The European economy is still showing signs of scarring from the financial crisis. In many economies, households and companies find themselves overburdened with debt. As a result, even though there may be profitable opportunities to invest, they cannot finance any expansion. In turn, this has slowed the recovery in the EU economy.
As shown in the table (below), investment in the euro zone economy in 2014 accounted for only 19.5 per cent of GDP whereas in 2005 it accounted for 22 per cent of GDP.
In the case of Ireland and Spain, investment before the bubble burst in 2008 was unsustainably high at between 28 per cent and 31 per cent of GDP. Hopefully we will not try and return to this level, but across the European Union there are now concerns that investment is too low and that this is both dragging down growth in the short term and having a negative impact on the potential output of the EU economy.
Investment in Germany and France has recovered from its low in 2009, but in countries such as Spain and Ireland, which suffered severely from the financial crisis, investment is still below 20 per cent of GDP, a “normal” level in a growing economy that is properly managed.
In the case of Germany there is recognition that significant public infrastructure is inadequate or needs renewal.
The United Kingdom also stands out as an exception, with a continuing very low level of investment. The UK case reflects an underinvestment in public infrastructure that goes back decades, as well as a dominant financial sector, which has less need for physical capital.
The Irish economy is now growing rapidly but there are a number of signs that things are not back to normal. Investment in Ireland is well below what would be expected in a developed economy that is growing. To produce the increase in output that is already taking place, more machinery is needed and more offices and factories.
There is a limit to how much the existing capital stock can produce and, in addition, machinery and buildings wear out and need to be replaced. Expansion of housing output to meet the pressures of our growing population and economy has been slow to materialise.
Some adjustments are needed to take account of exceptional factors that distort the data for Ireland. It makes more sense to express key figures, such as investment, as a share of GNP when making cross-country comparisons. The investment data include two special items – aircraft bought by leasing companies and investment in R&D – which should be excluded.
Investment in aircraft for leasing, although a large addition to the domestic capital stock, brings only a very small value added to Ireland. Much of the recorded investment in R&D takes the form of purchase of a licence or patent from abroad, bought by a foreign multinational operating here, with little R&D activity conducted in Ireland. This investment is likely to have a marginal impact on productive capacity; rather it is part of the reorganisation of their global economic activity by the firms involved.
Property bubble
When these adjustments are made, the graph shows the share of investment in GNP in Ireland. In the 1990s, before the property bubble emerged, investment accounted for between 20 per cent and 25 per cent of GNP. In today’s growing economy we might expect it to return to this range but, as shown in the Figure with the adjusted data, it languishes at under 15 per cent of GNP. In 2012 and 2013 it was down about 11 per cent, and investment in those years was not enough to replace ageing assets.
When the sectoral data are examined, the level of investment in manufacturing and some areas of the services sector looks appropriate. However, investment in public infrastructure, housing, and some services sectors looks too low to be sustainable in the longer term.
A significant factor in the inadequate level of investment in recent years has been the legacy effect of debt.
A result of this underinvestment is the rapid rise in household and commercial rents and in house prices. The correct response is to remove the constraints on increasing the supply of buildings. Also there are signs of increasing congestion affecting some key networks, for example in cities and in the provision of water. The cutbacks in public investment have contributed to the problem and a priority for any relaxation in public finance constraints should be new investment in infrastructure.
Raising taxation
One other implication of this analysis is that, as the economy returns to a more “normal” pattern of behaviour, investment will rise. In turn, this will continue the growth in the economy well beyond this year.
In particular, we are likely to see a significant increase in employment in building and construction. However, a key challenge for government over the coming five years will be to keep a lid on this growth to prevent another catastrophic bubble and burst. Slowing the economy through raising taxation, should it become necessary, needs to be part of the armoury of the next government.
