Stimulating Investment

A striking feature of the recent Quarterly National Accounts  was the dramatic fall in real investment: a 30.6 percent decline between 2007:Q4 and 2008:Q4.   The growth in real GDP over the same period was -7.5 percent.   Real investment contributed -7.3 percentage points (pp) to this change based on a standard decomposition with 2007:Q4 expenditure shares as weights.   [The contributions of the other components were: consumption (-2.0 pp); government spending (+0.1 pp); inventory investment (-1.8 pp); and net exports (+3.5 pp).]   It is worth noting that this dramatic fall in investment spending was not confined to building and construction.   In its recent Quarterly Bulletin, the Central Bank reports that overall real investment fell by 32.5 percent in 2008 (year-over-year), with building and construction investment down 35.3 percent, and machinery and equipment investment down 23.0 percent. 

Of course, investment is well known to be a volatile component of GDP.   Even so, the large decline raises concerns both because of its role in driving output below potential and also its influence on the medium-term growth path of that potential.  It is worthwhile to consider, then, what policies might be used to support private investment spending. 

One contributing factor to the decline is the contraction in the supply of credit.  Indeed, one of the central motivations for policy interventions to strengthen the balance sheets of the banks is to increase their willingness and capacity to lend.  The Central Bank’s recent Bulletin does report a modest tightening of reported credit standards between 2008:Q3 and 2008:Q4.  But the explanation for the tightening of standards is likely to lie at least as much in the problems with the balance sheets of the borrowers as with the banks.   Moreover, the deterioration in business net worth, profitability and cash flow are likely to have significantly curbed the demand for credit, explaining part of the decline in credit aggregates.

We thus need to look beyond banking policy to policy actions that might strengthen the financial condition of the non-financial business sector.   In considering possible policy actions, it is worth keeping in mind the well-supported finding from investment research that cash flow is strongly related to investment spending – particularly for smaller, less creditworthy businesses.   This is explained by various agency problems that make it hard to raise funds from financial intermediaries – problems that become more intense as the balance sheets of borrowers and the banks become weaker.    

These findings suggest the importance of examining policies that improve business cash flow.  Given the beating that business profitability has taken, cuts in corporate tax rates or investment-related tax breaks would be unlikely to have a strong stimulative effects.  However, one policy that would directly improve the cash flow (and after-tax profitability) of almost all businesses is a temporary cut in employer PRSI rates for all workers.   (Fine Gael has proposed a cut for new hires.  But this would have a very limited impact on the underlying cash flow position of businesses.)   It is hard to think of another single policy with more potential to ease the pressure on investment, production, and employment. 

5 replies on “Stimulating Investment”

Cutting PRSI is not likely to achieve the result you’re seeking, John. For an average medium-sized enterprise in the non-financial services sector, a 20% cut in PRSI would only reduce that firm’s operating costs by half a percent, while reducing payroll costs by 2 percent. In the manufacturing sector, the benefit would be less, given that it is less labour-intensive. In the modern export sector, the cut would have a negligible effect.

The cost to the Exchequer for this limited benefit would be considerable. Over a year, the Social Insurance Fund could lose up €1 billion (based on 2007 data). Given that the Fund is veering dangerously close to deficit, this loss could not be absorbed by the Fund and, so, would become a charge on the Exchequer.

Cutting all firms’ PRSI would have considerable deadweight costs. The Industrial Relations News has catalogued (not on a scientific basis) over 70 major private sector employers who have paid the first tranche of the now inoperative wage agreement. Clearly, these companies remain profitable enough to increase pay.

A more targeted approach is necessary. We could examine the German programme whereby, to avoid redundancies, a firm’s workforce is short-timed but the state subsidises the difference between the part-time pay and the previous full-time pay. This maintains employment and is cheaper than the cost of redundancy, social welfare and lost taxes. The state could support more creative strategies at firm level to maintain employment (e.g. career breaks, etc.).

This refers to maintaining employment. To address the credit-for-investment issue, companies willing to enter a new Solidarity Pact with their workforce (as proposed by ICTU), could benefit from state guaranteed loans or direct subsidies for investment purposes.

Irish social security contributions are the lowest in the EU-15 (they’d have to double to reach the EU-15 average). Cutting this low-rate base would be costly and ineffectual.

Lesson 1:- People don’t throw away money.
Lesson 2:- Governments do, to their real supporters.
Lesson 3:- Deflation is here and will stay for years and gifts from the government merely prevent the re-adjustments from happening soon. A policy that impinges less tax on productive areas? Clearly a good idea. As the malinvestments die off, we should accelerate this valuable and necessary process by removing all incentives and tax breaks while keeping a sound social welfare system intact. Don’t want revolts you know! Then we might find some productivity. As we will eventually become a pariah internationally, after the next Lisbon vote, we should also consider import substitution and soft protectionism, one of the benefits of societal corruption.

Michael, thanks for a very helpful response. Re-reading my last paragraph, I do see that I got carried away, making the policy sound like a panacea — which it certainly is not. But as I look down the list of policy alternatives, I believe it has merit despite your valid points about deadweight cost among others.

On the deadweight cost, you are right that substantial revenues are foregone on employees who would continue to be employed in any case. But my main point in the post is that boosting the cash flow (and profitability) of businesses is likely to bring a particularly storng investment reponse — including investment in working capital — in the current depressed environment, in part because standard financial intermediation is compromised.

Your alternative suggestions are certainly worth considering, especially the ideas for preserving employment relationships. However, I would be wary of policies that involve state-directed investment in the private sector.

Being in business myself and as a financial advisor a cut in PRSI for employers while welcome is not going to change employment policies much. Two things will do that
1. Improvement in business as things get moving again and a level of confidence returns. A cut in the 21.5% VAT rate could be an incentive to kick start consumer spending. Make it temporary initially even for 6 months only. Get people believing they need to spend before the rate goes up again. Psychologically it may persuade people to switch to buying down South rather than the trip up North. I’m not saying it will work but surely worth a try.
2. Opportunities for investment. Those that survive will buy out the best assets of those that don’t. HMV bought the Virgin stores they wanted. Others will pick off other businesses. Yes it’s back to my hobby horse – but only at sensible asset prices. I’ll bet HMV are not paying the same rents as Virgin were. The sooner these come down the better. I used to do ROI analysis for new DIY stores. The 2 most important components were turnover and rent. Rent really can’t go above a certain percentage of sales depending on the type of business and the margins they can get. What happened in the last few years was the assumption turnover was going to go up and up forever and therefore high rents were justified. This was fantasy. What should happen now is a retailer/car dealer/whatever fails or a landlord cannot find a tenant. The business is put up for sale, it will only sell at sensible prices and if the rent makes sense. I’m not convinced people accept this yet. There is excess supply in the market and prices must come down. (I did do a bit of economics!)

Deflation is inevitable and the faster we use the stimulus of bankruptcy and liquidation, the faster we can make the assets work in the new economy, devoid of mal-investment!

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