Book Review: The Road to Recovery.

Jim Bourlet
Economic Research Council, 1st December 2013

Adam Smith's “The Wealth of Nations” analysed the problems of Mercantilism in 1776, John Maynard Keynes' “The General Theory” analysed the problems of Demand Deficiency in 1936, and now Andrew Smithers’ “Road to Recovery” has arrived to analyse the problems posed by Corporate Misbehaviour - a set of problems not tackled comprehensively since Henry VIII found himself faced with wealthy monasteries in a bankrupt land, and felt, in the national interest, obliged to dissolve them.

The book is best taken in four stages, the first of which is to read Martin Wolf's five page Foreword.

He says 'When I look back on my many discussions with Andrew over the last quarter of a century, I find myself reminded of Bertrand Russell's remark that “Every time I argued with Keynes, I felt that I took my life in my hands and I seldom emerged without feeling something of a fool.” I feel the same way about debates with Andrew. But howeverfoolish Andrew may frequently havemade me feel, I know how much Ihave benefitted from his insights.'Wolf concludes 'This book is a feast.'So it is.

The second stage - one is still limbering up, and not yet ready to tackle anything too demanding - could be to read Chapter 6, 'The Particular Problem of Banking and Finance'. This, of course, covers familiar territory - the 2008 crisis, Lehman's demise, the need to split banking into 'normal' banking and 'investment' banking and the proposals for reform. Who can imagine such a discussion being enjoyable? But in pointing out that bankers need supervision more than accusations of deteriorating morality he explains that 'a parallel may usefully be drawn between the behaviour of banks and burglars. A rise in the incidence of burglaries can clearly be blamed on burglars, but as burglars will always steal if they can, an increase in their activities is like to have a more fundamental cause than a drop in their morals. A rise in burglaries is likely, for example, without any change in the ethics of the criminal community, if there are fewer policemen or the police become less efficient and catch fewer thieves. It is equally true that no decline in the ethical standards of bankers is needed to explain a rise in the foolish risks taken by them, if the monetary policy of central banks allows greater scope for their follies.'

Then, commenting on the banks’ability to put a large figure for'goodwill' as part of their assets -thereby being able to calculate amuch lower 'return on capitalemployed' - Smithers says 'It tells usa lot about banks' accountants thatthey should believe that banks inaggregate are in a position today ofgood-, rather than ill-, will'.

The third stage is to read chapter 16 ('Summary and Conclusions') because in a small scale map of just three pages Smithers gives us the gist of his case in straight prose. This summary is intense and, of course, does not contain detail, but the reader can then know where he is being led and what challenges he will need answered by the main body of the text. Our current recession, he says, is fundamentally structural rather than cyclical in origin. Boosting demand may be of short term benefit but is not the answer. In Japan, the UK and the US the key imbalance is an excess of savings over investment - corporate investment is low and corporate savings are high. The big companies in the UK and the US have developed, over recent decades, a set of management incentives - the 'bonus culture' which leads managers to maximise short term profits, buybacks, and share values at the expense of new, longer term investment.

They are treating their companies like mines with a finite value to be exploited and become, eventually, worthless. The big companies in Japan have a similar excess of savings over investment but in their case, this arises from Japanese accountancy and financial practises of being able to claim excessive 'depreciation allowances' against profits which diminishes their published profitsand tax liabilities.

We have therefore to revisit the old issue of management versus shareholder interests, rethink the rules on management remuneration and consider every aspect of incentives as they affect corporate strategy. Then, moving from individual countries to the world at large we need help from re-aligned exchange rates (Smithers has everything in common here, it seems, with John Mills) and some fiscal and monetary boost from countries other than Japan, the UK and the US - and he points very critically at Germany and China. Japan, the UK and the US have already done more than their share of demand maintenance. Asset prices for US equities, UK house prices and almost all bonds are at dangerous levels, and policies are needed that will encourage them to fall slowly.

So now, with this overall picture in mind, take on stage four and read the main body of the book. Unlike normal economic texts which move from premise to assumptions to analysis and conclusions without much in the way of deference to fact from the real world, and unlike economic history texts which certainly talk about the (past) real world and certainly give lots of facts but generally ignore theory, Smithers has accomplished a meticulous drawing together of logical analysis with factual back-up at every stage. Each point is accompanied by a relevant graph, bar chart or table. Each time the reader screams “that may or may not be so! - where is the evidence?”, there it is, in the very next graph and usually on the same page. The graphs are there in simple black and white - but readers are treated to two 'glossy' sections where the graphs are reprinted in colour in case that is useful for clarity. To have researched so much material from different countries and juxtaposed them coherently is no mean achievement.

Then, lastly - perhaps as item number five - one should ask what of all this is new? Most is, strictly speaking, drawn from previous work. The idea of shareholder and manager interests diverging goes back to the earliest Parliamentary debates on the original establishment of joint stock companies and has been a major topic in academic circles now for half a century. What is new here is Smithers’ insight in bringing this into the debate on macro-economic thinking. His remedies seem tame - to debate management incentive structures - and one might have preferred some ideas on empowering shareholders (Hayek's idea that ALL profits before management rewards should be paid out to shareholders with a request to send some of the money back IF the shareholder feel the managers are doing a good job, perhaps) but the damage is nowcatastrophic, the income effects obscene, and the need for reformhas risen to Tudor levels.

Again, Smithers' insight that, in Japan, it is corporate savings rather than private savings which are overwhelming investment expenditure was foreshadowed, for example, in Richard Katz's book 'Japanese Phoenix' published in 2003 which noted that by the year 2000 Japanese corporations taken as a whole had become 111% internally financed (page 205). Katz referred to this internal financing as coming from 'profits plus depreciation' but, in contrast to Smithers' lengthy and analytical treatment, left it as a simple observation.

Finally, the idea that one needs to scrutinise the internal workings of the large corporations that dominate the modern economy is far from new. But again, unlike the journalistic titillating approach to this in, say, J.K. Galbraith's “Economics and the Public Purpose” (1973) which did indeed emphasize the need to restrain the power of giant corporation, Smithers' blames not some unfathomable 'system' but rather the very much more tangible recent mistakes in public economic policy making.

This article was originally published by Economic Research Council Autumn 2013 - Vol 43 No 3