Andrew Smithers - Ideas Lab Series - July 27th, 2022

[00:00:07] Andrew

When they do well, companies, managements get very high bonuses. They have, therefore, an incentive to get those metrics up. When you change incentives, you change behavior, and the behavior change was that management became much more anxious to make short-term profits for themselves than they had to worry about the long-term future of their companies.

[00:00:36] Intro

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Here’s your host, veteran hedge fund manager, Niels Kaastrup-Larsen.

[00:01:32] Niels

For me, the best part of my podcasting journey has been the opportunity to speak to a huge range of extraordinary people from all around the world. In this series, I have invited one of them, namely, Kevin Coldiron, to host a series of in-depth conversations to help uncover and explain new ideas to make you a better investor.

In this series, Kevin will be speaking to authors of new books and research papers to better understand the global economy and the dynamics that shape it so that we can all successfully navigate the challenges within it. With that, please welcome Kevin Coldiron.

[00:02:10] Kevin

All right. Thank you, Niels, and welcome everyone. Our guest today is one of the investment world’s best known financial economists, Andrew Smithers. Andrew has spent a career studying how markets behave, how market participants behave, and how policymakers ought to take account of that behavior in their own decisions. He’s someone who’s not afraid at all to challenge consensus ideas, and some of those challenges are what we’re going to be talking about today.

By way of career background, he’s been Head of S.G. Warburg’s asset management business, which is now part of BlackRock, as are many investment businesses. He’s the founder of Smithers & Co, which is the economics consultancy firm, and I was lucky enough to have been a client of his for many years. Many of you will have read his work in the FT as well as the London Times and most recently, the Journal of American Affairs.

He has published six books, I think, if I’ve got the count right, and the last of which is The Economics of the Stock Market, which is what we’re going to be talking about today. So with that, Andrew, welcome to the show and thank you.

[00:03:26] Andrew

Thank you. I’m very pleased to be here.

[00:03:29] Kevin

I thought maybe we could start at the end, start with what to me seemed like the key conclusions or messages from the book, and then work our way through how you got there. So to me, what you’re saying is, hey, look, there’s two relationships that need to be kept in balance in order to promote economic stability. The first one is the difference between desired savings and desired investment. The second, where the stock market comes in, is the difference between the market value of equity and the underlying net worth. That difference, that ratio, is what you call Q.

You’re saying that we need to have both those things balanced if we want a stable growth. That seems intuitive to me, certainly, and I think probably to a lot of listeners, but that’s not how economists and policymakers focus. They really focus exclusively on that first relationship, the balance between the desire to save and the desire to invest. In doing so, they create imbalances in the second relationship, and that ultimately has the effect of making the economy less stable, not more. Would you agree with that as a summary of the last couple of years of work for you?

[00:05:00] Andrew

I agree with your analysis which was very well put. The points that you’re making have been made by other economists, notably, Nobel laureate George Akerlof and MIT professor, Ricardo Caballero. They have questioned whether the consensus model of the economy is correct. In that particular regard, the claim that there is only one equilibrium, which policy needs to manage for the economy to be stable, is something that they doubt.

I’ve gone one stage further. I have shown that there is at least one other equilibrium that needs to be maintained, which is, as you correctly say, the relationship between net worth of companies and their stock market value. I show that if you continue a policy which is too strongly aimed at getting the balance in the demand correctly, and you do that particularly by having very low interest rates, and particularly, if you continue to intervene in the bond market by purchases on what’s called quantitative easing, you can easily create a situation in which the Q Ratio goes up to a dangerous level. Frankly, that’s what we’ve had recently, and have now.

[00:06:43] Kevin

Let’s talk about that Q Ratio. Since that plays a central role in your analysis, can you just explain a little bit about how that’s constructed?

[00:06:56] Andrew

Yes. Companies obviously have a market capitalization; the value of their equity, i.e. the number of shares they have outstanding times the value of each individual share. That is the market value of the company equity. There is also a net worth, which is the equity value of the company measured not in terms of the stock market but in terms of the assets which it owns. Those assets are derived by surveys conducted, in the American case, by the BEA. The BEA conducts regular surveys of what is the value of secondhand equipment, and from that, they compose data on net worth of the corporate sector. Also the speed with which that net worth changes, they use to determine depreciation.

Now, if the stock market value and the underlying net worth is large, if stock markets are much higher, then you have a high value of Q, and this is unstable. Q is a mean reverting series. It gets pushed up temporarily by low interest rates. But that impact doesn’t last. When it starts to decline, the problem that faces the economy is that when share prices fall, they fall much faster than they rise.

