Thematic BlogSpot - Is sluggish growth in Europe a usual downturn or an investment gap?
From 2007 to 2013, investment has fallen by 18 percentage points of GDP in the EU, compared to just 6 in the US. In Southern Europe, investment literally collapsed. Even in Germany, DIW, the German economic institute, reckons that the investment gap is real. For the Eurozone, it puts the gap at about 2% of GDP, or €200 billion, enough for policy action.
The fall in investment in the eurozone
Determining whether low investment is a cause or a consequence of slow growth is not as easy as it may seem. Jean Pisani-Ferry underlines that falling capital formation is not a sufficient condition to imply an investment gap because excessive pre-crisis real-estate investment made a sharp downward adjustment inevitable. FAZ’s David Folkerts-Landau reminds us that the whole concept of a gap is based on the notion of an optimum. Such a calculation is based on historical data, in which one compares apples with pears. Peter Sirodov and Nicolas Heinen agree with this by enumerating some reasons linked with this drop such as the efficiency of investment or structural shifts.
How has this investment gap been occurred in the Eurozone? Saving glut?
Structural and cyclical factors, with a special contribution from Germany—According to Patrick Arthus, low investment, or excessively high savings, can be attributed to expected population ageing and a distribution of income detrimental to wage earners. However, cyclical factors are also important. In the 2000s, German labor market reforms were associated with a fall in productivity growth as showed by the Economist. Labor costs fell and so did goods prices. Simon Wren Lewis highlights the weaker increase of German nominal wages compared to their neighbors in the Eurozone between 2000 and 2007, contributing to current account surpluses and strengthening its role as a major creditor country in the Eurozone. Simon Tilford argues that the German labor market reforms were detrimental to capital expenditure and adds that Germany’s strong employment performance constrained the increase of real wages and explains in part weak inflation. For peripheral countries, the challenge is to lower real wages to regain competitiveness, but lower wages reduce nominal GDP, which makes fiscal consolidation harder.
The conundrum of low long-term real interest rate—the real interest rate is a key determinant of investment, yet its sustained decline has not been accompanied by higher investment rates. In a standard IS-LM model, interest rates drive the investment rate, with a multiplier effect that depends on the interest elasticity of demand for investment. Excess savings should drive down the interest rates and boost investment—except, as explained by Hansen, if new technologies require less capital, as discussed by Erik Brynjolfsson and Andrew McAfee in The Second Machine Age. In recent developments, the causality seems to have run from low investment to rate declines—Ben Bernanke’s “global saving glut” argument.
The fall in bond yield in the eurozone (Source :ECB)
Excess savings may be so large that the decline in real rates is not sufficient to equate savings and investment. According to Martin Wolf, there is more savings searching for productive investments than productive investments to employ it, even at very low interest rates.
The attached chart from the OECD shows the fall in investment in the European Union. Cash flows and capital expenditure dropped sharply after the tech bust in the early 2000s. Investment fell as a share of net sales from close to 6% in the late 1990s to less than 4% by 2012. Larry Summers argues that if the expected profitability of investment is falling, interest rates need to fall by the same extent. However, as noted by Robert Skidelsky, interest rates cannot fall below zero, otherwise the liquidity-preference might become virtually absolute and agents would build up their cash balances rather than holding debt—the Keynesian liquidity trap. If the fall in interest rates is insufficient to match the decline in expected profits, the excess of savings gets invested in secure assets such as government bonds.
European companies: cash, borrowings, expenditure and buybacks (Source: OECD)
Is the high cost of capital the culprit? In the euro area, high cost of capital and limited access to funding could impose additional impediments to investment (as illustrated in the charts below). While the ECB’s policy rate is close to zero, lending rates remain elevated in some countries as financial fragmentation persists. Given that debt financing in the euro area is mostly bank-based, this increases the cost of capital, particularly for smaller firms. Many smaller companies have difficulty accessing credit. Recent improvements in corporate bond and stock markets are likely to benefit mostly larger corporations (IMF, 2014).
Does high public debt crowd out private (and public) investment? In the context of debt overhang, Jérémie Cohen-Setton (see Bruegel) writes that short-term budgetary pressures led to myopic policymaking in which governments slash public investment in order to achieve savings—a phenomenon potentially amplified by the lower efficiency of public investment (see the IMF’s report on Public investment Efficiency and Debt Sustainability). Emran & Farazi (2009) show that private investment may suffer from crowding out effects in the presence of high domestic government debt.
Total government debt
What should be done to revive investment in the Eurozone?
Why public investment really is a free lunch? In the Fall 2014 World Economic Outlook, the IMF advocates for increased public spending on infrastructure, asserting that properly designed debt-finance infrastructure investment will reduce rather than increase the government debt burden. For Guntram Wolff (Bruegel), an investment boost in trans-European infrastructure would not only be beneficial for Europe’s single market, it would also constitute an important stimulus to economic growth, especially in the area of energy network and telecom, while avoiding crowding out private investments. Larry Summers mentions that Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps.
