The Road to Recovery: How and Why Economic Policy Must Change

The financial crisis caused widespread misery and the greatest loss of output and employment of the post–war era. The subsequent weak and faltering recovery has prolonged the pain. In The Road to Recovery: How and why economic policy must change , Andrew Smithers shows that both the crisis and the weakness of the recovery are the result of poor policies based on faulty economics. It is vital that governments and central banks can be persuaded to abandon the misconceptions on which their current policies are based. The Road to Recovery explains, in non–technical language, the major change in our thinking that will allow the world economy to recover and to prevent another financial crisis. There has been a dramatic change in the way managements are paid in the UK and the US. Incentives have changed and this has naturally led to a change in behaviour. This key problem is being ignored. The current management incentives are not only the reason for the massive gap between high and average pay but also for our economic stagnation. Attempts to generate growth, while ignoring the cause of this inaction, threaten to create another financial crisis. In his foreword Martin Wolf states that Andrew ‘has an apparently uncanny – indeed downright infuriating – tendency to be right’. Readers need to understand the errors that are currently being made in order to persuade policy makers to change tack and, in case that fails, to be warned and take action to reduce the costs of the financial and economic troubles that otherwise loom ahead.

Foreword ix Chapter 1 Introduction 1 Chapter 2 Why the Recovery Has Been So Weak 3 Chapter 3 Alternative Explanations for Today’s Low Business Investment and High Profit Margins 47 Chapter 4 Forecasting Errors in the UK and the US 61 Chapter 5 Cyclical or Structural: The Key Issue for Policy 69 Chapter 6 The Particular Problem of Finance and Banking 81 Chapter 7 Japan Has a Similar Problem with a Different Cause 107 Chapter 8 The End of the Post–War Era 125 Chapter 9 Misinformation as a Barrier to Sound Policy Decisions 149 Chapter 10 Avoiding Future Financial Crises 169 Chapter 11 The Current High Level of Risk 179 Chapter 12 Inflation 195 Chapter 13 Prospects Not Forecasts 219 Chapter 14 Tackling the Bonus Culture 229 Chapter 15 The Need for Change in Economic Theory and the Resistance to It 237 Chapter 16 Summary and Conclusions 255 Appendix 1 Mean Reversion of US Profit Margins 259 Appendix 2 Goods’ Output Requires Much More Capital Than Service Output 261 Bibliography 263 Acknowledgements 269 Index 271

Andrew Smithers is Chairman of Smithers & Co. Ltd. and is a leading expert on financial economics and global asset allocation. His forty–five years’ experience in international investment includes twenty–five years at SG Warburg & Co where, amongst other roles, he ran the investment management division, and over twenty years as head of his own investment consultancy firm, Smithers & Co, based in London. He is the co–author of three books on international finance: Valuing Wall Street , co–written with Stephen Wright, published in 2000; and Japan’s Key Challenges for the 21st Century , co–written with David Asher, published in 1999. His book Wall Street Revalued – Imperfect Markets and Inept Central Bankers was published by John Wiley & Sons, Ltd. in July, 2009. He is also the author of Chapter 6, “Can We Identify Bubbles and Stabilize the System?” in The Future of Finance: The LSE Report , published by The London School of Economics and Political Science in September, 2010. Andrew is a Trustee of the Daiwa Anglo–Japanese Foundation, a Fellow of CFA (UK) and member of the Advisory Board for the Centre for International Macroeconomics and Finance (CIMF) at Cambridge University. As head of Smithers & Co., Andrew has helped pioneer the application of academic analysis of financial economics to investment management. He is well known for his work on valuing markets, including application of ‘q’, for his pioneering studies on the distorting impact of employee stock options on US profits, and for work on showing the understatement of Japanese published profits compared with US ones. www.smithers.co.uk