If you then get a very sharp fall in the stock market, which is no longer, I think, likely to be able to be maintained by low interest rates, particularly if you have inflation picking up, then you have a handful of trouble on your hands, a great deal of trouble on your hands. Very often, you will then get a financial crisis. The trouble now is that we have the conditions precedent, not necessary, but precedent for another financial crisis having not long had the nasty serious one of 2008.

[00:09:18] Kevin

So ultimately, what you’re saying is that when the Q Ratio gets out of balance, as it is now, that creates the potential for a financial crisis, and that’s something that hasn’t been part of the decision making process of policymakers thus far.

[00:09:43] Andrew

I think that is correct. I had one, must be nameless, but extremely senior central banker saying to me, “Oh, but central bankers are aware of the problem. It is their fault when they get it wrong.” Because I was arguing that the fault largely lies with economic theory. I said to him, or wrote to him that I did not think it was entirely fair to blame the central bankers, because if they don’t have a consensus policy to refer to, they have great difficulty in saying to the world, “Well, we’re worried about Q, and we’re therefore going to put up interest rates.” Everybody will say to them, “But that’s going to put up unemployment.” They say, “Well, tough titty. Tough luck.” That is not a very easy thing to do.

What we need is a general appreciation, a much more general appreciation that there are these two disequilibria; that the central banks cannot be responsible for maintaining two separate equilibrium. If you have two problems, you need these two policies to deal with it. You can rely on the central banks to get the balance and demand there, but you need to do something else. I am suggesting that we can do that by adapting the tax system so that it changes the weight of taxation without increasing or decreasing the budget deficit. But, if you increase taxes on consumption and incomes and reduce taxes on investment, you should manage to achieve a stimulus to the economy with no change in the level of the budget deficit.

[00:11:49] Kevin

Well, let’s talk about that. That’s one of the key conclusions of your book and key recommendations is that we need to generate more investment without increasing the budget deficit. Do you think that what you’ve just recommended, changing the tax structure, is something that would need to be done, fine-tuned in the same way that interest rates are fine-tuned? Or do you imagine that being more of a structural change that gets revisited on occasion?

[00:12:24] Andrew

I hope it would, definitely be the second. Because it seems to me that if you manage to get demand in balance with the wishes to invest and to save, then you will be able to control the economy with its short wrinkles by changes in monetary policy. But you hit on a very important point. It’s obvious that you don’t want to have to use major changes in taxation for controlling the short-term fluctuations in the economy.

This has long been put forward as a reason why you really need monetary policy. You can’t just balance demand by budget deficits because you can’t quickly change them. But it also applies to changing the structure of taxation between consumption taxes and taxes on investment. I must admit, I do think taxes on investment, when we’re in a very slow growth economy on both sides of the Atlantic, is just downright foolish anyway.

[00:13:33] Kevin

I know that you said the UK has recently raised the corporation tax but then they tried to offset that with a tax credit on investment. Do you think that’s a move in the right direction?

[00:13:45] Andrew

Absolutely. I don’t mind what the rate of corporation tax is provided that nobody pays it. What we have, therefore, in the UK already, but initially only as a temporary measure, which is pretty useless, was an increase in the corporation tax rate. At the same time, tax credit was introduced for tangible investment. Both sides of the Atlantic have tax credits for intangible investment, and what we badly need to see is large tax credits for tangibles as well.

[00:14:33] Kevin

I want to go back to Q a little bit and its usefulness as a measure of value. Because you introduce some concepts in the book that I think a lot of the listeners would be interested in because a lot of our listeners are involved in the markets and so therefore, measuring value is something that’s pretty important to them. You talk about that when you look at the history of equity returns, that real returns to equity, once we adjust for their inflation value, are what you call stationary. Which is kind of like a fancy statistical term for saying they tend to rotate around some fairly stable number, which is roughly 7%, a little below 7%.

So you’re saying if we look at equity returns over long horizons, they rotate around this value of 7%. It doesn’t mean equity returns are going to be 7% next year, just over a long enough period once you adjust for inflation. Then you say, based on that, we can look back in the past and we can say whether or not equity markets were expensive or cheap at some point in the past using this idea of what you call hindsight value. Can you explain that idea to us a little bit?

[00:15:49] Andrew

Yeah. I owe hindsight value to my co-author of Valuing Wall Street, who is Professor Stephen Wright, and I think it’s a very important development. Clearly, you know from history whether markets are expensive or cheap, nobody doubts. They were not very expensive in 1929, and very cheap in 1932. Why? Because hindsight tells us that. We know afterwards, you get bad returns from one and good returns from the other. So the question is then, how do we quantify that more precisely? How do you judge whether a market, on a particular date, was expensive or cheap? If so, importantly, by how much?

