incentives to senior management when they are working in quoted companies and have this huge incentive based on share prices, EPS, etc., then you’ll get a divergence between the behavior of quoted companies and unquoted companies. And that’s exactly what the data show.
Caller: Walter, in the Sunshine State………If the new Federal Chairwoman continues to reduce the quantitative easing month by month do you think that will help or hurt the economy and the stock market?
AS: I think that after a while it will probably start to hurt the stock market. And I hope it won’t hurt the economy, because if we are lucky, then we will find that companies are changing their policies, they are not worrying about the stock market so much and they are going to cut back on their excessive pricing policies and they are going to start investing. But my fear………is that if we continue with present policies, we are going to run into a crisis whether or not the quantitative easing is cut back. The reason for that is I think that we are in a world in which unemployment has been falling far more rapidly both in the US and the UK than either the Federal Reserve or the Bank of England have expected……..there comes a point when unemployment falls in which it reaches what’s called the NAIRU, the Non-Accelerating Inflation Rate of Unemployment. Now no one knows exactly where that is but it’s probably around 6% or so. And if the economy continues to grow admittedly slowly, by our expectation and hopes, but sufficiently fast for the unemployment rate to be falling very rapidly, we frankly know, that under current conditions, this rate of growth, though it may seem unsatisfactory to us is actually faster than the economy can sustain for any length of time, without creating conditions of inflation, and what I worry is that we’re going straight into a world in which sometime, I don’t know, when inflation will start to pick up, and then we will find that interest rates have got to go up. And the trouble with interest rates going up and asset prices are so high in the bond and equity markets, is that that tends to produce a sharp fall in asset prices, and as I was mentioning earlier…the conditions which in the past have caused crisis are massive debt, which we have again today, it hasn’t barely changed from the peak of 2008, and we have large falls in asset prices, those are the conditions in the past which have set off financial crisis.
Caller: Paul, in Memphis…………What is your opinion as why the fiscal policy makers in the US do not drop the tax rates for earnings overseas for corporations….that if they would bring the money back into the economy what kind of effect if would have?
AS: I think it’s a very good question. I think that reform of the US corporation tax system would be highly desirable……the theoretical corporation tax rate at the Federal plus local level is something between 35 and 40%. But if you look at the data, you see that the rate of tax actually being paid by corporations is only about 23%. That’s in the domestic economy. If you allow for the fact that US companies are keeping money abroad in order to not pay taxes on that much, then of course the total rate of taxation which is being applied to corporations..Is way below the theoretical level………I think it would be a good long term benefit if you had a more rational tax system in which people were not charged for US profits on the profits they earn abroad which doesn’t happen here in the UK, companies can remit their foreign profits without being subject to UK taxation. And you could have a lower rate than the theoretical rate………particularly if you dropped all the other special allowances. And these special allowances don’t seem to encourage investment they just seem to encourage people to say ‘Whoopee we’ve got a nice thing going for us here’
BB: Now Andrew, pardon my directness here but it almost seems to me that US tax policy on bringing foreign profits back to the USA is naïve at best, stupid at worst. What say you?
AS: I think you’d probably find most people agree. The problem seems to me that getting Congress…………If each individual person in Congress agreed that something was sensible….it would still be a long way from getting to agree…as a group of people to do it.
BB:………….As we look ahead, Andrew, most of the forecasts for the USA Real GDP this year are in the general area of two and a fraction, for the most part, even the Federal Reserve midpoint is at 3.0. What do you see ahead?
AS: Part of my book is about the sheer folly of forecasting.
BB: Yeah, that’s why I asked you. Who else better to ask than Andrew Smithers?
AS: I don’t know what’s going to happen, and I don’t think that policy should be over concerned about making bets on something that nobody knows. It would be much better if policy should be more concerned with not making large mistakes and adapting policy to what we’re seeing going on at the time. ……..We’re having a very rapid drop in unemployment and that rapid drop in unemployment will in past experience lead us into rising inflation if it’s allowed to continue.…………it would be sensible for the Federal Reserve to be much more worried about inflation than it currently is and it should have stopped quantitative easing a year or so ago and it should be prepared to start raising interest rates now because it may be that the economy is not going to go pacing on at the rate it is going. But that rate however disappointing is too fast for the economy to continue without causing inflation to pick up.
BB:……Janet Yellen has shed some light on her view on this, she’s talked about the underemployment rate which as you know is extremely high on an historical basis in the United States. As we speak it’s at 12.7 [%], 12.7, that counts those working part time for economic reasons. It also counts the long term unemployed, it’s an extremely high number if you go back through history. And Janet Yellen referred to it…………And that’s been one of the main reasons that they’ve maintained this policy of very low interest rates and even the slow removal of quantitative easing, what say you?
AS: It’s very easy… to produce data which says ‘we’re justified in doing what we’re doing’, and the standard things that come out that I hear are one, that the participation rate in America has been deteriorating, and that means that the reason that unemployment is going up is not so much because more people are being employed but because people are leaving the workforce…….The BLS, the people who are responsible for this, publish a figure for the participation rate, which is very different from that published in other countries. The participation rate as it’s generally applied in the world is the number of people either employed or trying to be employed, that is the employment plus the unemployed, as a proportion of the people of working age, and the BLS seems to define it not as the proportion of people who are of working age but everybody who is non-institutionalized, as the wonderful phrase goes, who are over 16.……..
......in America, you’ve got an aging population and all this talk about ‘it’s all due to people leaving the workforce’ may or may not be true, but it seems to me that it overlooks the fact that people are retiring a lot more, because the population of America is aging…….a lot of this discussion is a smoke screen to try and persuade people who want to believe it in the first place…….Another thing people say is that ‘the productivity in America has been very poor for the last three years’, which is entirely true, it’s dropped very sharply…….‘this is a temporary thing and it won’t matter, because productivity is going to pick up’…….It may be true, these things may be true, the future is not easily recognized. All I’m saying is that the policy being pursued at the moment is making two large bets that the people falling out of the work force are not simply because it’s an aging population and the productivity of the US economy by historic standards is a temporary measure. If it isn’t true, if they’re not right on those things then the Fed are pursuing a policy which is very dangerous and is likely to end in tears
BB: Andrew thanks for joining us and we wish you continued success.
Brinker's guest-speaker today was Andrew Smithers: The Road to Recovery: How and Why Economic Policy Must Change