Stable public finances require stronger business investment
Economic recovery in Europe is being held back by the unprecedented weakness of business investment. Despite a secular decline in business taxation and labour market reforms that have boosted the power of capital relative to labour, the ratio of investment-to-GDP across the EU is at a 60 year low. Rather than investing their profits, firms are sitting on huge holdings of cash. This is depressing economic activity and forcing governments to run big fiscal deficits. Unfortunately, government policies across Europe threaten to keep things this way.
Europe’s austerity-minded politicians and policy-makers argue that business investment will recover once governments have put public finances on a sound footing. Companies will then feel confident about investing for the future. According to this argument, investment is weak because of the weakness of public finances. However, their assertions do not bear scrutiny. The widening of fiscal deficits followed the collapse of investment – not the other way round. Weak public finances are the flipside of low levels of business investment. Corporate cash holdings are now €2 trillion in the eurozone and an astonishing £750 billion in the UK. Until investment recovers, public finances will remain weak.
Why are firms not investing? One reason is corporate deleveraging. Firms built up high levels of debt in the run-up to the financial crisis, largely as a result of activity such as mergers and acquisitions rather than investment in organic growth, and are trying to reduce their debt to more manageable levels. Another reason is that many banks have stopped providing revolving credit lines, forcing firms to build up cash cushions. This is a particular problem for countries where banks, rather than stock markets, are the dominant vehicles for financing firms.
But the bigger reasons for the collapse in investment are almost certainly corporate governance and economic policy. Executive remuneration is increasingly driven by short-term share performance. Senior executives have little to gain personally by signing-off on investment, as most of it depresses profits over the time horizons which determine their financial rewards. This is most clearly the case in the UK, and helps explain why the country has the biggest problem with corporate cash hoarding.
However, the most important factor holding back business investment across Europe as a whole is government policy. Firms will not invest unless they are confident about the outlook for demand for whatever it is they produce. And here two factors are crucial. One is excessive fiscal austerity, which has snuffed out Europe’s tentative economic recovery and threatens a swath of the eurozone with slump. The other is that Europe has experienced a huge shift in the relative proportions of national income accounted for by capital and labour. Lower corporate tax rates and labour market reforms aimed at reducing the bargaining power of labour have boosted the income of the corporate sector and depressed that of the household sector.
While corporates continue to save much more than they invest, either households or governments will have to spend more than their incomes, or countries will have to export more than they import. Although some European countries are able to fill the gap by relying on exports, this is clearly not a suitable model for all. Europe as a whole will not be able to put its public finances on a sustainable footing until business investment returns to normal levels. This is highly unlikely to happen while governments are cutting public spending before the private sector has deleveraged, encouraging a further decline in labour income relative to capital income (as is happening across the eurozone), and failing to take steps to reverse the decline in bank credit to firms.
If investment is to recover, Europe needs to do a number of things. First, fiscal policies must be consistent with a return to economic growth. The eurozone and the UK provide ample evidence of the risks of doing too much too soon. Second, Europe must avoid policies that lead to a further erosion of labour income as a share of overall national income. Europe needs higher German wages more than it needs lower Spanish ones. If all eurozone economies attempt to reduce wages relative to the eurozone as a whole – as is currently happening – investment spending will remain chronically weak.
Third, Europe should resist calls to further reduce the tax burden facing business. The decline in business taxation and the rise in corporate income over the last 20 years has not encouraged higher investment, since the flipside has been a slump in household income (and with it consumer demand). Europe should revisit the case for a harmonisation of corporate tax bases and rates. Harmonised tax rates would make it hard for businesses to play governments off against one another. The issue of corporate remuneration also needs to be addressed. Excessive executive pay captures most of the headlines, and is undoubtedly socially corrosive, but the more serious problem is the perverse incentives facing chief executives. Too many firms are being run for cash rather than growth, with damaging implications for economic activity.
Fourth, European governments must do more to restore confidence in their banking sectors. At present, businesses are loath to increase their reliance on banks and the banks are wary of lending more.
The influence of business on economic policy across Europe has never been greater. Sometimes this can be positive: governments can learn from the corporate sector and businesses are right to warn of the damage done by excessive and ill-thought out regulation. But the macroeconomic effects of business influence on policy are pernicious. Countries are not like businesses. A business can save more (for example, by cutting wages) without undermining demand for its products. Countries can only behave like firms if they are able to rely on exports to close the gap between what they produce and what they consume, which they cannot all do simultaneously. Europe’s business community should be lobbying for policies that promise a recovery in demand, not demanding that governments step up the pace of fiscal consolidation and cut business taxes.