Now, to do that, Stephen invented this concept of hindsight value. What he pointed out was that you can’t judge a market’s return over a set period of time. If you say I’m going to say that markets were cheap in the past, if they gave a high return over the next 10 years because that merely may mean that you are judging it up to the next peak. It may not have been very cheap at all. It may just have gone up a lot in the next 10 years. What you need to do is to take the average of all possible holding periods over any given period of time. But how long do you need, is then the question.

We have data for 220 years, and obviously, if we have to use 100 years of data, we can’t tell very much because we have so much we can’t use. What I do in the book is I show that you can use 30 years as hindsight values, because if you then compare 30 years with longer term periods, the answers are almost exactly the same. Hindsight value made over 30 years is almost identical with hindsight value over 50.

Therefore, if you’ve got at least 30 years of data for hindsight, you can now measure the value of the market using hindsight from 1801, where Jeremy Siegel’s very valuable data series starts, right up to 30 years ago, i.e. to 1990. Having had values which are now, definite, they are historical values, they’re not forecasts or anything like that, you can see whether you have a metric which will give you a good fit to those.

We show that there are two metrics which give you a good fit to hindsight value. One is Q, and the other is the cyclically adjusted PE or CAPE, and you find the fit by measuring the R squared correlation. The R squared for Q is extremely high, it’s 0.8. It’s pretty good for CAPE, which is 0.52. So you have two pretty good guides. Obviously, since CAPE is not quite as good as Q but significantly less good, I tend to use Q as the number one, with CAPE as it were as the number two backup. There’s a reason, which I can explain later perhaps, about how they differ.

[00:19:37] Kevin

So if I can summarize, what you’re saying is with this concept of hindsight value, we can go back to 1800. At each point, or let’s just say each year from 1800 on till 30 years ago, we have a pretty good estimate of whether the market was cheap or expensive at that point in time, and then we can see how well your measure of Q, or Robert Shiller’s measure of CAPE, matches up against that, and that tells us whether or not they’re valid measures of value. You’re saying that Q turns out to be, on that basis, a very good measure of whether the market was cheap or expensive in the past, and therefore, it tells us something about whether the market is cheap or expensive now.

[00:20:29] Andrew

Exactly. That is exactly correct.

[00:20:31] Kevin

Okay, so if I look at Q, how it’s evolved, let’s say, in the last 30 years, for almost the whole time since 1990-ish, it’s been in what you might call overvalued territory in the sense it’s above its long term average. For a lot of that time, it’s been well above that average, very expensive. One of the things I hear about, one of the criticisms or skepticisms about Q as a measure of value is it always says the market is expensive. It’s been in overvalued territory for 30 years. How can it be a valid measure of value if it’s always saying the market is expensive?

[00:21:15] Andrew

Well clearly, who is always saying the market was expensive? It would be an upside-down stockbroker, wouldn’t it? The market is cheap. Of course, if it always said the market was expensive, it wouldn’t fit with hindsight value. It does fit with hindsight value, so that criticism is invalid.

[00:21:40] Kevin

Does it then mean that there’s some structural forces, if you will, that have come together to keep it above its fair value since 1990 or so?

[00:21:54] Andrew

Well, it hasn’t been entirely above its fair value since 1990. It went below that in 2008, that I remember.

[00:22:02] Kevin

Yes, for a little bit.

[00:22:05] Andrew

Yeah. For a little bit, but quite a lot. Jeremy Grantham tells me that it bottomed at the devil’s number of 666, which when one’s looking at the value today is just worth remembering. That is quite a jump. You’re correct. It has been high, particularly in the last few years; at exceptionally high levels for quite a long time. Yes, I do attribute this to a change. It’s a change which I consider a very bad one. It’s the change I was talking about, which is the way in which monetary policy, if misapplied, can cause instability in the economy.

Monetary policy has done just that. We are looking at an economy which is dangerously liable to fall because of the disequilibrium. That level is the result of monetary policy, not only low interest rates, but in particular, of quantitative easing, which has had a very, very strong impact (I believe, and it’s fairly unique, frankly, in history terms) on putting the market up for an extended period of time at very high levels.

[00:23:31] Kevin

Let’s follow through on that. How precisely or how in your framework does quantitative easing lead to this Q Ratio becoming out of balance and therefore creating potential instability in the economy?

[00:23:48] Andrew

In the book, I show that companies prefer to borrow long. If you’ve got your debt in short-term, you’re very liable to have trouble if you have interest rates going up in the short run, particularly in inflation. Because the short-term impact of inflation on short-term interest rates is far bigger than it is on profits. If you get a passive change in interest rates from, say, 1% to 2% because there’s an increase of 1% in inflation, and you’re all borrowed short, your debt payments will go up by 50% while your profits have gone up by 1%.

