I have agreed to meet Andrew Smithers at Kitchen W8 in Kensington, west London. This, he explains, “is very much my local, but it is a very good local.”
I have known Andrew since the late 1980s, when he worked for SG Warburg & Co in Japan. Subsequently, he created Smithers & Co, an advisory boutique. Over the past two decades it has gained a reputation among the cognoscenti as a source of provocative and original economic and financial analysis.
Noteworthy has been his argument that the stock market was hugely overvalued in the late 1990s and his fierce criticism of the monetary policy of the Federal Reserve under Alan Greenspan and Ben Bernanke.
His book Valuing Wall Street, co-authored with Stephen Wright, then at Cambridge, and published in March 2000, was promptly vindicated by the stock market crash. In autumn 2013, he published The Road to Recovery, which argues that the “bonus culture” of US and UK public companies is weakening investment and slowing the recovery.
Now in his mid-seventies, Andrew has made enemies, as all worth their salt must. But he has also won many admirers, including me.
I arrive punctually to find my guest is already at a corner table. He orders a glass of white wine, while I stick to sparkling water. Turning to food, he asks for caramelised Orkney scallop as a starter, followed by another starter, crispy hens’ eggs. I choose tartare of venison, then duck breast as a main. We enjoy our food but do not discuss it. The conversation focuses on our shared interest in economics.
We begin with what is happening in Japan. Andrew disagrees with “Abenomics”, the popular name for the policies of prime minister Shinzo Abe’s government. He thinks it foolish to hope for a sustained rise in investment, which is already too high in Japan, not too low.
I then take him back to the Cambridge of the 1950s, where he was taught economics by the late Brian Reddaway, head of the department of applied economics. Andrew, who loves the ridiculous, enjoys telling me a revealing story of a visit to the Reddaways with his wife, Jilly. “Brian told a story of how he had been dining with Keynes at King’s College. And Keynes apparently said to his wife Lydia and Mrs Reddaway, ‘Now we’re going to talk economics.’ And then at the end of their discussion on economics, Keynes turned and said, ‘Now you can talk about shopping or whatever you like.’ And Jilly thought it quite funny to hear this story told by Brian, since what he described was not a million miles away from his own habits.”
Andrew then tells me he took his own “attention to applied economics . . . from my teachers, rather than from the general atmosphere of extreme Keynesianism, from which Cambridge was suffering at the time.” Another influential figure was the Hungarian-born economist Nicholas Kaldor, later an adviser to prime minister Harold Wilson. One of the lessons Andrew took from Kaldor was that “if you’re going to devalue, do it in a recession”. This point seems relevant now.
. . .
At this point the starters arrive. My venison tartare is excellent and Andrew enjoys his scallops. I ask how he ended up at Warburg, since investment banking was much less fashionable in the early 1960s than now. He explains that he had wanted to go to the World Bank, because he had learnt from Reddaway that “the only social purpose of economics was to make things better”. The World Bank, however, told him he was too young. So he worked for two years at the Commonwealth Development Finance Corporation, a now defunct organisation. “I thought they were hopeless. It was an appalling place to work.”
After the World Bank rejected him again, he could have joined Akroyd & Smithers, a stockjobber (intermediary among stockbrokers) in the pre-Big Bang stock exchange. Andrew’s father was a successful doctor but he had family connections with the firm, founded by Andrew’s great-grandfather. Akroyd & Smithers was prepared to take him on, he notes, despite his going to university. The City of that era was quite anti-intellectual. But, we agree, maybe it was better for that.
Instead, Andrew explains, he went around asking people what was fun. “And they said that merchant banking was the thing. So I got a couple of interviews and one of them was at Warburg’s where I was taken out to lunch by John Nott [later defence secretary during the Falklands war] who had been at Cambridge with me.”
He joined Warburg’s in 1962, staying for 27 years. “Siegmund [Warburg] was an ideal person to work for when you were young. He had immense courage. He had a self-belief that Napoleon would have envied. But he was a terrible bully. This didn’t impact on you when you were young and you got promoted extremely fast.
“One of the things I am proud of was that I realised that the future of asset management in the UK was very promising, because there was huge potential growth in pension funds. Warburg hated the investment business and tried to give it away.
“So I spent a great deal of time trying to persuade my colleagues that here was the opportunity. And this was contrary to the perceived wisdom at the time. But the business we built up, by the time I left, was, I think, the largest fund management business in the UK.
“Yet this was not greatly appreciated by the senior management, partly, I think, because fund management is measurable, which meant that you’re bound to be wrong sometimes. And the ethos of corporate finance is: you are always right.
“So, even though the business was doing extremely well, it was the perceived wisdom of the seniors that the business was unprofitable. Eventually, I was very pleased that, when Warburg’s did eventually go pretty nearly bust [in the early 1990s], the only thing of any value in the place was the investment management business.”
How did he find running the business? “Management”, he responds in a characteristically sardonic manner, “is not an intellectually satisfying occupation. It consists of telling people things that you’re not sure about and they don’t want to hear. So I’ve been much, much happier since I ran my own business and so can do what I want intellectually.”
Managing people consists of telling them things that you’re not sure about and that they don’t want to hear
I turn to how the Big Bang of 1986 – the abolition of fixed commissions and the old distinction between stockjobbers and stockbrokers – had changed the City. Andrew tells me that he told Warburg’s management that it would have to change from an advisory business to a dealing business, by acquisition.
Yet, “by allowing banks to become dealers, you’re building serious long-term problems because dealers go bust. From time to time there’s a crisis and some of them go under. And the most likely to go bust are, of course, the small ones.” This, indeed, happened in 2008: think of Bear Stearns and Lehmans, the smallest of the five biggest US broker-dealers.
