The slump in business investment remains one of the biggest disappointments of the post-Great Recession recovery. And now the IMF thinks it knows why.
The situation is stark. As the IMF points out in its latest World Economic Outlook (WEO) report, “private investment has declined by an average of 25 per cent since the crisis compared with pre-crisis forecasts, and there has been little recovery”. That is significantly more severe than what we have seen in previous recessions.
This is what that looks like in chart form:
There are some very interesting things to note from the chart. Although business investment in advanced economies remains well below both 2004 and 2007 forecasts, global business investment is roughly on track with early 2000s estimates. This suggests that emerging economies have seen substantially higher levels of business investment over the past decade than the IMF was expecting.
However, it also masks the scale of the slump in the advanced world. Not only has it been deep but it is also broad based, with investment dropping below expectations in residential, business, business structures and business equipment.
And here’s the big policy question: what’s holding back business investment, demand or supply?
The demand case
A number of economists have argued that business investment is low because economic activity has not yet recovered. That is, businesses aren’t investing because they don’t see enough demand for their goods and services.
This case has been prominently made by Nobel-prize winning economist and New York Times columnist Paul Krugman. For example, in a 2011 blog post he writes:
Yes, business investment is low — but no lower than you might expect given the depressed state of the economy. In fact, business investment is roughly the same percentage of GDP now that it was at the same stage of the much milder 2001 recession.
What the data actually say is that we had a catastrophic housing bust and consumer pullback, and that businesses have, predictably, cut back on investment in the face of excess capacity.
Under this theory what you need in order to get businesses investing again is to put more money into consumers’ pockets. In other words, getting people spending again will unwind the majority of the investment problem.
One possible inference of this is that governments should respond aggressively to economic downturns by increasing spending in order to mitigate the collapse in private sector demand and get the economy back on track as quickly as possible.
The supply case
There are, however, alternative theories to the investment slump.
One is that after a banking crisis companies struggle to get access to the credit they need to invest. This makes some intuitive sense as financial institutions are forced to restrain their lending as they repair their balance sheets. As a consequence, the theory goes, businesses can’t get the money they need to fund growth.
Another proposal is that uncertainty over the impact of government or regulatory policy might also be to blame. That is, if companies are not confident in their ability to gauge whether new policies are beneficial, detrimental or neutral for their prospects they might hold back on investment until such time as the outcome becomes clearer (e.g. after the policies have already come into effect and their results are apparent).
This too appears to be a credible thesis given the unconventional policy responses to the Great Recession including large scale asset purchase programmes undertaken by central banks and widespread fiscal austerity in Europe and to a lesser extent in the US.
Towards an answer…
So the IMF’s research department looked into all of these theories in search of a comprehensive answer to the global investment dearth.
Their conclusion? Krugman was right.
Although the effects of credit supply and policy uncertainty are statistically significant in the early stages of a crash, ultimately it is the hit to demand that accounts for the slump in business investment.
In the IMF’s words (emphasis added):
The analysis in this chapter suggests that the main
factor holding back business investment since the global financial crisis has been the overall weakness of economic
activity. Firms have reacted to weak sales — both current and prospective — by reducing capital spending. Evidence from business surveys provides complementary support: firms often mention lack of customer demand as the dominant factor limiting their production.
And the policy suggestions make for interesting reading too. Alongside supply-side reforms to boost labour markets (such as providing incentives for more women to enter the labour force), the IMF suggests public infrastructure investment as a means to “spur demand in the short term, [and] raise potential output in the medium term”.
Sadly this advice comes a little late as many of the governments that undertook spending cuts to rein in public borrowing chose to slash investment spending. The lesson from the WEO is that this was a mistake, and one that their economies are still suffering the effects of more than seven years since the start of the crisis.