Japan cannot put its economy on to a sustainable path unless it reforms its corporation tax system. Fortunately, this is now under active discussion. Unfortunately, it is far from clear that the right changes will be made.

One sector of the economy cannot lend unless another borrows. The sum of the net lending and net borrowing in an economy must therefore equal zero. Japan’s government is a huge borrower and, if this is to be brought down to a sustainable level, the net lending of other sectors must come down by an equal amount. As chart one shows, it is the corporate sector which has moved into massive cash surplus since 1988, when Japan’s fiscal balance moved into a structural deficit. It is therefore the corporate sector which must take the brunt of any fall in government borrowing through a similar decline in the sector’s net lending. Current tax arrangements and regulations are the key cause of the massive cash surpluses run by companies which must be brought down if the fiscal deficit is to be reduced to manageable proportions. Read more

Hedge funds’ portfolios are often leveraged and they can be big winners or losers if this pays off. In this sense the US is also a hedge fund. In terms of its international assets, the US is long equities and short debt. This has been hugely to its advantage because equities have given much better returns, but this benefit carries large risks for the future.

 Read more

The damage done to the UK and US economies by buybacks in preference to capital investment was a central theme of my book The Road to Recovery, and it has found its way, not too often I hope, into these blogs. I have therefore been heartened by the growing interest shown by the financial press in this threat to our economies. The Economist recently devoted a major section to the issue, as did the Financial Times on October 12.

The change in the way managements are paid drives buybacks but this has yet to be widely appreciated. The US Federal Reserve’s quantitative easing programme was rightly underlined by my colleagues as adding the fuel of cheap debt but, without the preference for buybacks, low bond yields would have encouraged capital investment. This they markedly failed to do. An important paper, shortly to be published in the Review of Financial Studies, “Corporate Investment and Stock Market Listing: A Puzzle?” by John Asker, Joan Farre-Mensa and Alexander Ljungqvist demonstrates that a huge difference has appeared in recent years in the levels of investment by quoted and unquoted companies. Read more

The following comment on my blog post about quantitative easing and the eurozone struck a chord:

“The unaddressed and unanswered question about fiscal stimulus in the eurozone is about why it will be anything other than another short-term sugar rush?” Read more

I showed in my previous blog that the ratio of depreciation to operating profits is much higher in the published figures for Japanese non-financial companies than it is for their US counterparts and that this could not be justified in terms of either the amount of equipment that needed to be depreciated or the rate at which it should be written off. There is therefore a strong implication that Japanese profits are understated relative to US ones, but this is subject to two provisos.

First, even if the ratio of depreciation to output should be the same in both countries, the ratio of operating profits could be very different if US companies had much higher ratios of profits to output than Japanese ones. Read more

In two earlier blogs I explained why the cyclically adjusted price earnings yield (Cape) could not sensibly be applied to valuing Japanese shares. (One of several reasons is that Cape is only valid if profit margins are mean reverting over relatively short periods of time, such as 10 years or so, and this has not been the case in Japan.) This does not mean that they cannot be valued by other means. In this and the next blog I attempt one possible way to do this. Read more

The eurozone’s economy appears to have stalled. It was widely expected that growth would pick up to 1 per cent this year, but these estimates are now being toned down as the first two quarters of 2014 have been below expectations. The pattern shown in chart one (below) is, at best, one of stagnation. It is therefore agreed with near unanimity that the eurozone’s economy needs a boost.

 Read more

It is generally agreed that the stock market dislikes falling profits and rising interest rates and that the two in combination are particularly to be feared. History supports this. According to my rough calculations, the stock market has declined 29 per cent of the time since 1947, but 40 per cent when falling profits and rising interest rates have coincided. Fortunately for investors, such conditions are relatively rare, as 75 per cent of the time the impact of rising rates has been offset by higher profits.

In a recent blog I argued that the risk of a negative combination of interest rates and profits is unusually high. Profits tend to be boosted by falls in personal savings, which have now fallen to a low level and this support is now less likely. Since 1947 increases in interest rates have been accompanied by rising profits in 23 years; in all but six of these years personal savings have fallen. History, therefore, suggests that the decline in savings has been very important in reducing the risks of the damaging coincidence of rising rates and falling profits. Read more

In my previous post I showed why it seems likely that profits published by US companies are currently overstated by much more than they have been in the past. This does not necessarily mean that the degree of overvaluation of the stock market shown by cyclically adjusted price-earnings ratios is understated. The profits as published have been far more volatile than shown in the national accounts, and it is probable that published profits were heavily understated in 2008, as earnings per share in Q4 2008 were negative, while those shown in NIPA Table 1.14 remained strongly positive. Read more

Chung Sung-Jun/Getty Images

  © Chung Sung-Jun/Getty Images

The profits published by US companies are defined in a very different way from those published in the National Accounts (NIPA Table 1.14) and in recent years they have increasingly diverged.

Those published by companies have become even less “honest” than they used to be. This is the result of the much greater incentives for management to alternately over- and understate the “true” profits, and the much greater ability to do so.

