Monday , August 19 2019

Causes of stagnation

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Summary:
Ben Chu reports that business investment has been “considerably weaker” than the Bank of England had expected “due to fears over a Brexit cliff-edge for trade.” The Bank, however, has a history of over-predicting capital spending. In November 2014, for example, it predicted that business investment would rise 10% in 2015. In fact, it rose only 3.7%. And that was in the happy days before we knew about Brexit. This is not an idiosyncratic failure by the Bank. My chart shows the OBR’s record at forecasting business investment, comparing forecasts made in November or December for growth the following year to the out-turn. In only two of the last eight years has investment exceeded expectations. In one of these years (2014) the excess was tiny, and in the other (2017) the OBR seems to have

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Ben Chu reports that business investment has been “considerably weaker” than the Bank of England had expected “due to fears over a Brexit cliff-edge for trade.” The Bank, however, has a history of over-predicting capital spending. In November 2014, for example, it predicted that business investment would rise 10% in 2015. In fact, it rose only 3.7%. And that was in the happy days before we knew about Brexit. Obrbusinv

This is not an idiosyncratic failure by the Bank. My chart shows the OBR’s record at forecasting business investment, comparing forecasts made in November or December for growth the following year to the out-turn. In only two of the last eight years has investment exceeded expectations. In one of these years (2014) the excess was tiny, and in the other (2017) the OBR seems to have over-estimated the damage Brexit uncertainty would do.

Of course, over-optimism about 2016 can be attributed to firms delaying investment because of Brexit uncertainty. But the OBR was over-optimistic for most of the 2011-15 period too. That can’t be blamed on Brexit.

The OBR and the Bank have for a long time thought that high corporate cash balances, a small output gap and high profits would stimulate investment. This has proved too optimistic. Why? Here are six possibilities:

 - A fear of technical change. If you invest in new robots, you risk being undercut in a few months’ time by a rival who has invested in cheaper or better ones. The prospect of rapid technical change can retard investment. This explains the paradox that there’s lots of talk about new technologies such as AI and robots but little investment in them.

 - Intangibles. As Stian Westlake and Jonathan Haskel have shown in Capitalism without Capital companies’ assets – and especially the assets of growing companies – are increasingly intangible: things such as good ideas, brands or firm-specific technologies and skills. These are lousy collateral. Which means it’s hard to finance for expansion. For this reason, firms must build up cash piles not only to finance future investment but to ensure that they have future cashflows if things turn bad – so they are in effect self-financing. This means that rising cash holdings aren’t as predictive of capital spending as they once were.

 - Illusory capital constraints. Increasing capacity constraints don’t necessarily boost investment as much as the Bank or OBR has thought. A study (pdf) of a steel mill by Igal Hendel and Yossi Spiegel  showed that it doubled production over 12 years with the same plant because every time the mill seemed to be at “full capacity”, its managers found ways of tweaking production methods to eke out more output. “Capacity is not well defined,” they conclude. If this is true of an old economy steel mill, how much more true is it of intangibles-intensive companies that are more scalable? The “output gap” might not be a useful idea.

 - Irrelevant profits. Profitability has been high recently, according to official figures at least. But this tells us only that past investments have been successful. It doesn’t necessarily tell managers much about the likely success of future, different projects.

 - Low wages. Sustained low wage inflation means firms have had little reason to replace workers with capital.

 - Learning. In the past, investments have often proved unprofitable. Charles Lee and Salman Arif have shown that rises in capital spending lead to earnings disappointments, in part because firms have underestimated how hard it is to maintain profits while expanding. To the extent that managers have learned from these mistakes, capital spending will be lower now.

None of this is to deny that Brexit uncertainty is depressing investment: we know that uncertainty causes firms to put projects on ice. What it does mean is that there are many other reasons for weak capital spending. Our obsession with Brexit is distracting us from the fact that there are deep structural reasons why British capitalism is stagnating.

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