Demand solution won't suit a supply problem

Andrew Smithers
Financial Times [In Letters], 15th August 2016

In his article “The progressive case for championing pro-growth policies” (August 8), Lawrence Summers correctly implies that depressed investment is at the root of our poor productivity and weak growth. But his failure to recognise its key cause has led him to propose a demand solution to a supply problem.

Most companies have considerable short-term monopoly power and this provides a conflict between managements’ wish to maximise short-term profits, and the risk of losing market share if companies price too aggressively and invest too little. The dramatic change in the way managements are paid has altered the balance to favour, even more than before, short term considerations over longer term ones. The results are high profit margins and low investment. The change in remuneration, which dates in the US from around 1992, coincided with the change in corporate behaviour. The correlation between corporate returns on equity and tangible investment as a percentage of output, which was very strong from Q1 1972 to Q4 1991 has since been statistically insignificant. Incentives are designed to change behaviour and we should not therefore be surprised at the marked change in corporate behaviour that has followed the dramatic change in incentives.

Quoted companies have recently been investing around half as much as unquoted companies, though the two groups appear of equal importance to the economy. As today’s perverse incentives apply most strongly to quoted companies, this provides additional evidence for attributing low investment to the malign impact of the bonus culture. Increasing investment and growth thus requires that we reform management remuneration.

It is dangerous, not helpful, to increase demand to try to solve the supply problem, which low investment has caused. Unemployment currently appears to be around its minimal level compatible with stable inflation. Additional demand thus threatens to drive up inflation and its expectations, which would then need to be checked by a sharp tightening of monetary policy. At a time of such high debt levels and asset prices, this could readily lead to a nasty recession and possibly set off another financial crisis.

We need to increase investment by changing the perverse incentives by which it is currently inhibited. If we succeed, we will also need to increase by an equal amount the level of savings. This will probably require a reduction in the fiscal deficit, reminding us of Milton Friedman’s comment on the absence of free lunches.

Andrew Smithers
Founder, Smithers & Co,
London W8, UK