Profit at the expense of investment is destroying our economy

These are bold statements, and the economy is a hazy concept that is largely inconceivable to me, so they may be wrong.

But, thanks to Andrew Smithers, a prescient economist I once interviewed on internet TV, I think I’ve experienced a moment of lucidity that has made one small section of the economic puzzle more comprehensible.

I would share more of Smithers’ notes but it takes too long for me to decode them. They’re not written in the easy language of pop-economists, and the economy is fairly low on my list of research priorities.

But his latest note strays into the subject of the bonus culture, which, has, I have already written, undermined the British industry. The ever-growing piece of the pie Britain’s bosses are, on the whole, taking must be paid for and so jobs, and whole industries, are ‘relocated’ to lower wage economies making us ever more reliant on service industries, some of which (see below) are part of the problem.

Smithers note* answers the question of how to revive the economy if the Government can’t spend its way out of recession because it’s already borrowed too much, and the Bank of England can’t lower interest rates any more (encouraging people to spend), because they’re already near zero. In the words of economists: fiscal policy and monetary policy can’t work.

If government can’t spend, and consumers won’t, who can? His answer is companies can, because unlike the government, they’re running a cash surplus (which is unusual) of 6% of gross domestic product.

But they won’t because short-term targets and short-term rewards lower the risks to management of raising prices, and increase the risks of long-term investment. In the short-term investment increases costs and decreases profit margins. Decreasing profit margins means missed targets and lower bonuses.

This, I think, explains something that has been puzzling me for quite a while. How it is that profit margins have been rising in the UK and the US, while our economies are doing so badly? The answer is, high profit margins aren’t indicative of a strong economy. In fact high profit margins increase profit at the expense of salaries and wages and since corporate savings rates are much higher than personal savings rates, they’re a harbinger for unemployment and recession.

The case for change is most urgent in industries that have high profit margins and invest very little, and I wonder if you can guess which is top of Smithers’ list?

It’s banking, he says, which is very likely:

…not a fully competitive industry and has been rent-gauging at the expense of the rest of the economy.

More competition is the answer, which could be created by increasing the equity requirements of large banks.

Shareholders are right at the centre of this crisis in modern capitalism because we own the companies that pay the bonuses that motivate the directors to profit now and not invest in the future.

Frustratingly, private investors have little influence. Our companies, especially the bigger ones, are mostly owned by investment funds operating for savers and investors but often managed by people motivated by short-term performance targets and overly generous pay.

So what can we do?

We can form an opinion on whether the directors of companies we own are paid too much, either in absolute terms, or using a measure like the holding ratio invented by my fellow blogger Lewis.

We should follow the example of Nate and register a protest vote against excessive remuneration at annual general meetings (although voting down the remuneration report does not compel directors to reconsider it, and its unlikely to succeed given institutional investors’ general support for the status quo).

We can vote with our feet by refusing to invest in companies that appear to overpay. Such a policy would have kept investors out of bank shares over the last decade or so, not such a bad thing.

Although I think the personalisation of the bonus debate around individuals like RBS boss Stephen Hester is deplorable because it misses the point, the whole culture is at fault, those of us who write about companies should draw attention to those paying bonuses likely to reward disinvestment.

We can favour shares in companies that are run prudently for the long-term.

I know it’s hardly picking up a pitchfork and storming the bastions, but it’s better than being complacent. And complacency is what got us into this mess.

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* There’s much more in Smithers’ note about how to stimulate recovery, principally by allowing sterling to devalue, which would make manufacturing more competitive and increase investment, and relaxing planning restrictions, which would reduce the price of land and boost construction. By stimulate investment, these moves would reduce the corporate savings rate and help ward off recession.