"So this is the challenge for this Budget and for the future: by our tax and fiscal decisions, to secure rising levels of business investment and rewards for entrepreneurship." Last year's Budget was focused on the whole issue of raising investment in the UK economy. Indeed, Gordon Brown was keen to stress one particular measure of success, namely the share of investment within national income. "Business investment has grown by 2 per cent as we lock in a higher level of investment as a share of our economy, over 14 per cent, higher than at any time in forty years."
Is a high investment share of GDP really a useful measure of economic success? Intuitively, the concept seems to be appealing. The more investment you have, the more you are likely to have a decent underlying rate of growth. Putting away a few pennies today should provide a useful nest-egg for tomorrow. Investing in the future of your economy is, surely, a better bet than consuming today without any regard for levels of prosperity in the years ahead.
All of this may be true but the idea that a higher share of investment in GDP is somehow a good thing is, in reality, a fairly odd conclusion. It is clear that the attractions of this particular measure come from the US experience over the last few years: in the second half of the 1990s, the investment share within US GDP rose dramatically, associated with the emergence of the New Economy. If that increase in investment could be emulated elsewhere, then the New Economy could be for everyone, not just for dynamic, entrepreneurial Americans.
We can live in hope. In my view, there are big problems with using the investment share of GDP as a measure of economic success. It is true that the US has enjoyed a rising share of investment in GDP and it is equally true that the US has overtaken the eurozone on this particular measure during the course of the 1990s. On that basis, there might be a case for suggesting that the eurozone's lack of growth recently may have something to do with a lack of capital spending. However, the argument begins to break down when you start looking either within the eurozone or elsewhere. Chart one tells an interesting story. Remarkably, America's investment share within GDP last year was little different from either the UK or Germany. Even more remarkable, all three countries had a lower investment share within GDP than Japan.
Given these facts, little comfort can be gained by focusing on the investment share within GDP. In truth, the measure says absolutely nothing about the long-term sustainable rate of economic growth. Indeed, on some occasions, a rapidly rising investment share within GDP could be regarded as a bad sign, an indication of corporate hubris, whereby excessive gains in the capital stock choke off profits and future investment. Indeed, looking at the experience of Japan, the UK, Spain or Sweden in the late 1980s, a rapidly rising investment share of GDP could be regarded as a source of subsequent economic instability. All four countries ended up in recession – or economic stagnation – in the first half of the 1990s and eventually saw their investment share of GDP falling from dizzy heights.
One problem with these measures is that they do not deal adequately with the life expectancy of a given lump of investment or, to put it another way, they don't capture the rate of depreciation of capital goods. Capital spending can, theoretically, be split up into replacement investment and net new investment. In practice, however, these distinctions are difficult to make. After all, if you have to replace worn out machinery, you are likely to use an updated, more productive and more efficient model. In other words, the new investment will partly be a replacement story and partly be a net new story.
One of the justifications used for the rapid gain in the investment share within US GDP has been the impact of rapid technological progress. The argument is straight-forward. Rapid technological change enhances profits in the short term – because of faster productivity growth – but, at the same time implies that capital becomes obsolete more quickly than in the past (after all, would you bother to buy an IBM 286 these days?). This greater obsolescence implies an increase in the amount of replacement investment that has to be carried out each year, thereby boosting the share of capital spending within GDP.
This is a neat argument but there are problems with it. Two underlying assumptions are being made, both of which may be wrong. First, it is assumed that the productivity gains stemming from the new investment will benefit company profits and shareholders. This assumption is important because it provides the incentive for investment to carry on at an elevated level. Yet the experience of the US over the last couple of years has been that many of the rewards of faster productivity have gone to workers rather than shareholders, thus reducing the incentive for even more investment in the future. Second, it is assumed that rapid technological change must imply a heightened rate of capital depreciation. This, however, does not seem quite right. You are only likely to replace your investment if you believe there is money to be made. If your expected future returns come down you may decide to "stretch out" the lifespan of your existing capital stock. By doing so, the replacement investment rate falls as does the share of investment within GDP even if technological progress continues apace.
Even worse, of course, it may be that the productivity gains that should accrue from investment in new technologies may simply not materialise. It is odd, for example, that the UK has seen a similar capital spending pattern to the US but has yet to reap the rewards of this entrepreneurial activity in the form of sharply higher productivity growth (chart two). Of course, it may simply be the case the higher capital spending in the UK has brought other benefits along instead – greater job opportunities and, hence, a lower unemployment rate – but there are also signs that British workplaces have not been flexible enough to extract the full benefits of the new technologies.
Whatever the case, it is clear that numerical ambitions for investment spending – whether they be for the economy as a whole or within the public sector – have to be buttressed by notions of quality and sustainability. The experience of the major industrialised countries suggests that simple rules of thumb along the lines of investment shares within GDP are fairly misleading. Yes, investment for the future is a desirable aim in theory. But not all investment is ultimately good. Unless something can be said about the quality of investment, its impact on productivity and profits and on jobs, it is a good idea to hold off from making sweeping generalisations. The rise in investment within the US economy has looked good because productivity growth has been so strong (although the story may still be undermined by weak profits). The same cannot be said – yet – for the rise in investment in the UK.
Stephen King is managing director of economics at HSBC.Reuse content