James Athey: Is investment the answer?

If there has been one question which electorates have asked, nay demanded, of their politicians most consistently through time, it has been – how do you intend to improve the economy?

In the low-growth, low-inflation aftermath of the Global Financial Crisis it became apparent that monetary policy was “the only game in town”. Many Western governments, concerned about the vast sums they had spent bailing out financial institutions, retrenched almost immediately once the worst of the crisis had passed. The austerity they imposed wasn’t widely popular among constituents but was deemed necessary by leaders to put national finances back on a sustainable long-term path. The responsibility for stimulating the economy thus fell exclusively on central banks and that created significant unintended consequences.

Fifteen years later the wisdom and success of those choices is still debated and debateable. What is clear however is that most Western governments today appear far less constrained by concerns about the health of national finances. Fiscal policy is back at the top of the agenda.

The recent US election offered voters the chance to choose between candidates who made no secret of their desires to spend more and/or tax less. We can never be sure of the exact economic implications of vaguely described manifesto pledges, not least because economic forecasting with any degree of precision is simply impossible. However, the overwhelming consensus was that either political choice would result in the US government borrowing more money.

In the UK election earlier this year, the Labour Party won an historic majority in the House of Commons by effectively neutralising the issue of fiscal responsibility through a pledge to essentially “do the same as the other lot”. Yet in her first budget as the UK’s first female Chancellor Rachel Reeves announced a series of policies which, according to the UK’s independent body tasked with analysing public finances (the Office for Budget Responsibility or OBR), would likewise result in a significant increase in government borrowing. Furthermore, the OBR estimated that over the full five-year parliament the effect on UK economic growth would be small and negative. The communication from Number 11 Downing Street, however, stated that it was a budget for growth and the number one commitment of the government was economic and fiscal stability.

How are we to square this seemingly contradictory circle?

The answer we are told is investment. Through investment the government can borrow more today and – by increasing the long-term growth rate of the economy – pay for that borrowing and begin to pay down previous borrowing in the long-term. Sounds great! Unfortunately, we believe a little caution is required before we all start patting ourselves on the back.

In theory the Chancellor could be correct. Debt is not inherently bad. Used correctly, debt can be a vital means of long-term wealth creation. A company making widgets profitably from its factory in Rotherham sees demand for widgets rising consistently. But it is reaching the limit of how many widgets it can manufacture from its current and only location. The company is profitable, but it doesn’t have enough cash in the bank to simply pay for a new factory to be built. So instead, it performs a simple calculation of how many additional widgets it could make and sell from a new factory over say the next 10 years, the price it should receive for its widgets and the cost of their manufacture. It compares this to the cost of borrowing, and then paying back with interest, the amount required to build a new factory. With a little mathematics to account for the time value of money (simply put – money today is worth more than money in the future), it can compare these two sums and if the end result is a positive number, then the investment should be a good and profitable one. The company will have more debt in the short term but over the long term the company will be more profitable. Thus Rotherham/UK GDP will increase, as will employment (assuming these widgets are not all made by artificial intelligence-powered robots) and eventually the debt will be paid back. Everybody wins (including the lender who makes a nice profit on the money they lent to the widget maker).

Thus, we come to the crux of the matter. The key is the profitability of the investment. This is where the Chancellor’s plans currently lack detail. For, while she made many announcements on 30th October, when it came to the investment aspects of her budget the details were scarce. I suspect the reasons for that informational scarcity relate to the difficulty of identifying those investments which are so obviously profitable for the UK economy and thus ultimately for the UK government. Anyone who has lived in the UK for any length of time in recent years will, I am sure, be able to attest to the need for investment in our roads and railways. Yet it is very hard to imagine the economic payback for a road network with fewer potholes or less railway signal failures. I’m sure there is one – but one sufficiently lucrative to pay back not just the debt required to fund the work but the roughly 4% interest that the government would be paying on that debt in the meantime? I am not so sure - this is not Victorian Britain after all.

Away from projects such as those described above (as socially desirable as they no doubt are) identifying these growth-boosting endeavours becomes even harder. Especially when you consider UK government’s prior record with large-scale projects. I am sure previous governments had made many growth-boosting assumptions about the HS2 rail project but unfortunately that didn’t prevent a mammoth and unforgivable underestimation of the likely cost of the project, thus leaving the original profitability calculation in tatters.

The cold, hard reality is that investment is not some magical growth elixir which can simply be fed to the economic patient during times of economic malaise. Where there are obvious and productive projects just waiting to be funded it seems difficult to imagine why the private sector, with its seemingly infinite access to borrowing, would not already be funding them (to be honest it seems difficult to imagine why a previous government would not have tried – for cynical re-election reasons if nothing else). In a free-market economy such as ours that notion is prima facie evidence of a paucity of obviously productive investments, given our current regulatory environment, wage structure, trade policy, exchange rate and myriad other factors which feed into the prevailing economic status quo. Using dubious assumptions to justify pressuring already strained public finances to fund investment is just as irresponsible and short-termist as borrowing to fund current spending (something which the new Chancellor has committed not to do).

One need look no further than China to get a glimpse of what can happen when governments use investment as a pseudo-virtuous shortcut to boosting economic activity. China has had to borrow money at an increasing rate over the last 10 years, while seeing its growth rate simultaneously decline. More and more debt has been taken on, to produce less and less growth, leaving a dangerous legacy for the Chinese leadership of today to deal with. Its economy has far too much capacity, which it often dumps overseas, raising trade tensions as it does so. The result is an economic situation which is the envy of no one. China has high debt as a percentage of its economic output and faces a choice between borrowing more just to stand still or allowing a dangerous deflationary mindset to take hold, strangling the economy under the rising real burden of servicing that debt. Their catch-22 situation should act as a cautionary tale for any government seeking to invest its way to economic nirvana.

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