Common sense should prevail to promote investment

'Should we be satisfied with the UK's performance? The Deputy Governor of the Bank of England, suggests not. He points out that the share of investment in GDP in the UK is much less than in other comparable economies - a matter of considerable concern'

It is sad in many ways that the role of investment in promoting a high standard of living and faster economic growth has become a political football in the UK, since many common sense propositions which most sensible people would instinctively believe are now the subjects of acrimony and distortion.

The common sense propositions that I have in mind are that more capital investment is better than less; that the quality of investment is as important as the quantity; that it is crucial to invest in people as well as in machines; that technical progress is easier to introduce when investment is high; and that public policy should feel a responsibility to address all of these areas. If you already share these common sense propositions - if you are, for example, Gordon Brown - please stop here, lest the remainder of this column should shake your sensible beliefs. For the rest, please read on.

Should we be satisfied with the UK's investment performance? A recent speech by Howard Davies, Deputy Governor of the Bank of England, suggests not. He points out that the growth in investment since the trough of the last recession has been much less than that following the two previous downturns, and that the share of investment in GDP in the UK is much less than in other comparable economies. He believes this to be a matter of considerable concern, though he points to some mitigating facts. While investment has risen less than usual in the present recovery, it also fell by less in the last recession, so it is natural to expect a smaller bounceback. Investment in plant and machinery has been less disappointing than that in construction, which may be less important for boosting growth. Furthermore, in reality the level of equipment investment may have been greater than shown in the official data, reflecting a much greater fall in computer prices than the official statisticians have allowed.

The government takes these extentuating arguments one stage further, claiming that new forms of investment have become much more productive than in earlier periods, and that the sluggish rise in capital spending in the past couple of years is therefore no cause for concern. There may be some truth in this, since there is plenty of anecdotal evidence that firms are now able greatly to enhance the productive potential of old machinery by ''tweaking'' it with a new piece of computer technology. But this argument should not be taken too far. Business surveys show that firms felt constrained by a shortage of capacity in 1994, after only a modest bounceback in manufacturing output, and recent surveys suggest that even in the service industries capacity utilisation is reported to be high. This indicates that the UK is still plagued by its old problem of capacity shortage during an upswing.

Still more important is the question of whether UK investment is too low on average over the cycle, and whether this is responsible for depressing our long-term trend rate of economic growth. This proposition, which is at the heart of Labour's economic analysis (and which is not particularly denied by the Tories), has been the subject of recent attack, including from Bill Martin of UBS, who seems to think that extra investment is unimportant. His argument, which reflects a raging debate in the academic community, rests on two strands.

First, he says that higher investment over the long term will not lead to higher growth. Why? Because of diminishing returns to scale. Every extra unit of equipment that is added to the capital stock produces a smaller return in extra output than the previous unit, so any benefit to growth is temporary.

Even if this is true, I would argue it is irrelevant, because a temporary boost to the growth rate of capital and output leaves the absolute quantity of each at permanently higher levels, even after the growth rate has returned to its original state. The US and the UK may now be growing at similar trend rates, but because the level of the capital stock and output is higher in the US, America remains permanently better off than Britain. If extra investment can temporarily boost the growth rate of output, while permanently boosting the level of output, that is a goal well worth pursuing - end of story.

What is more, there are severe doubts whether the law of diminishing returns actually applies in the real world. New growth theorists such as Paul Romer, Brad de Long and Larry Summers (all American, unfortunately) claim that returns to investment can often be increasing rather than diminishing, especially if investment takes the form of new plant and equipment in manufacturing, or of extra education and training for the work force. If true, then these forms of investment should permanently boost the growth of output, as well as its level.

If extra investment is a good thing, what can we do about it? Some obvious steps seem to be worth trying - for example, cutting the budget deficit to reduce interest rates; emphasising low inflation and macro-economic stability; tilting public spending away from social security and towards infrastructure spending and education; restoring incentives for R&D and training; and encouraging companies to retain rather than to distribute profits. Even if these measures were to boost productivity growth by only a fraction of a decimal point each year, they would pay handsome dividends over a decade or two.

Start your day with The Independent, sign up for daily news emails
ebooksAn unforgettable anthology of contemporary reportage
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Recruitment Genius: Digital Optimisation Executive - Marketing

£30000 - £35000 per annum: Recruitment Genius: The UK's fastest growing, multi...

Recruitment Genius: Financial Reporting Manager

£70000 - £90000 per annum: Recruitment Genius: A Financial Reporting Manager i...

Recruitment Genius: Payments Operations Assistant

£23000 - £25000 per annum: Recruitment Genius: They win lots of awards for the...

Recruitment Genius: Telephone Debt Negotiator

£13500 - £20000 per annum: Recruitment Genius: This nationwide enforcement com...

Day In a Page

Sepp Blatter resignation: The beginning of Fifa's long road to reform?

Does Blatter's departure mean Fifa will automatically clean up its act?

Don't bet on it, says Tom Peck
Charles Kennedy: The baby of the House who grew into a Lib Dem giant

The baby of the House who grew into a Lib Dem giant

Charles Kennedy was consistently a man of the centre-left, dedicated to social justice, but was also a champion of liberty and an opponent of the nanny-state, says Baroness Williams
Syria civil war: The harrowing testament of a five-year-old victim of this endless conflict

The harrowing testament of a five-year-old victim of Syria's endless civil war

Sahar Qanbar lost her mother and brother as civilians and government soldiers fought side by side after being surrounded by brutal Islamist fighters. Robert Fisk visited her
The future of songwriting: How streaming is changing everything we know about making music

The future of songwriting

How streaming is changing everything we know about making music
William Shemin and Henry Johnson: Jewish and black soldiers receive World War I Medal of Honor amid claims of discrimination

Recognition at long last

Jewish and black soldiers who fought in WWI finally receive medals after claims of discrimination
Beating obesity: The new pacemaker which helps over-eaters

Beating obesity

The new pacemaker which helps over-eaters
9 best women's festival waterproofs

Ready for rain: 9 best women's festival waterproofs

These are the macs to keep your denim dry and your hair frizz-free(ish)
Cycling World Hour Record: Nervous Sir Bradley Wiggins ready for pain as he prepares to go distance

Wiggins worried

Nervous Sir Bradley ready for pain as he prepares to attempt cycling's World Hour Record
Liverpool close in on Milner signing

Liverpool close in on Milner signing

Reds baulk at Christian Benteke £32.5m release clause
On your feet! Spending at least two hours a day standing reduces the risk of heart attacks, cancer and diabetes, according to new research

On your feet!

Spending half the day standing 'reduces risk of heart attacks and cancer'
With scores of surgeries closing, what hope is there for the David Cameron's promise of 5,000 more GPs and a 24/7 NHS?

The big NHS question

Why are there so few new GPs when so many want to study medicine?
Big knickers are back: Thongs ain't what they used to be

Thongs ain't what they used to be

Big knickers are back
Thurston Moore interview

Thurston Moore interview

On living in London, Sonic Youth and musical memoirs
In full bloom

In full bloom

Floral print womenswear
From leading man to Elephant Man, Bradley Cooper is terrific

From leading man to Elephant Man

Bradley Cooper is terrific