On crowding out

This morning, I got into a Twitter row with Jackart. He says: "State spending CAUSES lack of private investment." I agree with him that this can happen sometimes. But I disagree with him that it happened with Gordon Brown's fiscal loosening in the mid-00s.

My chart provides some background. It shows that in the mid-00s - well before the financial crisis - the government did start to run a deficit. And companies ran a surplus, with retained profits exceeding capital spending. It's also clear that, over time, these two financial balances have been mirrors of each other; the correlation between the two has been minus 0.77 since 1988Q1.

This poses the question: was it the government deficit that caused the corporate surplus? There are three ways in which it might have done - in which state spending might have crowded out private investment - but I don't think any of these mechanisms operated in the mid-00s:

 - Financial crowding out. Government borrowing can raise interest rates which chokes off private spending. One simple fact tells us that this didn't happen in the 00s - real gilt yields fell; ten year ones dropped from 2.6% at the end of 2001 to 1.7% at the end of 2006.

 - Ricardian equivalence. It's possible that companies saw rising government borrowing as meaning higher future taxes, and so cut investment for fear of a lower future post-tax return. If, however, the incidence of corporate taxes falls upon workers rather than profits, this mechanism won't have worked; even if firms did anticipate higher future corporate taxes (and I'm not sure this was true), they might have thought: "these'll reduce future wages rather than profits" which shouldn't have affected investment*.

 - A wage squeeze. If governments hire more workers, wages will rise and this will squeeze profits and expected profits and so deter investment. This can happen; Silvia Ardagna and Alberto Alsina have shown (pdf) that sometimes fiscal contractions can raise growth because they cut wages and so alleviate a profit, so it's reasonable to suppose that fiscal expansions can sometimes do the opposite. But again, this did not happen in the mid-00s. As the IFS has pointed out, real household incomes (most of which are wages) grew very slowly then. That's the opposite of what should have happened if there were wage crowding out.

I suspect instead that the causality between the two financial balances ran the other way. A dearth of monetizable investment opportunities - because of, among other things, slower technical progress and the migration of low-wage industry to China - caused companies to reduce  investment. This led to falling real interest rates and weak incomes growth, and increased government borrowing was the response to this.

Now, I'll concede that this story still gives Jackart many things to complain about. You could argue that the response to weak corporate investment should have been looser monetary rather than fiscal policy - though personally I suspect this would have increased speculation, house prices and malinvestments even more. Or you could argue that the fiscal loosening should have taken the form more of tax cuts than spending increases. And you can certainly complain that higher spending was accompanied by a lack of public sector productivity growth.

However, I just don't buy the claim that, in the 00s, Brown's fiscal expansion caused the lack of private investment.

* I suppose you could argue that firms cut capital spending because they thought that lower future wages would have depressed aggregate demand - but I'd welcome decent empirical evidence on this.

Comments

[Jackart]

During Brown's tenure, the state took all the money, and all the graduates, and employed them to stand in the way of firms and their investment wielding clip-boards. There was no-one to invest with, thanks to a more controlled labour market, and thanks to an absurd regulatory raj, investment was less profitable. Hiring became more risky, and the public sector was having money fire-hosed at it. AND YOU'RE SURPRISED THERE WAS NO PRIVATE SECTOR INVESTMENT?

To suggest Brown and Labour had no choice but to spend like drunken sailors in port is willfully stupid, and looks to me like a desperate leftist attempt to justify absurd levels of state spending under any and all conditions... no... sorry, you lot call it "investment".

[pablopatito]

We know that aspirin lowers your temperature during a fever. If I take an aspirin at the start of a fever and my temperature goes up, that doesn't mean that aspirin doesn't work, it means I'm getting sicker. My temperature may have been even higher if I hadn't taken the aspirin.

Isn't that similar to comparing one set of economic figures at the start of a period to those at the end and deducing that the theory can't have worked (because say interest rates went down rather than up)?

In other words, is it possible to have wage crowding out and still have wages fall? Or do the two always have to be mutually exclusive?

[Luke]

Jackart,
"... Brown...took all the money...wielding clip-boards...controlled labour market...absurd regulatory raj..... .public sector was having money fire-hosed at it.....etc etc"

Got *any* numbers to back up *any* of that? Any comparisons with neoliberal small state countries such as Germany? Or the socialist US which had no recession or financial crisis at all? Any answer to the arithmetical issue of what happens if the private sector is a net saver?

I'm not saying you're wrong, more that (much of) what you are asserting is simply unprovable/falsifiable.

[chris]

@ Pablo - you have a point. Wages probably would have been lower, without looser fiscal policy. But that surely strengthens my point, that the private sector was suffering from weak growth, without policy intervention.
@ Jackart - it's possible that red tape reduced investment. but that's a separate argument from fiscal policy: red tape can increase whatever the fiscal position. I find it hard to believe that many graduates were hired to enforce regulations, or that very many firms were impeded by a lack of graduates or by high wages thereof. Do have any empirical evidence?

