We need an investment-led recovery

Allister Heath
One of the main arguments being used by sceptics to attack David Cameron’s austerity package is that Barack Obama’s America is still attempting to pump-prime demand. If the US thinks the way out is for the state to spend more, and rack up an ever larger deficit, then why aren’t we following suit?

So it is worth taking a look at what is really happening in the US, why Obama’s stimulus is actually failing to stimulate and why the coalition right to be going down a different route. Robert Higgs, an economist at California’s Independent Institute, has crunched the numbers in a superb piece of analysis.

The story starts with a basic fact. It is often argued that governments must boost consumer spending by increasing handouts or hiring staff. But recessions are rarely, if ever, triggered by a collapse in consumer spending, even though such expenditure accounts for the bulk of GDP; rather, it is investment which plummets, dragging down overall activity and jobs (and sometimes eventually feeding into consumer spending).

Consumer spending actually increased during the downturn as a percentage of US GDP, going up from 69.2 per cent in the fourth quarter of 2007 to 71 per cent in the second quarter of 2009. Private domestic US investment peaked in the first quarter of 2006 when $2.3 trillion (in 2005 dollars) were spent by firms, worth 17.5 per cent of GDP; it troughed in the second quarter of 2009, having collapsed 36 per cent to $1.45 trillion, 11.3 per cent of US GDP. The main problem for the US economy is that gross private corporate investment still remains over 20 per cent below peak – with net private investment a disastrous two-thirds under its previous peak. What isn’t a problem at all is consumer spending, which is what most people want to boost via stimuli programmes: as Higgs argues, in the second quarter of this year, personal consumption was actually at an all-time high of close to $9.3 trillion (in 2005 inflation-adjusted dollars). There are many lessons here, for Cameron as much as for those convinced that trimming state spending will kill the recovery. First, we need firms to spend more; the UK and US have become even more imbalanced. They rely on too much consumer spending and too little on savings-financed private investment. However, unlike last time, the right investments need to take place. Trying to pump artificially easy credit back into the economy will merely lead to another wave of incorrect investment decisions of the sort that caused the crisis in the first place.

Second, one doesn’t get more private investment by chasing away multinationals, bashing tycoons, cheering when hedge funds relocate or by making the country a hostile place for senior executives and high earners (who determine most investment decisions) to be based. Stability is required, not the constant threat of new regulations or taxes; what matters is the expected profitability of the investments, so anything that will trash them must be avoided. The net rate of return for non-financial UK firms is now 11.6 per cent, down from 15.1 per cent in the fourth quarter of 2007.

Cameron is right to stick with his austerity policy (though he was also right to put the cuts in context yesterday – they are not that large and are spread over many years). But his mixed messages towards business is a mistake. We need to encourage firms to invest, not consumers to spend.