Short-term approach by British business holds back investment
Surveys which ask companies to list the biggest obstacles to new investment regularly blame uncertainty about demand
Thursday 30 January 1997
The difficulty in answering these questions is trying to find an explanation that applies to the UK and US, but not to other industrial economies, for the Anglo-Saxon share of investment in GDP at 17 per cent is strikingly lower than the investment share on the Continent, or in Japan, at 20-30 per cent. This is why institutional explanations are favoured by many commentators, like Will Hutton, who pins much of the blame on free-wheeling and short-termist capital markets.
The trouble with this is that it does not persuade hard-nosed economists, who point out that outside a few special areas - possibly very small business, possibly hi-tech firms - it is impossible to find any evidence that companies cannot get the funds they need to invest. There is no greater shortage of capital available to finance investment projects in the UK or US than anywhere else. British businesses actually finance a bit less of their investment from retained earnings than businesses on the Continent.
Of course, businessmen are normally very happy to pin the blame for underinvestment on short-termism in the City. But the IPPR's recent business commission displayed its independence from partisan Labour views by blaming short- termism in business instead. Its report* says: "There is much evidence that both in their investment decisions and in their approach to building relationships too many British companies are short-termist." Rubbing salt into the wound, it adds, in a section headed "UK company myopia": "The culture and attitudes of managers in some industrial and commercial firms are quite congenial to a short-term, deal-making approach."
Getting to the bottom of the problem demands a dissection of the evidence first of all. The Eeyore tendency claims that Britain's investment performance has been particularly disappointing during this recovery compared with previous recoveries at the same stage.
The claim needs a health warning. The soggier performance mainly reflects the housing market slump and declining investment by the privatised gas, electricity and water companies following a privatisation-related surge in earlier years. In addition public sector investment has fallen sharply.
Non-residential investment by private business has grown at a reasonably healthy pace although not, as the chart shows, reaching its late-1980s heights. Within this category, manufacturing investment has been weak but investment by services - more than twice the size - has been strong.
Health warning posted, why should British business be especially short- termist in its investment decisions? Surveys which ask companies to list the biggest obstacles to new investment regularly blame uncertainty about demand. The IPPR's business commission notes that the UK's tendency to run its economy via boom and bust plays a role here. For example, the inflation rate has been one of the highest and most variable in the OECD since 1980, and growth has been similarly volatile. This is partly because policy-making is overactive - for example, if the Chancellor could reduce taxes in the past two Budgets, why did they have to go up so much in the previous two Budgets?
According to Ciaran Driver, an economist at Imperial College, London, there is evidence that companies think the business environment has become more uncertain since 1980 because there is a higher risk premium in the return they demand from investment projects. This is another way of saying the hurdle rate of return on investment is so high because companies want a higher reward for taking a greater risk.
Evidence for the increased perception of risk, he argues**, can be found in answers to a question in the CBI's industrial trends survey. The proportion reporting that their investment was restricted by inadequate expected returns has trended strongly upwards during a period when the actual rate of return was also increasing strongly. The pre-tax rate of return for industrial and commercial companies as a whole more than doubled, to 8.3 per cent, between 1980 and 1993. The logical conclusion is that other forces had raised the required rate of return. It could have been a rising cost of capital, but the survey contains this as a separate question. That leaves a higher risk premium as the most likely explanation.
This still leaves the question as to why the risk premium for investment has risen, and why it is higher in the UK than elsewhere. There have been extraordinary swings in policy fashion since 1980, it is true - hard-line monetarism, then pragmatic monetarism, then membership of the ERM, inflation targeting following the UK's undignified exit from the ERM, and possibly now a return to an exchange rate target. But it has to be said that policy was overactive before 1980 too.
British businesses face current uncertainties not shared by most of the European and US counterparts, in not knowing whether or not the country will join the European single currency on the one hand, or perhaps leave the EU altogether. But this is a pretty recent risk.
Dan Corry, an economist at the IPPR, says: "It is a more tenable explanation for low investment than many others, but it is hard to understand why risk would affect Anglo-Saxons more than others." Without that understanding, it is equally hard to be dogmatic about recommending public policies to tackle the investment problem, if it is a problem.
The IPPR commission recommends levelling the tax playing field between dividends and retained earnings and, more vaguely, changing the legal and tax framework to encourage managers to take a longer-term view. Worthy stuff, but if this is the sum result of their collective wisdom, you have to begin to wonder whether there is an underinvestment "problem" at all.
* Promoting Prosperity: A Business Agenda for Britain, IPPR, pounds 8.99.
** Chapter 4 in "Creating Industrial Capacity", ed J Michie and J Grieve Smith, OUP 1996.
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