Capital reasons for extra public investment
`Two percentage points of GDP is a huge amount, requiring large off-setting cuts in current spending, but we would be much better off after a decade if this were done'
Monday 17 June 1996
The paper makes some perfectly justifiable points about Britain's recent investment performance. For example, although the recovery in investment in the current economic upswing has been extremely anaemic by past standards, this is partly because capital spending fell by less than usual in the recession. And the share of business investment in GDP is not too bad by international standards.
Nevertheless, as this column discussed in detail a fortnight ago, I still favour the common sense proposition that additional capital spending is good for the economy, and disbelieve the claim made by some economists that investment is either irrelevant for growth, or otherwise unimportant for government policy. This is not a mistake made by the Heseltine paper, but it is made by many others - for example by Bill Martin of UBS who wrote in the letters column of this newspaper that my comments a fortnight ago "failed to understand" his arguments on the subject. Possibly my grasp of his oeuvre is less than perfect, but if so I am in good company, including that of the deputy prime minister, the deputy governor of the Bank of England, the shadow chancellor, and the US Treasury department, to name but a recent sample of the great unwashed in this respect.
I shall not repeat all the reasons given last time for believing that a high investment propensity is likely to be good for an economy. But at the risk of giving this matter more attention than it deserves, I feel I must comment on Martin's claim that empirical studies have definitively established the absence of a connection between investment and growth. The truth is that plenty of cross-country studies have shown that higher investment is indeed associated with higher output growth in samples which include the experience of emerging countries as well as the old industrialised OECD nations. But I will concede that if we exclude the emerging markets, then the correlation does not seem to have been established for the developed economies alone.
Can we therefore conclude that extra investment is irrelevant for growth in old countries like the UK? No we cannot. Brad de Long, one of the American economists who believe that investment is crucial to the growth process, wrote a letter to the Sunday Telegraph on 19 May explaining why stripping out the non OECD countries introduces a serious bias to the analysis. Essentially, it is because this misses out the very cases which are most instructive - ie the emerging Asian countries where investment and growth has been exceptionally high, and the Latin American economies, where both have been low. As De Long concludes: "I can prove that all swans are white - if you let me throw the black ones out of the sample. It makes as little sense to analyse growth by looking only at the OECD as to analyse unemployment by looking only at people with jobs." Quite.
The Heseltine paper, which gives a balanced account of the evidence on this topic, reckons that a one percentage point increase in the investment share of GDP increases the long-run growth rate by 0.1 per cent per annum. It follows that if we can increase the investment share by two percentage points for a decade, an ambitious goal, then by the end of that period we will have created an extra 2 per cent of GDP, worth around pounds 15bn in today's money, each year from then onwards. The point is that even a small effect on the growth rate for a decade quickly cumulates into a huge benefit in perpetuity thereafter.
Of course, there are serious questions to be asked about whether the private sector may already be providing the optimal level of investment in a free market system. If pushed I would concede this possibility, but still argue that it would be desirable to increase public investment in infrastructure and human capital (ie investment) by a very large amount. Two percentage points of GDP is a huge amount indeed, requiring large offsetting cuts in the current spending of the state to find the necessary finance. But I have little doubt we would be much better off after a decade if this were done.
Enthusiasm for a greater quantity of investment does not, however, imply that the quality of investment, and the way that we use the existing capital stock, is unimportant. In fact, if anything, these matters are even more important than simply boosting the overall total of investment, as the Heseltine paper correctly implies.
A fascinating study published last week by the McKinsey Global Institute in Washington makes this point more powerfully than almost any work previously published. McKinsey looks at the quantity of savings and investment in the US, Japan and Germany, and also at the returns which each of these economies generate on their capital stock. As is well known, Japan and Germany save and invest much more of their GDP than the US - 31 per cent and 36 per cent in the past two decades, compared with 25 per cent in America. But the returns generated on this investment are exactly the other way around - 9.1 per cent per annum in real terms in the US, compared with about 7 per cent in both Japan and Germany. The result is the US economy needs to save and invest less than its main competitors in order to generate the same living standards and long-term growth.
McKinsey does not say where the UK fits into this picture. But there is one piece of encouraging evidence - the OECD reckons that the UK is the only one of the major economies which has been able to increase the growth rate of its capital productivity since 1979. And this has implications for the debate on the merit of "stakeholder economies", in which the power of the outside capital markets is reduced relative to the so-called internal market of managers and labour representatives. (Note: I am referring here to the Will Hutton version of stakeholding, rather than to the Tony Blair version.)
Japan and Germany are two prime examples of stakeholding systems, while the US is the prime example of the opposite. The irony is that by getting rid of the "short-termism" of the financial markets, the stakeholder economies may create conditions in which firms are willing to invest more. But by reducing the disciplinary threat from the capital markets, they appear to allow managers to use that investment far less efficiently, and to get lower returns on it. The challenge of designing a system which will both encourage a high propensity to invest, and then achieve maximum returns on that investment, has still not been solved.
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