While that’s an extreme example, it’s not too irrelevant in today’s conditions. Therefore, companies prefer to borrow at the long end. I show that if you exclude wartime conditions, from the data that we have, you’ll show that companies like to keep a level of debt which is consistent with having, roughly speaking (and I’m drawing from memory here), a cover of five times between their profits after depreciation but before tax and interest, relative to the payments of interest.

Now, that therefore means that a company’s willingness to borrow is very much dependent on the nominal rate of long bonds. Therefore, when the Federal Reserve went in and flattened the yield curve, i.e. it brought long bond yields down nearer towards short term rates than they would otherwise have been, they encouraged companies to borrow. Now, what happens when companies borrow? They can either use the money to buy back shares or they can use money to invest.

Well, frankly, they’ve been using it to buy back shares, and the natural result of buying back a lot of shares, literally, is that if a company goes out and buys a share and nobody is the seller, the price of the stock market goes to infinity. You have to get somebody else to sell. It is as difficult as that. Company’s buying are a very powerful influence on pushing the stock market up. The reason that companies buy is a wish to do so because that is the way that the management is remunerated by higher share prices, and the ability to do so, which comes when you get the Fed to drive down the rate of long bond yields.

[00:26:48] Kevin

You touched on a couple of things. I’ve written about this quite a bit myself, if you actually look at the data in the US, on a net basis, the only consistent purchaser of US equities has been companies buying back their own shares, just on a sectoral basis. For every buyer, there has to be a seller and the key buyer has been companies.

You mentioned incentives for company managers, and it seemed to me that forms a key piece of your argument in why Q may have become elevated certainly cyclically, potentially, structurally as well. Can you elaborate a little bit on that? On how the change, and I think what you call the bonus culture, the remuneration policies, has led to a consistent under-investment and therefore increase in the value of Q?

[00:27:53] Andrew

Yes, thank you. Yes, this was the subject of my previous book. A couple of years ago, I published a book called Productivity and the Bonus Culture. Now, what I showed in that was something which is quite well-known, so it was just illustrating a well-known part, which was that there was a dramatic change in the way company managements were remunerated in the 1990s. The introduction of bonuses, and it went along actually at the same time with often very considerably higher increases in actual annual pay as well. But the bonus element was what mattered.

Because of bonuses, the remuneration of management went up relative to everybody else by a huge jump. But those that got that extra money did so because the return on their shares was very good. Either the share price itself, or the earnings per share, or very often what’s called total shareholder value, TPS, whatever it is; a combination of the dividend plus the share price.

When they do well, companies, managements get very high bonuses. They have therefore an incentive to get those metrics up. When you change incentives, you change behavior. After all, that’s what incentives are for. The behavior change was that management became much more anxious to make short-term profits for themselves than they had to worry about the long-term future of their companies.

Now, in the new book, I go into this in a little more detail in some respects. I say that, basically, I think there are two main motives for company managements. Number one is to keep your job, and number two is to get as well paid as possible while you’re keeping your job. Now, they’re not the only incentives. I’m not saying that people are universally wicked, bad, awful, but I’m saying those are important motives and they will naturally have a very large impact on behavior.

If you don’t invest, you are at risk of your company falling behind its competitors because your productivity won’t improve as fast as theirs. Not investing is a risk. If you change the incentives, however, so that you put more incentive on getting rich, you will naturally switch the balance away from investing towards getting rich. In doing so, people invest less. What we’ve seen is a weakness, which is well-known in corporate investment in the last decade or so, and with that, by the way, has gone the fall in productivity, which is why I call my previous book Productivity and the Bonus Culture.

[00:31:09] Kevin

I want to pick up a little bit more on the incentives for management because I really liked the way you talked about it, and then also how that leads to another long term relationship, which is the stability between interest payments and profits over time. You talk about managers wanting to manage leverage of the company in a way that there’s a certain degree of leverage that’s needed, but you don’t want to have too much.

Can you talk more about the incentives for managing the level of leverage? Because that obviously plays into it when you buy back shares because you’re increasing leverage on the balance sheet when you do that.

[00:32:08] Andrew

Okay, as I mentioned, keeping your job is probably the single highest important thing of importance for management. Now, what are the threats to your job? Well, the big threat to my job is a sudden fall in the share price or being taken over. Now, if you are under-leveraged, you are very vulnerable to being taken over. Because obviously, a company of otherwise identical status in terms of abilities, prospects, everything else, could buy you and gear up their balance sheet and they would find that their earnings per share had gone up. Their leverage would then become the combined leverage and you would probably be out of a job, because one of the usual things that happens when you get taken over is the senior management says goodbye. That is a threat you want to avoid so you don’t want to be under-leveraged.