Marco Buti, Philipp Mohl mentioned that the sluggish growth outlook is clearly hampering investment through the traditional accelerator effect (Chirinko 1993), suggesting in return that investment would be a strong driver for economic growth in Europe. The IMF (Euro Area Policy, 2014) finds that while historically model projections track investment closely, actual post-crisis investment has remained below its model-implied value for most countries.
Private sector calls for alternative sources of funding? A number of proposals are on the table (notably reviewed in a Warning Signals BlogSpot by Rigaud and Raso and the EPC Special Collection on Investment in Europe):
Jean Pisani Ferry, in a Project Syndicate article, argue that EIB could lend more to the private sector though this may crowd out private operators and create greater solvency risks. He lays out a few rules for effective investment: public investment should be undertaken especially in countries with excess savings, and in support of the private sector, offering positive externalities by targeting social and economic impacts.
Natacha Valla (CEPII) suggests the creation of a Federal fund that could act as a substitute for banks and assist countries with impaired socio economic environments—with privileged partnerships with a broad range of investors (pension funds, institutional investors, venture capital, private equity, etc.).
ALDE proposed a €700bn plan for investment in energy, transport and digital markets. Projects would only be funded in countries that are implementing structural reforms and whose drafts budgets have been approved by the EC. Capital gains on investments in the fund would be exempt from taxes, to encourage households to invest in it. The plan would be accompanied by legislation to reduce red tape for business, integrate EU capital markets and strengthen the energy and digital markets.
Another way to unlock funding for SMEs and increasing available funding to the real economy could be the ECB’s ABS plan. This could free up regulatory capital to allow further lending, as well as transferring risk on to investors. John Muellbauer argues that ECB must go further and pursue Milton Friedman’s “helicopter drop” strategy.
Acting on the supply of credit: Could banking structural reforms and a European capital market play a role? Paul Krugman argues that accelerating the European Banking Union project would halt the financial fragmentation between Northern and Southern private sectors, and thereby promote lending and investment. Enhancing securitization, for example thanks to the ECB's asset purchase program, could help unplug financing according to Patrick Arthus. Jeffrey Sachs however notes that further deregulation would not imply a sustained boom in productive private investment and calls for a new strategy based on sustainable investment-led growth and global cooperation.
Are recent initiatives to be taken seriously?
The Enderlein-Pisani report attempts to propose real steps to jumpstart the European economy, with a number of proposals on the investment front for France and Germany—a minimum threshold for net public investments as a complement to the debt brake, to avoid a further reduction in the value of German public assets and a five-year fund for priority projects at the municipal level; and the enhancement of the allocation of investments in France. The report also proposes the creation of a euro area fund to boost public investment by 5% over three years, in priority areas and in support of long-term growth and innovation.
The Juncker’s investment plan—high in ambitions, low in financing. EU Commission President Jean-Claude Juncker unveiled an investment plan to provide 315bn in new investments. A new European Fund for Strategic Investment (EFSI) is central to the plan, to be endowed with 21 billion euros (16 from EU member states and the remaining 5 from the European Investment Bank (EIB) (Eurointelligence). The plan re-engineers existing funds by bringing together various smaller investment programs and channeling them towards one big effort (see our Warning Signals BlogSpot on 26th November).
While Zsolt Darvas reminds us of the counter-cyclical stabilizing role played by the EIB during the financial crisis and criticizes the current pro-cyclical plans to reduce investments in 2014 and 2015, Spiegel emphasizes the criticism that Junker’s proposal raises.
Debt and limited growth impact—For Markus Ferber, this program will burden EU member states with more debt. FAZ’s David Folkerts-Landau highlights that Germany has a better infrastructure than Japan, the US and the UK. They should by all means invest more money, but the author doubts that it will have a big impact on GDP.
Unattractive precedents—Jean Pisani-Ferry reminds us of the deception that followed the White Paper on growth, competitiveness and employment in 1993 and more recently the Compact for Growth and Jobs that was meant to spur EUR180bn of total public and private investment by boosting the EIB's capital by EUR10bn, but which did not make a dent in the investment shortfall.
Political constraints—Guntram Wolf points to inherent politic constraints that challenge the implementation of the plan, also highlighted by Eurointelligence. Marcel Fratzscher (Project Syndicate) criticizes Germany for not supporting the European investment agenda (one of four Neins—on a more active fiscal policy elsewhere; on an EU-level investment program; on allow a fiscal drift at home; and on QE), and encourages the country to trade off deeper reforms in France and Italy in exchange for more time to consolidate deficits. In Welt, he insists that to maintain a well-performing economy, Germany needs more investment (hat-tip Warning Signals).
Ambitious plans fallen by the wayside? Wolfgang Munchau points out that the overall outlook for investment in Europe remains rather mixed. Debt sustainability concers, elevated cost of capital, greater financial constraints, high corporate leverage, and uncertainty have weighed on investment across the euro area. Investment is expected to pick up as the recovery strengthens and uncertainty declines. However, a sustained recovery in investment will require dealing with the corporate debt overhang and financial fragmentation. Even though Juncker’s plan is published, Matthew Dalton points out that there is a lingering question as to whether these projects are truly incremental to those that would have occurred otherwise.
By Annabelle Pigeon & Xiaqing Liu
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