Saturday, March 11, 2017

The low down on our concerns about investment

Governments and economists have been worried for ages about investment. First we had too much, then we didn't have enough. But what is "investment"? What's so special about it and why are we likely to be living with less of it in future?

The first trap is that the word "investment" is used to mean two quite separate – though related - things.

People say they've invested in some shares in a bank or invested in some government bonds. This is financial investment in financial assets – a piece of paper (or, these days, an entry in an electronic ledger) that records the owner's legal claim on the finances of the particular company or government.

Companies and governments originally issue these securities to raise money from the public. Mostly, however, people buy the securities second-hand (in the "secondary market") from someone who no longer wants to own them.

What do the original issuers use the money they raise for? Mainly to invest in – to build or buy – tangible or physical assets, such as equipment, buildings and structures in the case of businesses, and buildings (schools, hospitals, police stations), roads, bridges, rail and power lines and so forth in the case of governments.

This is the "investment" economists keep on about – investment in the building of new (not second-hand) physical assets.

Households invest in new housing; businesses invest in new equipment, buildings and mines, and governments invest in new infrastructure (see above).

Economists divide the spending done by households and governments into two categories: on consumption and on new physical investment.

Both kinds of spending add to "economic activity" – the production and consumption of goods and services, the value of which is measured by gross domestic product. Our participation in this economic activity allows us to earn an income and use it to meet our physical needs for food, clothing, shelter and all the rest.

But here's the trick: although all spending, whether on consumption or investment, generates income and employment at the time it's done, spending on investment goods does something extra: it increases our ability to produce more goods and services and, thus, generate more income and employment.

In econospeak, both consumption and investment spending add to demand, but investment spending also adds to supply – our capacity to produce more goods and services in the future. (The future service produced by new housing, by the way, is accommodation – shelter – for many years to come.)

It's this special characteristic of investment in physical capital (but also, in "human capital" – the education and training of our workforce) that explains economists' obsession with "investment".

Four main factors contribute to economic activity, and hence to increasing it: using more hours of labour, investing in more physical capital (including infrastructure), investing in more human capital (education and training) and improving productivity – through better machines, economies of scale, better ways of organising work, and so on.

Now we've got all that clear, what's been happening lately to new physical investment spending?

Well, households have been investing in a lot more housing, particularly in Melbourne and Sydney, though this looks like easing back before long.

Governments – state more than federal – have increased their investment in infrastructure, though many would say they should be doing more, and some (like me) would say the investment they are doing could be in much more useful stuff than it is.

Which brings us to the main thing preoccupying economists, business investment spending.

According to a report by Jim Minifie and colleagues at the Grattan Institute, Australia's investment has been "exceptionally strong".

"Since 2005, the capital stock [aka the stock of physical capital at a point in time] per person has grown by a third. Even excluding mining, capital per person has growth by more than 15 per cent. By contrast, in both the US and Britain the capital stock per person grew by just 7 per cent," Minifie said.

"Strong investment has helped to increase output per person in Australia by 10 per cent between 2005 and 2015, compared to 6 per cent in the US and just 4 per cent in Britain."

But – there had to be a but – we're now experiencing the biggest ever five-year fall in mining investment as a share of GDP.

"And non-mining business investment has fallen from 12 per cent to 9 per cent of GDP, lower than at any point in the 50 years from 1960 to 2010."

This, of course, is what's been worrying economists: the failure of non-mining investment to grow strongly as the mining investment boom ends. Latest figures do show growth in the non-mining states of NSW and Victoria, however.

What factors encourage greater investment? Textbooks tell us lower interest rates – lowering the "cost of (financial) capital" – helps, but the Reserve Bank believes that, while its manipulation of interest rates has a big effect on the behaviour of households, it doesn't have much effect on businesses.

Minifie says the Turnbull government's proposed cut in the rate of company tax would probably attract more investment by foreigners, but it "would also reduce national income [the bit Australians get to keep] for years and would hit the budget". Oh.

But the biggest direct effect on businesses' investment spending is how much spare production capacity they've got and how fast they're expecting the demand for their products to grow beyond their present capacity.

My guess is that many firms still have a fair bit of spare capacity and that many aren't confident of strong growth in the future.

Minifie reminds us, however, that there are good reasons business doesn't need to invest as much as it used to. The cost of capital goods – particularly computerised equipment – has fallen, and service industries, which make up an ever-growing share of the economy, don't need as much physical capital as goods-producing industries do.