Uncertainty and the business of growth
- 25 October 2013
- From the section Business
One of the biggest drags on economic growth is business investment.
UK business investment fell 25% during the recession and has lagged significantly in the recovery. The US lost a similar amount and has recovered a bit better, but still remains below pre-crisis levels.
In thinking about the sustainability of the recovery, there are two useful indicators to look for.
The first is an acceleration in GDP growth, which we might begin to see more signs of in today's UK figure. This would be in contrast to the zigzag pattern of negative and positive quarters of GDP in the early part of the recovery that I wrote about before.
Second, there needs to be a strong pick-up in business investment.
So why is that so important to the recovery?
First, it implies that firms are increasingly optimistic about future demand, so they start to install extra capacity now.
Second, spending on buildings, equipment, machinery and vehicles is large and boosts GDP. Importantly, when firms start to invest again, they also tend to start recruiting.
It is common for business investment to lead the way when emerging from recession, but not this time.
Back in 2010, things looked better for a while. Stimulus packages around the world, and a slowdown in the rate at which companies were running down their stocks, gave GDP a bounce.
That autumn, the newly formed Office for Budget Responsibility (OBR) published its first economic and fiscal outlooks for the UK. GDP was expected to exceed its pre-recession level in 2012 and business investment, along with exports, would be the driving force.
Between 2011 and 2015, business investment was expected to grow at an average annual rate of 9%, adding one percentage point to GDP growth each year.
The OBR also expected the UK economy to rebalance, so that business investment and exports would contribute more to growth than before the recession, instead of relying on government and household spending.
However, since then, business investment has not only failed to be the driving force in the economy, but has hardly grown at all.
The average growth rate was less than 1% in 2011 and 2012. At the same time, the OBR has been forced to significantly revise down its growth forecasts for the economy.
The OBR thinks things will soon get better. Its latest forecast, published in March, expects growth to slowly accelerate from 2014 onwards, with business investment also picking up strongly.
The overall growth in business investment, though, has been revised down and the OBR no longer expects the economy to rebalance to the same extent as before.
The uncertainty factor
In explaining its forecast downgrades over the last three years, the OBR cites two main factors.
First, the impairment in credit markets has made it difficult for firms to borrow to invest. This may have particularly affected small and medium-sized firms that tend to be more reliant on bank financing.
Second, the uncertainty generated by the eurozone crisis and other events has stifled investment intentions.
The view that uncertainty has been holding back the recovery is widely held, not just in the UK, but also the US and the eurozone.
Ben Bernanke, before becoming Federal Reserve chief, was well known for his academic work on this topic.
Uncertainty gives firms an incentive to delay investment and recruitment, because projects are expensive to cancel and it is costly to hire and fire.
More recent academic work has focused on how uncertainty puts upward pressure on the cost of finance. Banks are unwilling to lend to businesses operating in a risky environment - so either add a risk premium to the interest rate charged on the loan or do not make the loan at all.
Much of this work is theoretical. The difficulty in working out the effects of uncertainty on business investment is due to how hard it is to measure uncertainty.
Step forward three researchers from the Universities of Stanford and Chicago. Scott Baker, Nicholas Bloom and Steven Davis have created a measure of economic policy uncertainty.
A big part of their measure is the number of newspaper references to policy uncertainty.
A team of researchers sifts through more than 4,000 newspaper articles looking for reports where there is uncertainty over who is making decisions, what the decisions are, when they will be taken, uncertainty over the effects of past, present and future policies, and also uncertainty caused by inaction.
They also look at the number of temporary tax measures, as well as how much forecasters differ in their forecasts of growth.
In the US, spikes in policy uncertainty occurred around presidential elections, debt ceiling debates, the two Gulf Wars, the 9/11 attacks, the collapse of Lehman Brothers and the euro debt crisis.
Since 2008, uncertainty has been at historically high levels. As uncertainty hurts firms' investment and hiring, the researchers conclude that it delays the recovery.
They also created one for Europe by combining news reports from France, Germany, Spain, Italy and the UK.
This follows broadly similar trends to the US index, but also shows spikes corresponding to close German elections in September 2005, the Northern Rock rescue in September 2007, the first Greek bailout in May 2010 and the aborted call for a Greek referendum in October 2011.
Unsurprisingly, uncertainty too has been at elevated levels in recent years. Unfortunately, it also implies that things may not get better until a long-standing resolution to the euro crisis is achieved. The recent US shutdown has also not helped matters.
That's what happened in the past. Peering ahead, recent business surveys in the UK have begun to look up.
Markit's Purchasing Managers' Index does not report on investment intentions, but the combined surveys for manufacturing, construction and services reported strong activity in the third quarter. In fact, the survey would not be inconsistent with GDP growth of 1.2%, which would be strong acceleration.
In August and September, the Bank of England's regional agents surveyed nearly 500 firms on their investment intentions. This showed a modest increase in investment over the last 12 months.
What's promising is that firms are now reconsidering projects postponed from before the crisis, because of growing demand and confidence.
The British Chambers of Commerce also reported a considerable improvement in investment intentions in the manufacturing and services industries in their third-quarter economic survey. Although these remain below 2007 levels, both have now risen above long-term averages.
There are some positive signs of growing confidence that would help the recovery. It reminds me of the importance of what Keynes called "animal spirits" in driving investment.
Decades later, it's still rather hard to quantify.