However, if you’re very highly leveraged, you have a threat which is not necessarily bankruptcy as the ultimate threat of being over-leveraged, but the biggest short-term threat being highly leveraged is if you have a sudden drop in profits, and this goes with the economy. Management can’t control profits. They can try and do as well as they can, but you will find they are at the mercy of the swings and errors of the economy. Companies are always at risk of sudden falls in profits.

Now, if you are highly leveraged and you have a sudden fall in profits, you have to then go to shareholders for more money. It is an interesting feature of the way in which shareholders behave. They don’t mind companies running quite large savings in terms of the dividend not being all the profits. There’s no great big shock. Companies are largely priced on PE multiples rather than dividend yields. So unless you’re outrageously mean, you’ll find that increasing your equity by corporate retentions doesn’t do any damage to the shareholders.

If on the other hand, you will need to increase your equity by going to them for a new issue, the effect of new issues is almost invariably a very sharp fall in the share price. Therefore, we are in this situation which is very clear. Under-leveraging risks your job because it risks you being taken over. Over-leveraging risks your job because it risks you suddenly having to go to the shareholders for new equity issue and being sacked, or suffering badly because of the sharp drop in share prices.

[00:35:18] Kevin

It’s funny you mentioned the dislike of investors of rights issues. One of the examples I used in my class to talk about the quantitative models we used to use at my firm for investing was a company called Oerlikon, a Swiss company that had over-leveraged in the early 2000s, had to issue a rights issue and share price collapsed. Subsequently, they turned the business around. The rights issue helped shore up the balance sheet. They turned the business around, sales started growing, profits started growing, all those metrics.

Our model, which had no emotional connection to the rights issue, said, “Hey, this looks like a good, profitable company.” But the multiple stayed low for a long time because people felt burned from the rights issue. It ended up being a good opportunity. So yeah, I agree. That really resonated with me, the fact that the market dislikes rights issues, and that’s a risk of being over leveraged.

What I thought was interesting, or kind of clever about this analysis is you said, “Okay, then based on that notion that managers don’t want to be over or under-leveraged, that leads to a mean reverting relationship between interest payments and profits. In the same way that Q or real equity returns is stationary, the ratio of interest payments to profits is also something that’s stationary over time. Is that correct?

[00:37:05] Andrew

Yes. There is, however, one exception to that, which is if you’re not allowed to borrow the long bond yield, you then tend to find that you can’t borrow. What happened in wartime, when the long bond market was restricted to government issues, you found that company balance sheets became much less leveraged and there was a sharp fall in leverage from the outbreak of war till the end of the war. After that, it came down again quite fast, but it took some while.

It’s only if we exclude the bit between wartime and the return back to the normal ratio, you can measure the mean reversion of that ratio. You must allow for exceptional things. John Kay and Mervyn King have recently written a very good book called Radical Uncertainty, which emphasizes that you must allow for what’s called Knightian uncertainty, i.e. you cannot use statistical tests when you don’t have any examples or ways to use them. Frank Knight, in the 1920s, wrote about this and it’s something that Keynes also agreed with. Some people don’t but it seems to be very important.

When you’re looking at a data series, you must exclude from that data series things which are unpredictable, total one-off events which nobody can judge. For example, you cannot include statistics for a stock market, worldwide, when the economy on a stock market like Russia, like St. Petersburg in 1917 was taken out completely. That is a one-off. It doesn’t hit people’s expectations about what’s going to happen in the future, because you can’t say, “Well, how’d that happen? What’s the chance of it happening again?”

Another example is World War II. The capital stock of Germany and Japan in particular, but also others, was massively destroyed in the Second World War. Now, you don’t recover from that. You don’t get the returns on that capital when it isn’t there. You can’t use the data of Germany and Japan, covering the Second World War period, when you’re looking at what expected returns are. Some people try to do that. They say, “Well, let’s include the risks of world wars.” I really don’t think it’s very sensible. I don’t know that I can measure the risks of World War III in terms of what happened in World War II. Is it going to be similar? It’s just not something that you can sensibly do. You have to allow for Knightian uncertainty.

[00:40:26] Kevin

I agree with you, although having spent a career looking at data, it can be a danger, right? Because you have to be careful about not throwing out all outliers. You have to have a framework for saying which of these extreme events fits within the kind of world that I think is “normal” and which don’t, because throwing out outliers can change statistical relationships quite dramatically.

[00:40:59] Andrew

Absolutely. The counterpart of failing to take note of Knightian uncertainty is, of course, to think that it affects everything so you could never make any judgment about anything. There is obviously a risk that people will get concerned or use it all the time as any excuse for whatever they wish to think. You’re absolutely right. Now, I think that the right answer to this is the correct answer of all sciences, which is to try and use rational argument. It’s only by understanding. This is the purpose of science is to understand, and the debate that contributes to whether we know something or not, we never know anything for certain.

