Investment alone will not solve Britain's problems

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The Independent Online
Gordon Brown has thrown down the gauntlet on investment. Without a budget for investment, he says, Britain will continue to slip down the prosperity league. But the link between investment and growth isn't as straightforward as the Shadow Chancellor makes out.

Investment is undoubtedly too low and should rise in the second half of the 1990s. But it is not the golden key to national prosperity that you would imagine from listening to Mr Brown. And if investment does rise - as is likely in the next few years - it is unlikely that Labour's new batch of incentives will be responsible.

Instead, it will increase mainly because of a rise in national savings, which has been largely induced by the climate of economic insecurity that the government has wittingly or unwittingly generated.

Since the end of the recession, business investment has been particularly disappointing. It is now only marginally higher in real terms than it was at the trough of the recession in the first quarter of 1992. This pattern stands in marked contrast with the previous two recoveries when business investment recovered quite sharply.

Even though the shortfall is most marked in the property sector, investment in plant and machinery has grown less than in earlier upswings.

Few would deny that this is a problem for the long-term health of the economy. Investment is vital if we are not to run into capacity bottlenecks which lead to the recovery foundering on the rock of renewed inflation. Outside the business sector, infrastructure investment - for example in roads - is just as important if we are not to end up in permanent traffic jams and chronic congestion.

But investment is not the holy grail of growth. If it were, the Soviet Union would not have collapsed in economic ruins. What matters at the end of the day is higher productivity.

Labour makes much of Britain's standing at the bottom of the league for investment for the Group of Seven leading industrial countries since 1979. But two can play at league tables. Productivity in the business sector has been higher in the UK than in the rest of the G7 since then.

According to the OECD, total factor productivity - which measures the contributions of both labour and capital - grew in the G7 as a whole by 0.8 per cent a year.

In the UK, it grew by 1.4 per cent - the highest in the G7 along with Japan. By contrast, in the golden era of high growth between 1960-73, when productivity was rising much faster higher , the UK came fifth, a position it retained in the doldrums of the mid to late 1970s. Let us assume that Britain could lift its investment ratio to levels seen in other countries - say, by about four or five percentage points.

How much difference would it make? Some, but not a lot, according to Nick Oulton, an authority on investment and productivity at the National Institute of Economic and Social Research.

On the basis of a comparison of growth and investment among 25 rich countries over the period 1973-89, he estimates that the hike in the investment ratio would contribute about a third of a percentage point to the growth rate. Given an underlying growth rate somewhere between 2 and 2.5 per cent, that would be handy but hardly the bonanza you might imagine from Labour's rhetoric.

One reason why Britain's overall shortfall in capital formation has proved less damaging for productivity is that investment in machinery - generally regarded as particularly important for growth - has been roughly the same as in other countries. According to the Penn World Table, a dataset which enables international comparison, the investment ratio for machinery to GDP in the early 1990s stood at 7 per cent in the UK. Japan had a markedly higher ratio at around 10 per cent, but Germany and France were also investing about 7 per cent in machinery. Much the same is true of business construction.

The areas where the investment shortfall are concentrated are infrastructure and housing. This is the real scandal of investment in Britain today - but it was a subject on which Mr Brown had little to say. After all that would simply raise the question of whether Labour would reverse Tory tax cuts to pay for the roads programme.

Both parties shelter behind the convenient fiction of the private finance initiative. The need for higher investment in these areas is clear. But it is unlikely that any of the measures Labour is now considering is likely to make a major impact on overall investment.

The plan to double first year tax allowances is only for a year, and is therefore likely simply to shift forward investment. A two-tier capital gains tax does not address the real fiscal problem that encourages high pay-outs, namely the pressure from pension funds on companies to issue dividends on which the institutions pay no tax rather than retain profits which are taxed.

Despite this, the level of investment is likely to rise in the second half of this decade. If low-inflation growth can be sustained, this will eventually overcome the concerns about the viability of recovery that have made businessmen less willing to commit themselves to capital projects. But the impetus will also be derived from another source - a rise in household savings.

With internationally integrated markets, national investment should in theory not be dependent upon national savings. In practice, it is highly correlated. So an investment shortfall can also be seen as a savings shortfall.

According to a recent paper by David Miles, UK economist at Merrill Lynch, savings rates are set to rise sharply in the next 15 years.

He expects the household savings ratio to rise from its present level of about 11 per cent to 15 per cent or higher. Provided that the Budget deficit did not rise, this would translate to a commensurate increase in national savings.

Mr Miles ascribes this impending sea-change to the new climate of insecurity. As the value of the state pension withers, so people will want to make greater provision for their retirement.

Uncertainty over income and employment prospects is now much higher than it was in the past: this too will push up savings. Governments are encouraging greater provision for income and health risks as well as retirement.

The upshot is that Labour could come into office, pledging higher investment to sort out the nation's economic ills - only to find that a rise in the savings rate caused mainly by Tory policies help to achieve that pick- up in capital formation. That would be an irony, indeed.