12 October 2014

The Road To Recovery

How and Why Economic Policy Must Change

Andrew Smithers
2013, Wiley, 360 pages, £18.99
ISBN 1118515668

Reviewer: Mark Cleary, Kinetic Economics

In Smithers’ introduction to this book, he quotes Lewis Carol’s Alice asking what is a book without pictures or conversations? Given that he has 128 charts, of which 128 are produced in the text in black and white and then the same 128 in colour, he can claim that his is indeed a book worth having. To keep the analogy going, a picture paints a thousand words so therefore a quarter of a million words have been saved.

I felt there were two ideas worthy of consumption from this book. The first is that the ‘Keynesian trio’ of the UK, the US and Japan are doing the heavy lifting in trying to reboot the world economy, but that these three economies were not the appropriate catalysts of growth. Instead, Smithers argues that this role should be shared more equally with the surplus ‘Keynesian-rejecting’ economies like Germany, continually running balance of payment surpluses.

The second, more substantive and interesting part of this book is the view and accompanying evidence about the dislocation between the long-term interests of economies, companies, long-term shareholders and corporate executives.

Smithers suggests that, as executives are in their roles for such short periods of time, their interests and the long-term interests of their company diverge. Of course to suggest divergence of interest is nothing new; after all, we are all economic agents who seek to maximise our own utility. This is obvious whether we use Baumol or other economists to explain away the divergence of interests between master and servant. Smithers argues that this gap has widened in the US and the UK, due to the rise of the bonus culture, leading executives to become increasingly focused on the short-run share price and therefore not the lasting interests of the organisation.

As we know, for companies to grow and prosper they must engage in strategic decisions to maximise the value of the firm. But as Smithers argues, marshalling impressive empirical evidence, this is currently something that companies are simply not doing. The required strategic actions, vision and policy required to maintain the long-term interests of the organisation are unattractive as they involve costs that will depress short-term profits, share prices and so ultimately bonuses.

Smithers suggests that it is because of this managers engage in actions that manipulate and exaggerate the profits of their companies in the short run to the detriment of the long-term future prospects. He argues that there are effectively three ways executives manage the profits of a company in this way. The first is the failure to invest for future growth and profits, the second is based upon destructive pricing strategies, and the third is to use accounting tools to ‘exaggerate’ profit.

In the case of the first, the author uses copious graphs and figures to illustrate how corporate investment has fallen in the US and the UK. Although his figures indicate a decline in relative investment to GDP, he goes further to illustrate the manipulation of share prices to increase the value of bonuses at the long-run expense of the company’s interests. One example he proffers to support his view is the evidence of deterioration of the ratio of investment to share buy-backs. It points towards a convincing story of actions being used to inflate share prices with little real benefit to companies beyond short-term share price movements, and to an increasing failure to invest.

In the case of the second, Smithers suggests that many companies have failed to impose price cuts required in the current business environment, as to do so would damage profit margins. Smithers argues that companies can get away with this in the short run, because although economic agents do react, it is with a lag and so profits remain temporarily inflated. Customers will switch eventually in reaction to the failure to change price and so the company’s prospects will be damaged in the medium to long term, but the executives concerned will have moved on, with their reward.

The third argument, again which he supports with substantive empirical evidence, is that companies are now increasingly overstating their accounting profits. He uses as evidence the change in the way companies report their profits for accounting purposes relative to profits they report for National Income reporting purposes. His argument, and the evidence backing it up, suggests that there has been a dislocation between these two types of profit figures. The accounting profits are of course used for share-price valuations and the latter for macroeconomic policy reasons. He shows that the latter has not really changed much in recent times whereas the former has increased dramatically. His conclusion is that these profits are being overstated for bonus purposes.

Ultimately, the argument of this book is clear and compelling. Executives are not investing for the long-run interests of their companies, their shareholders and their respective economies. Instead, they are engaged in selfish and cynical manipulation of profits in the short term to boost their bonus payments, to the detriment of the other stakeholders. After all, “If profitability were the driving force behind companies’ capital spending plans, investment would be at record levels.” It isn’t, as Smithers shows us.