But whether we have a better model in this one than that one is a matter of debate and discussion. When it comes to the question of whether you exclude things from Knightian uncertainty or not, then I think there is no substitute but for open debate on the issues for people to judge, which is the right model to use. Judging from the history of science and even the history of economics, when people do that, it doesn’t usually prove a huge and insuperable barrier to coming to a reasonable agreement.

[00:42:27] Kevin

Do you think, when we look at this notion that managers try to balance under and over leverage and that, aside from World War II, that we have this going fairly stable relationship between interest payments and profits, is that also a measure or a tool that policymakers ought to be focusing on in the same way you use suggest they should focus on Q?

[00:42:59] Andrew

Well, I think it’s more so they understand why they shouldn’t indulge in quantitative easing. If the data is correct, then they will simply find that when quantitative easing takes place, the stock market goes roaring up and people get more leveraged. You remarked earlier, Kevin, correctly, that one difference between consensus models and the critiques of consensus theory is this belief that there’s only one equilibrium we have to preserve. Showing that Q is another one doesn’t mean there aren’t others.

I personally expect that there is another disequilibrium, which is excessive debt. But I can’t demonstrate the levels at which that becomes excessive. I haven’t been able to find out ways of showing that excess levels are too dangerous or not. Also, I suspect, that’s quite tricky because I think that the level of excess debt goes a bit with the level of inflation. You have to be quite careful about that.

If it is, then it means, actually, that in practice we probably don’t have to worry too much about debt levels considered in isolation. Because it is quite clear that debt and Q do go together to some extent. I doubt you’ll find that, with Q at a reasonable level, you’ve got to worry about over-leveraging in the economy.

[00:44:38] Kevin

So if policymakers, let’s say, adopted your suggestion that they more than keep an eye, that they actively incorporate Q into their decision-making policy, monetary policymakers don’t have control over taxes. So are you saying that they should simply just make their decisions on interest rates with an eye toward the level of Q? They may have interest rates higher than what they think is necessary if they just looked at the desired level of savings versus investment, because higher interest rates are necessary to keep Q in line.

[00:45:27] Andrew

I think this is a very interesting subject. What extent would central bankers be justified in turning to the government and saying, look, Q is dangerously high, or if we cut interest rates anymore it will become dangerously high. We therefore cannot stimulate the economy anymore by monetary means. Therefore, it’s now on your watch, not mine. We are here to make sure that inflation doesn’t go above 2% or whatever target you have.

What we are not able to do, when we follow that, is to also secure full employment if we are unable to control dangerous levels of Q over to you. Now, at the moment, I think that would probably be a very difficult thing to say. That’s why I was defending central bankers, when I said it wasn’t entirely their fault to another central bank. I think that we do need to get a major change in economic consensus. Changing the model of economics used in economic policy is a step to allowing monetary policy to be effective.

[00:47:01] Kevin

It’s an interesting point. In the conclusion to our book, we talk about we’re going to need changes, quite big changes in the structure of how policy is done. Really as you were saying that I’m thinking, well, it wasn’t that long ago that central bankers did not have inflation targets. Inflation targeting is a relatively new phenomenon in the history of central banks. So it’s not crazy to say that maybe Q targeting could be something that’s introduced. Is that ultimately what you’re hoping would happen?

[00:47:45] Andrew

I don’t think Q targeting should really fall into central bankers. I’m saying, if you accept that there’s more than one disequilibrium out there, to control two, just to avoid the possibility of two different disequilibria, you need different policy tools. I’m suggesting that monetary policy is not a suitable policy tool for stimulating the economy once Q gets up 20%, 30%, 40% above its average value.

Therefore, what I’m saying is that in the world which we look forward to, you and I, Kevin, in which everybody understands that they’ve got the wrong model. Back then in 1922, they had a bad model. We’ve got another much better one. Once they’ve gotten to that improved level of paradise, we will be able to get policy, having two policy tools, but they will not both be operated by central banks. The two disequilibria I’m talking about require two different policy tools. One of those policy tools will be and should remain with central banks. The other has to come, I think, from government.

[00:49:07] Kevin

So really, what you’re imagining is a world where central banks are able to say, without any shame, “Hey, look, we’ve reached the limit of what we think we can sensibly do with interest rates given where Q is. We need changes to the corporation tax. We need changes to the incentive to invest or consume to bring that back into balance.”

