Does Europe need more investment?
September 22, 2017
A long-standing view among the European institutions and some member states is that Europe suffers from an ‘investment gap’. Two years ago, the Commission launched its scheme (now dubbed EFSI or European Funds for Strategic Investment) to generate new investment worth over €300 billion (using only about €15 billion of resources) because it thought it had identified a large shortfall in investment.
The overall idea that growth-enhancing investment is crucial for a sustainable recovery has become deeply entrenched in public discourse and is now being used to argue for various schemes to create a euro area budget for investment. The underlying assumption is that more investment is always better, because it increases the capital stock and future growth prospects.
But more investment is not always better and there is little evidence that the euro area suffers from an ‘investment gap’. The Commission first argued in 2015 that annual investment was running €400 billion short relative to 2007.
But the comparison is misleading, because 2007 was the peak of a credit bubble that led to a lot of waste. The Commission has just recognised this now and is simply arguing that investment is lower that even during the pre-credit-boom years. According to that measure, the investment gap is only half as large.
Unfortunately, even the pre-boom years are not a good guide for assessing Europe’s economy today, because something fundamental has changed. Namely, its growth prospects have declined, mostly due to sharp shifts in demographic trends.
The eurozone’s working-age population had been growing until 2005, but it will fall from 2015 onward. Given that productivity growth has not improved, fewer workers mean significantly lower potential growth rates. And a lower growth rate implies that less investment is needed. An economy whose population is expanding rapidly needs lots of new roads, airports, houses and factories to service the growing population and satisfy growing demand. But an economy whose population is shrinking needs much less investment because the capital stock of today will be approximately sufficient also for tomorrow’s population and economy.
In more technical terms, this means that a slowly growing economy needs much less investment to maintain the capital-output ratio. A comparison with the US is instructive as it suggests that Europe has invested too much: one finds that the same amount of capital yields a better return in terms of output in the US than in the euro area.
If the euro area had maintained its investment rate at the level of the pre-boom years, there would soon be even more capital relative to the size of the economy. One might be tempted to ask: so what? Isn’t more capital always welcome?
An ever-increasing capital stock relative to output, however, means ever-lower returns to capital and, thus, the accumulation of ever-more non-performing loans in the banking sector over time. Given the still weak state of its banking system, Europe cannot afford to waste valuable resources. Some reduction in investment relative to the years when Europe’s population was still increasing would thus be entirely appropriate.
This argument applies with particular force to Italy whose growth rate has been falling for almost 20 years now, but its investment had actually held up relatively well until the euro crisis hit the country. The very large non-performing loans (NPLs) on the books of the Italian banks are thus also due to the fact that investment was too high, for too long. A large part of the ‘excess investment’ then turned out to have been a waste. Given that Italy is supposed to have suffered over the last few years from too little investment, it might appear strange to argue that too much investment in the previous period is part of the problem today. But the most recent growth numbers confirm this view: the growth rate is now finally accelerating, not because investment is booming, but because the NPLs are being dealt with and the economy is getting more out of less investment.
Moreover, there is no longer any shortage of funding for investment available in most of the euro area. Even in the periphery of the eurozone, where credit was scarce a few years ago, enterprises now report that they no longer face serious funding problems. A lack of funding is not the reason why investment remains somewhat below the levels of the past.
Finally, if one looks carefully at the so-called investment gap, one sees that most of it is due to lower construction activity. Investment in plant and machinery, which is key for the productive potential of industry, has actually fully recovered. It is now running at 10.5% of GDP, exactly the same value it was at the peak of the boom in 2007. The €200 billion investment gap, which the European Commission still argues remains, is in reality due to lower construction spending. But this seems entirely appropriate given that excesses in the housing sector constituted the root cause of the financial crisis.
Calling for more investment is superficially always attractive. But there are fundamental reasons to believe that the eurozone’s investment rate should remain permanently lower. The often-invoked investment gap is mostly a result of wishful thinking and should not be used to create new budgets or other mechanisms to channel public funds into the construction sector.
[From the same author see also “The Juncker Plan: From €21 to €315 billion through smoke and mirrors”, CEPS Commentary, 27 November 2014].