The Road to Recovery: How and Why Economic Policy Must Change, by Andrew Smithers, Wiley RRP£18.99
Andrew Smithers annoys people. A great deal. Long one of the best-known and most respected analysts in the City of London, in my experience he provokes anger and annoyance in the Square Mile like almost no other.
This is partly because of his arguments. He has been bearish about stocks for a while, which irritates those who have been enjoying a protracted rally. But other stock market bears remain popular.
The issue is that Smithers does not hide his disdain for what he calls “stockbroker economics”. His regular weekly reports, always ineffably logical with numbered paragraph flowing from numbered paragraph, drip with contempt for arguments from the City.
I doubt that Smithers much minds antagonising these people. If he did, he would not have produced The Road to Recovery, a remarkable book which puts front and centre his problems with the bonuses paid to corporate executives and to traders.
Although he is about as far from a leftwing populist banker-basher as it is possible to imagine, this book is a startling and authoritative attack on the system of tying executives’ bonuses to the share-price performance of their companies.
For Smithers, the bonus system was the principal cause of the financial crisis, and is now the main reason why the recovery has been so weak. He establishes this claim meticulously, with a plethora of charts, and looks for alternative explanations. (He accepts that greater concentration, or lack of competition, could be an important factor.)
His argument goes as follows. Corporate behaviour has changed significantly from its historical norms in the past two decades. It has been driven to do so by the change in remuneration for executives, which encourages them to maximise either their share price or short-run return on equity. This change accounts for the problems in building a recovery.
This is not an argument about the effects of bonuses on traders and investors. Rather, the problem is the bonuses paid to managers of companies. They invest less and take more in profit margins than they used to do. This harms an economy that needs corporate spending to rise and take some of the strain in reducing government deficits.
Thanks to the attempt to tie executives’ incentives to those of their shareholders, managers are now less inclined to take short-term risks, such as cutting profit margins, and more likely to run the long-term risk of cutting investment.
Profit margins over history tended to revert to a long-term mean (driven by the competing claims of labour and capital). But the past few years have seen a clear deviation from this pattern in the main anglophone countries, with US margins staying at record high levels, while UK margins are only slightly below average, even though output is severely depressed – suggesting that margins should be at a cyclical low.
Brokers say that margins could stay high for years, but Smithers contends that none refers to the economic theory which shows that their arguments must be flawed. With donnish disdain, he says: “This reticence can be attributed either to the fact that the analysts are ignorant of the theory or to the hope that their readers are.”
Meanwhile, spending on plant and equipment has fallen as managers devote cash to buying their own shares – a move that boosts profits for shareholders in the short run. Profits have grown more volatile, because it is in managements’ interests to take all their losses in one lump (as happened in the months after the Lehman bankruptcy).
Smithers is clear that there have been policy errors aplenty – he has no time for central banks’ panacea of “quantitative easing” which drives up asset prices – but suggests that even here the change in managements’ behaviour may be largely to blame. This has caused forecasting errors, as inflation is consistently higher than expected, while investment is lower.
Critically, he holds, economists fail to grasp that the problem is structural, not cyclical, and that weak demand from the private sector is a permanent feature of the landscape (driven by the bonus culture), and not temporary. He has many policy recommendations, but all pale next to the urgent need to fix executive pay.
This book deserves to remove the emotive issue of executive pay from tired arguments between left and right, and make it a central concern for public policy. Sadly, it cannot be guaranteed to do that. In the meantime, however, it can be guaranteed to annoy a lot of people.
The writer is the FT’s senior investment columnist