[00:49:37] Andrew

Absolutely. If we’ve got a world in which that is accepted, the central bankers won’t have to say anything because you and other analysts will be pointing out and saying, “Look! Look! Treasury department, Q is at this dangerous level.” Obviously, the Fed will not be able to cut interest rates anymore if there’s any weakness. It’s up to you. You must now do the pretty. To some extent, that already exists with the budget deficit, but the budget deficit creates its own problems.

At the moment, we do have two separate tools for controlling the economy. One is monetary policy, and the other is fiscal policy, but both of these create debt. Monetary policy creates debt in the private sector. Fiscal policy, in its current form, creates debt in the public sector. There are political limits, and quite probably real limits to how much you need to increase or can afford to increase the size of government debt levels.

As Japan has shown, it’s by no means clear that they are that low than maybe people should at the moment, and I certainly think it would be better to stimulate the US economy in the last decade by fiscal stimulus rather than monetary. I do think it’s not enough. I think that the fiscal management has to include not only the size of the budget deficit, but the distribution of taxation between consumption, income, taking off therefore a proxy for consumption demands and investment.

At the moment, therefore, quite clearly, we need to reduce the taxes on investment, which are corporation tax net of any credits that you get for investing. We need to increase the taxes on VAT in the UK, or sales taxes in America, or income taxes. Politicians will not necessarily want to hear that because people would rather not have their consumption taxed. But unfortunately, if they don’t have the consumption tax, they’ll have their investment taxed and their future would be pretty grim. In any democracy, one of the first essentials is to educate voters.

[00:52:21] Kevin

Yeah. In some ways, the notion that having the stock market way out of value, way out of line with its fundamental value, at one level that might seem like an esoteric concept. I actually think, given the involvement that people have day to day in the markets now with defined contribution plans, they’re much more engaged with the stock market and they have a better understanding of how it potentially could impact the economy. I don’t think it’s a wholly unrealistic idea to eventually incorporate that into policy making decisions. I’m optimistic that could be done down the road.

You mentioned your conversations with central bankers and that although you couldn’t name them in public, there is some recognition that what you’ve been talking about in terms of Q is important. That surprised me a little bit because I remember very clearly Alan Greenspan saying, “There’s no way we can identify bubbles ahead of time so we’re just going to sit back and wait till they pop, and then when they pop, we’ll clean up afterwards. I think he called it the risk management approach, which I think in the end, has been very damaging and it’s just only served to reinforce some of these instabilities.

Do you think that kind of idea, that Greenspan approach, is no longer consensus within central bankers?

[00:54:00] Andrew

Undoubtedly. I don’t think central bankers quite know what to do but they do, I think, know what they shouldn’t do. But they may not be able to avoid it. Stephen Wright and I published a paper which we called The Economic Consequences of Alan Greenspan. We published it in the Journal of World Economics and we were very critical of that and of other central bankers who made, what we thought at the time, outrageously optimistic assumptions about the ability to control the economy by central banking alone.

A student invented the phrase that we had not only a problem of convincing people against the folly of the efficient market hypothesis, but also against the folly of the efficient central banker’s hypothesis, and I think that advance is certainly made. Immediately after the last crisis, there was a large number of people saying central bankers must now take note of asset prices. Unfortunately, that died down.

There’s an old adage: “You should not lose the benefit of a good crisis.” We lost the benefit of that last crisis. I hope we will at least remember that if we have another crisis, and I feel we are going to, we will not lose its benefits when we come to reassess policy and economic theory.

[00:55:41] Kevin

Well, I agree with you. I think that is going to be tested, unfortunately, and it will be much trickier now because with higher inflation flooding the market with liquidity in the aftermath of a crash in asset prices is, I think, going to be immediately recognized as highly inflationary.That will be much trickier to see how they manage that. I want to thank you for joining us. It’s been a real honor for me to be able to talk to you. Now, I want to ask you one final question.

My ex-business partner once said something to me. I’m not a native of California. I live in California now right on a fault line, and when I first moved here, I got very anxious about earthquakes and the impact of earthquakes. I did a lot of preparation and he said to me, “Look, if there’s a bad earthquake, as long as you have a fresh supply of water, dried food and all your Smithers reports to read, you’ll be fine.” The question is, are there going to be more Smithers reports? Is there going to be another follow up book? What are your plans going forward?

[00:56:54] Andrew

Well, let me make this remark. I have already issued invitations for people to come to my 85th birthday which is due in September. Clearly, when you get to 85, time’s winged chariot speed is notably faster for you if you’ve any wits. I do know that I haven’t got a great deal of time and I would like to do more if I can. I’m trying very hard to get the ideas which I set out in The Economics of the Stock Market, broadly understood and debated.