“And you will tend to get a concentration, a very profitable concentration, but a concentration. And that means that each crisis is going to be worse than the last one. You’ve got a doomsday machine on your hands.
“So I do think that John Vickers, you and others [that is, the UK’s Independent Commission on Banking, chaired by Sir John Vickers] were on the right lines when you said it’s important for the stability of the economy that there be a clear separation between banking and dealing.”
I move on to what he has done at Smithers & Co, which he opened in 1989. How, I ask, did he have the idea of using “Tobin’s q” – named after Nobel laureate James Tobin, this is the ratio of the market value of companies to their net assets, at replacement cost – as a way of determining whether the market was correctly valued? He explains that he started the work at Smithers & Co with the assistance of Martin Weale, now a member of the Bank of England’s Monetary Policy Committee. Reddaway introduced him to Weale, saying it would be good for the latter to gain some experience of the real world.
To this, Andrew replied that he was “setting up Smithers & Co in the City. So there’ll be no exposure to the real world. But there would be an exposure to another form of unreality.” Weale then recommended Stephen Wright, now at Birkbeck College, who, Andrew tells me, spent six years as a pop singer before going to Cambridge and getting the top first class degree in economics in his year.
“The first thing Stephen said to me was, ‘You don’t do forecasts. Isn’t that what everybody in your business does?’ I replied, ‘Stephen, I don’t have any faith in forecasts, and if we could have faith in them, a small organisation like ours wouldn’t be the place you could do them.’
“There’s a chapter in the new book on what I think economics should be about, which is not forecasts. It’s about not taking the wrong risks. You don’t know what’s going to happen but you can avoid excessive risk-taking and this, unfortunately, has not been the policy of the Federal Reserve.”
Our main courses arrive. My duck is astonishingly tender and Andrew seems content with his eggs. He takes up his story: “So Stephen and I were then doing what we were interested in, which was asking: what drives the stock market? And this got us to worrying about valuation.
“And, back in the 1960s, the standard view, which was that stock markets followed a random walk [that is, the past told one nothing about the future], had been shown to be wrong. Markets exhibit negative serial correlation in their returns [that is, they tend to do relatively badly after they do relatively well and vice versa]. This has a number of consequences, one of which is that, to a moderate extent, they must be forecastable.”
Of course, the predictability of the stock market must be poor: “If predictability were good, even investors would notice,” he remarks somewhat sarcastically.
. . .
Our plates are cleared. We order two double espressos and then turn to another of Andrew’s bêtes noires, central banks and, especially, the policy of “quantitative easing” (QE).
“The financial crisis occurred because we had excessive debt, particularly in the private sector. And if you are in a central bank, your aim should be to modify the growth of debt and you should also aim to avoid excessive asset prices. And what you don’t do is put up asset prices, and that’s what QE does.
“Prior to the great crash, Ben Bernanke wrote a paper claiming that central bankers have been responsible for what he called the ‘great moderation’. I thought he was right but I thought it was a disaster: in the process of moderating the swings of economies, they were also moderating the perceived riskiness of debt.”
Siegmund Warburg had a self-belief Napoleon would have envied. But he was a terrible bully
The orthodox answer, I point out, would be: well, you have only one instrument. One instrument can’t hit two targets – asset prices and consumer prices.
“If too much debt and high asset prices are the fundamental problem, then you want to address these. And how do you address these? Well, I don’t think I know an economist who doesn’t think that having interest allowable as a deduction for corporation tax isn’t stupid.” This standard feature of almost all tax codes rewards debt finance and penalises equity finance. This is indeed foolish.
“So it seems to me a failure of central bankers is to say one thing we must do is tackle the tax incentives for too much debt. The other is, of course, the failure to say we shouldn’t rush to support weak economies.”
The waiter asks whether we want another coffee. We say no and I ask for the bill.
Some think we might be stuck in “secular stagnation”. I ask whether Andrew shares that concern. “I do indeed, but the analysis is wrong. People like [former US Treasury secretary] Larry Summers, who says we’ve got a problem with secular stagnation, do not seem to consider why.
“And a large part of my new book argues this is a result of the change in management incentives and the consequent change in management behaviour. The thing I find most sad about this is the difficulty of getting this subject discussed.” So how does the way we pay corporate executives create deficient demand? “The most serious thing, probably, that can happen to a company is losing market share. And what are the ways in which companies lose market share? One is overpricing in the short term. Another is failing to invest.” So healthy companies need to invest heavily for the future.
But, he asks, “what is the main risk for a chief executive? Not extracting the maximum amount of money from shareholders in the few years he’s in charge. And if you have these bonuses, you will want to put up the return on equity or earnings per share. And how do you do that? You push profit margins up more than you would otherwise and you underinvest, because you can’t spend money on everything. So what we’ve done is to increase the conflict between the short-term interests of management and the long-term interests of the company.
“You would expect the cost of capital to go down when the stock markets roar up, bond markets roar up, and interest rates come down. But that has been singularly unsuccessful in stimulating the economy, and we’ve gone to extremes [through ultra-aggressive monetary policy], to put it mildly. And why is that? If management’s perception of the cost of capital is the cost of not buying back their own shares, then, of course, there is a large wedge between the perceived cost of capital to management and the real cost of capital to companies. And so cheap capital does not stimulate investment.”
On this provocation we part. Often criticised, but usually right, Smithers & Co has been a fount of original and penetrating ideas. When it is closed this year, as Andrew plans, it will be greatly missed.
Martin Wolf is the FT’s chief economics commentator
11-13 Abingdon Road, London W8 6AH
Bottle of sparkling water £3.95
Venison tartare £11.50
Crispy hens’ eggs £10.50
Breast of duck £23.95
Glass of Albariño x2 £19.00
Double espresso x2 £7.90
Total (incl service) £104.98