Would a shift towards exports and investment cure the chronic indebtedness of Western economies? Iain Murray asks economist Andrew Smithers for answers. 

It was George Bernard Shaw who said if all economists were laid end-to-end they would not reach a conclusion. On that basis, it is perhaps wise to seek the opinion of just one and we have chosen Smithers.

He founded economics consultancy Smithers & Co in 1989 and his book, Valuing Wall Street, with co-writer Stephen Wright, predicted the bursting of the tech bubble. So, can he foretell what lies in store for markets and economies in 2011? Sadly, the answer is no.

Forecasting, he says, is not a very successful activity and the reason for this is that it shouldn’t be. ‘If you assume financial markets have a very important impact on the real economy, you can’t forecast the real economy unless you can forecast financial markets, and if you could do that they would always be correct, otherwise you could make money out of the mistakes.’

It’s tempting at this point to conclude the interview, but Smithers has more to say, about how we got into the current mess and why we may be digging a still bigger hole. ‘In the 1990s, the US Federal Reserve had a policy which was to pretend to ignore asset prices. The then chairman of the Fed, Alan Greenspan, and his successor Ben Bernanke, both said that you couldn’t value markets and it didn’t matter if they fell anyway because you could solve the problems afterwards with a little adjustment to monetary policy.

‘There are two things wrong with this. One is that the policy is not consistent with the claims because the Fed did actually interfere with markets, but asymmetrically. It interfered by lowering interest rates whenever the market showed signs of tumbling but it didn’t respond the other way.’

The result of prolonged and abnormally low rates was an asset bubble and the crash of 2008. After that shock, says Smithers, it seemed for a while that Bernanke had seen the light and decided that booming asset prices were dangerous.

‘It would now seem that that contrition was temporary and the current policy is quite clearly designed to create a bubble. The Fed has said it thinks the inflation rate in the US is too low and the proposal is to push it up by buying bonds. If you push inflation up you lower the value of bonds and a division between price and value is by definition a bubble.

‘What we have is a Fed that puts the risk of a double-dip recession – not just the occurrence of it but the damage of it – as a higher risk than the risk of another asset bubble. I find this odd. However, I think the risk of another asset bubble collapse is the worst case scenario and the risks of the economy falling back into another mild recession are not particularly grave.

‘Looking forward, it seems to me that the first point to make about asset prices is while nobody can forecast them, the Bernanke effect is very real. If the largest central bank in the world is buying assets a precipitate fall in asset prices in the short term seems improbable. So, from the point of view of people managing portfolios, they don’t need to rush around trying to make agonising decisions based on their forecasts of the economic outlook because we will have a very good chance of seeing some of these developments very quickly.’

What if Bernanke’s efforts to stimulate the US economy fail?

‘If we don’t get a recovery, there will be a growing realisation that the profit outlook and the financing outlook for US corporate business is going to fall and the market will go down. The market is very expensive anyway, it’s already about 50 per cent above its average. That is nothing like the extremes of 1929 or 2000 but it is very near the levels at which we have had large falls in the past, such as in 1906, 1937 and 1968.

‘That could occur in a deflationary environment. The Fed doesn’t achieve much, we get low inflation to deflation in America, which puts pressure on profit margins and we get a very unpleasant time in the stock market. A moderate fall over a period of time in the stock market would be much the best way of getting back to gentle reality, but if it were to happen suddenly, on past experience, it would drive the economy back into recession at a time when there is hardly much scope for fiscal or monetary weaponry to do much about it.’

On the other hand, Bernanke runs the risk of increasing inflationary expectations. ‘What would that produce? People would try to push up wages and prices more rapidly and we would then find we had stagflation on our hands. That is because without a relative depreciation of G5 currencies you’re not going to get the essential net export growth of the G5.

‘Also, you would achieve exactly the opposite of what you want, namely stimulated economies and output gaps narrowing. We know from experience that when you get rising inflationary expectations they will go on accelerating unless you deliberately increase the output gap. So, the policy solution to rising inflationary expectations is to achieve the exact opposite of the current policy objective.’

Smithers thinks that Western economies could survive through the time-honoured method of muddling through. ‘How would that take place? It would mean that the household sector in the US and UK, while desperately in debt and with low savings rates, won’t change very much because trying to replace debt very quickly has a depressing effect on the economy; that with a bit of luck the exports of the G5 countries to the rest of the world on a net basis will start to improve; that there won’t be too rapid rises in raw material prices because that would be very destabilising; and that world growth will benefit from rising corporate investment.’

At root, our present economic malaise has a single cause and one that will continue to fester until it is cut out – chronic indebtedness. The UK and the US have been far too dependent on debt-fuelled consumption and government spending.

‘It would be nice to avoid another recession,’ says Smithers, ‘but perhaps even more importantly it is essential to revise the structural problems in the economy. The post-war world saw US debt rise relative to GDP by five times in the private sector. This was a long-term trend which clearly couldn’t go on and has had its nemesis in recent crashes.’

He also believes the UK should make interest no longer allowable for corporation tax. ‘Clearly, in a world of debt problems we are quite mad to subsidise debt. It is an outstandingly stupid thing to do. We also need to shift the economy away from consumption, both government and household, towards exports and investment,’ he says.

‘The economy of the world at the moment is not going down the plughole. In fact, in some places it’s growing a bit fast. As long as it continues on an even keel, cutting back on the government deficit here in the UK is part of a necessary shift, because by definition that improves the savings rates of the economy and makes room for an increase in our investment, either overseas by improving our current account deficit, or domestically. And we have been under-investing appallingly in recent years. So I think we might be quite lucky.’

Who is Andrew Smithers?

The son of a cancer specialist at the Royal Marsden, Andrew Smithers, 72, was born in south-east London. ‘My father said I was a cockney – it was within earshot of Bow Bells. But it would have to be a pretty clear day.’

His great-grandfather founded stockjobbers Ackroyd and Smithers, and his grandfather was an MP. After studying economics at Cambridge, he turned down an offer to do a PhD at Stanford and joined investment bank SG Warburg.