One of the things I’m grateful to you, Kevin, for is your efforts in that direction. But I recognize that if you start saying, “Listen to my ideas.” You are also probably wanting some sort of boost to yourself on that. Motives are almost always mixed. Vanity is probably part of anybody who writes a book. But I hope and believe that my motives are not entirely vanity, they are pro bono, and I would like to continue to do that.

At the moment, my energies are engaged in promulgating, as much as I can, the ideas set out in The Economics of the Stock Market. I doubt whether I shall write another book, but I’m not going to say no. I never say never.], I try not to, but I certainly expect and propose to be writing papers and articles. I did, after all, publish the article in American Affairs after I published the book, and I published several things which I think I’ve also had things published in other journals like World Economics. I hope to continue to do that. So that’s going to be my aim.

I think they will probably be largely concentrated on the ideas in the book, but there is at least one other, which is very much in my mind, which is that standard growth theory is, I think, wrong. But one way in which it’s wrong, I think it would be quite widely recognized, which is that it has no scope for the environment or raw materials in it. What happens is that in standard theory, the negative consequences of changes in the environment are simply included in the speed of depreciation.

What I think we’re witnessing today is that, as the environment probably is deteriorating quite a bit faster than before, you’ll get more negative consequences from that. If the water doesn’t run through the Hoover Dam, electricity goes down. Those sorts of instances become more common if we get climate change. Ports will silt up faster and require more repairs, hurricanes will do more damage. I suspect that we’re already at the beginning of the stage in which we’ve started to suffer from environmental damage and I think it’s possible to begin to isolate that from other forms of depreciation.

Depreciation in the standard model, the famous Solow Tobin Weizsäcker Model, is depreciation comes from the rise in real wages. Because if real wages go up, the value of your existing capital stock goes down because you don’t get increased output for unchanged capital stock. Nearly all increased output from improvements in capital has to be embedded in new equipment. Inventions do not increase productivity for the most part, unless you invest with them. This has been a major fault in a lot of people’s understanding of the economy because tangible investment is essential for growth.

The proportion of total investment, which is anyway quite weak, which is tangible, has been falling in recent years quite markedly. Hence, when I was talking about the need for credits, we need the credits to extend to tangible investment and not just to be only on intangible. But if we do that, we will then recognize, I think, that we need to invest more. The capital stock, which we are using doesn’t only deteriorate in its value because wages go up, but it deteriorates in its value because the environment changes.

That is an additional point, but I would like to see, therefore, new work done on that. I’ve also in my own sphere, the work I’ve been doing, there is huge scope, I think, if economists can be persuaded to take their eyes away from the consensus theory to look at the stock market model because it provides immense scope for very valuable contributions by economists who will use that model.

[01:02:54] Kevin

Well, I hope you do follow up on those ideas. I know that I had in my notes, I wanted to talk about the difference between tangible and intangible investments because you make some really good points about why certain things, intangible investments, really shouldn’t be considered investments. So for people out there, that’s one good reason to read the book. We haven’t had a chance to talk about that.

In addition to the book, there’s Andrew’s piece in American Affairs, called The Stock Market Model: A New Foundation for Economic and Monetary Policy. That’s a really good starting point for the ideas that are in the book. So I hope you have a great 85th birthday and I very much appreciate you joining us today. Andrew Smithers, thank you.

[01:03:50] Andrew

Well, thank you. If I can say as a small point, I work hard at answering serious questions as hard as I can. If anybody wishes to email me with questions they had coming out of this, I hope you will let them know my email address. They’re very welcome to ask them. It’s andrew@smithers.co.uk. Thank you very much. Kevin, thank you very much for giving me this opportunity. I hope that we can attribute pro bono improvement in economic philosophy and management as a result. Thank you.

[01:04:29] Kevin

Thanks, Andrew. With that, I’ll pass it back over to Niels.

[01:04:36] Niels

Thank you so much, Kevin and Andrew, for a very insightful and interesting conversation on a broad range of economic topics. Andrew’s latest book, Economics of The Stock Market, touches on some really important topics because the current consensus economic model depends on assumptions that are shown to be invalid.

Economic policy based on this consensus has led to the financial crisis of 2008, the great recession that followed, and the slow subsequent rate of growth. Instead, Andrew proposes a model that is robust when tested and, by including the impact of the stock market on the economy, overcomes both of these defects. I also really liked the ideas that Andrew is thinking about for his next book, despite his mature age, namely how the standard growth model is impacted by the changes in the environment and how we really need investments in tangible assets.

Make sure you go and follow Andrew and Kevin’s work, make sure you get a copy of their books, because as you can tell from today’s conversation, some of these ideas and topics are not being discussed on mainstream media. From Kevin and I, Thanks so much for listening, and we look forward to being back with you on the next episode. In the meantime, take care of yourself and take care of each other.

[01:05:57] Ending

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