The massive rise in bonuses paid to managements, which depend on the data the companies publish, has encouraged companies to boost profits in the short-term as bonuses often depend on short-term changes in earnings per share or return on equity. Even when they are more directly related to changes in share prices, these often respond to similar changes in the published data. Parallel with this rise in incentives to misrepresent profits has been an increasing ability to do so, with the change from “marked to cost” to “marked to market” accounting.

The result might be compared to the increase in theft that we might expect if windows and safes had to be left open by law, and items stolen were declared to be the lawful property of the thieves. Read more

Asset prices fall if investors’ liquidity preference rises or if their liquidity falls (ie, if investors need the money or want to have more cash in their portfolios). Liquidity depends on central banks; they can create it or soak it up. The US Federal Reserve seems unlikely to reduce liquidity unless inflation picks up, but is likely to stop creating it in October. Therefore, one way in which asset prices will fall is a rise in inflation or pre-emptive action by the Fed to stop it.

When the Fed creates liquidity, it takes a larger rise in liquidity preference than before to hit asset prices. The Fed is thus in the process of increasing the market’s sensitivity to rises in liquidity preference and, as small changes are the normal response of investors to new information, the volatility of the market is therefore likely to rise. In the absence of increased interest rates, large changes in liquidity preference, however, are likely to depend on falling profits. Read more

After a period when consensus ruled, economists are as much at odds today as they were in the 1980s, and policies can alter sharply when those in charge change. Quantitative easing is today the main bone of contention among policy makers and economists.  Read more

According to an article in The Economist on August 2, “economists trying to explain the feeble pace of America’s recovery regularly blame deleveraging”. This raises two questions: can the US recovery sensibly be described as feeble and, if it can, is deleveraging to blame? Read more

In a comment on my recent blog regarding the equity risk premium, “Le gun” asked for a guide to making long-term investment decisions and I promised to try.

In 2009 TengTeng Xu and I addressed this issue in a paper called “Investment and Spending Strategies for Endowments”. We were specific because the need for income and the investor’s time horizon should both be taken into account when deciding on a sensible policy for individual investors. We considered the use of only three asset classes: equities, long-dated bonds and short-term deposits (cash). We did not include property because we were unable to find suitable long-term data and dismissed commodities, including gold, as combining poor returns with high volatility. With regard to the possible portfolios, we came to several conclusions which I will adapt here for all long-term investors, rather than just endowments. Read more

I assume and hope that Scotland will vote to maintain the union on September 18. I am, however, sceptical of the barrage of claims that Scotland will either be necessarily better or worse off if a majority vote “Yes”.

Countries have grown at hugely different rates in the past. Chart one (below) shows the relative growth rates in terms of gross domestic product per head of Ghana and South Korea. In 1950, when the data series starts, the standard of living of Ghanians was 30 per cent higher than those in South Korea, but the latter were ahead by 1965 and, by 2008, when the data series ends, had living standards twelve times higher.

 Read more

The gross domestic product data for the second quarter of 2014 showed that the US economy bounced back strongly, and with enough vim to justify the view that its first quarter weakness was largely due to bad weather.

However, the productivity figures provided another bad surprise. In the first quarter GDP per hour worked fell, and it would therefore have been reasonable to expect it to improve with the sharp recovery shown in the second quarter. In fact, there was another fall.

 Read more

Ed Balls, who has a high chance of being the UK’s next chancellor of the exchequer, has announced that the opposition Labour party is “examining the case for introducing an allowance for corporate equity, to redress the systemic bias in favour of debt finance”. This would be very sensible, but it needs to be done sensibly.

Allowing interest as a deduction before calculating the profit on which corporation tax should be paid encourages excessive debt, buybacks of equity in preference to long-term investment and debt-financed takeovers. The views of economists on its undesirability are one of the few instances on which they are almost all agreed. It is one of the rare exceptions to the old rule that “n economists = n+1 opinions”. Read more

The UK has a seriously unbalanced economy, with little spare capacity and a slow trend rate of growth. To correct its imbalances, the current account deficit and the cash flow surpluses of the corporate sector need to fall. This would permit a fall in the fiscal deficit, but requires a fall in the real exchange rate and in the share of consumption in gross domestic product.

The fall in the trend rate of economic growth comes from a combination of a slower growth in the population of working age and a drop in productivityRead more

In some of my more gamesome moments I have challenged my students to produce an article about the equity risk premium, which made a useful contribution to our understanding of the way financial markets work. So far the challenge has not been met. This may reflect the modesty and good manners of those I teach but also, I hope and believe, the fact they are too sensible to wish to defend the way this often ill-defined and generally useless concept has been habitually discussed. In practice, comments on the ERP seem to me to have been a source of confusion and error rather than illumination.

The ERP can be defined in at least two ways. One is the historic difference between the returns on bonds and equities and another is the expected difference in these returns. Alternatively, the “risk-free rate” can be used in place of bonds. Read more

A few weeks ago, I promised to write about claims that the stock market could be valued by comparing earnings yields to bond yields. This approach is sometimes called the “Fed model”. This was fashionable in the 1990s and seems to have some followers even today. It is not only nonsense but is the most egregious piece of “data mining” that I have encountered in the 60-plus years I have been studying financial marketsRead more