[Jackart]

Chris, I am not an academic economist. But I do know counter factuals are pointless. But EVERY TIME Tories get in, they reduce labour market regulation, and in time, reduce unemployment. Cutting state spending has nowhere led to a recession (It's accepted that protectionism and monetary effects are responsible for the depression, not a lack of state spending). In the UK Labour massively increased regulation on business from the complexity of the tax-code, to the hiring and firing of workers. This creates non-wage costs. They also added to taxation, another non-wage cost. This served to reduce the incentive to employ in the private sector. At the same time, wages were going up in the public sector, reducing the incentive to seek productive private sector employment. None of these things are on their own, enough to explain what's going on, but all of them together might just add up to the conclusion that Gordon Brown is a shocking turd, and the UK would have been better off if he'd been still-born.

[BenM]

@Jackart

"I do know counter factuals are pointless. But EVERY TIME Tories get in, they reduce labour market regulation, and in time, reduce unemployment. "

Just wrong with regard to 1979 to 1997 government.

[pablopatito]

"Just wrong with regard to 1979 to 1997 government."

And every Tory government of the 20th century I think (I've only taken a cursory look). I haven't checked the 19th century yet, so maybe they were better then with their deregulation.

[paulc156]

@Jackart
"(It's accepted that protectionism and monetary effects are responsible for the depression, not a lack of state spending)."

Well it's also accepted that massive state spending [US] ended the depression in the form of the war economy and that premature fiscal tightening in 1937 snuffed tentative recovery out.

"In the UK Labour massively increased regulation on business from the complexity of the tax-code, to the hiring and firing of workers."

The World Bank (2010b) Doing Business 2010 – Reforming through difficult times presents a comparison of the 20 top countries rated for ease of doing business. The UK in 5th place after Singapore, HK, NZ and the US.

http://ec.europa.eu/enterprise/policies/industrial-competitiveness/competitiveness-analysis/seminars/files/bbs_falkenhall_report_en.pdf

Impressive if not world beating and hardly the bureaucratic nightmare you describe.

The ONS describe the UK labour market thus;
"Qualitative analysis by the World Economic Forum (WEF) identifies the UK has having the 5th most efficient labour market (out of 148 countries), compared with the United States (4th), Canada (7th), Germany (41st), France (71st) and Italy (137th). The measure considers flexibility in wage determination, hiring & firing and redundancy costs among other labour market factors."

http://www.ons.gov.uk/ons/rel/elmr/an-international-perspective-on-the-uk/labour-market-performance/art-internationallm.html#tab-Labour-market-flexibility

"At the same time, wages were going up in the public sector, reducing the incentive to seek productive private sector employment."

Yet as evidenced by ONS data cited by Incomes data Services shows; "There had been an increasingly tough policy from the Treasury on public sector pay since 2005, for about six years, with increasingly lower limits set for pay rises, dropping down to 1 per cent under the Labour Government.
Here's the chart with private sector pay for comparison."

http://idseye.com/2011/12/08/how-did-private-and-public-sector-pay-change-over-the-recession-years/

All a far cry from the evidence free picture you've painted.

[Simon Reynolds]

@paulc156

Good response with some interesting links. I think that the problem jackart has is not just that he paints an evidence free picture, but that his comments are counter to the evidence. It's is like someone arguing that Coventry City won the FA cup last year.

@jackart

“During Brown's tenure, the state took all the money...”

“To suggest Brown and Labour had no choice but to spend like drunken sailors in port is wilfully stupid, and looks to me like a desperate leftist attempt to justify absurd levels of state spending under any and all conditions...”

Are you sure? Are you certain that these statements are accurate descriptions of what happened? Is it true that the “state took all the money”, and spent at “absurd levels”, under Brown?

According to the useful IFS spreadsheet:

http://www.ifs.org.uk/uploads/publications/ff/lr_spending.xls

o Over the 18 years of the Thatcher / Major governments (1979-80 to 1996-97) Total Managed Expenditure averaged 43.2% per year.

o Over the 13 years of the Blair / Brown governments (1997-98 to 2009-10) Total Managed Expenditure averaged 39.7% per year.

[Thornton Hall]

Or we could ask people. You only have 65 million people over there, total. How hard could it be?

[Dave Timoney]

Re "There was no-one to invest with, thanks to a more controlled labour market, and thanks to an absurd regulatory raj, investment was less profitable".

The UK labour market is widely acknowledged to be one of the most flexible in the developed world, regularly held up as a paragon by such lefty outfits as the OECD and IMF, as well as the WEF referenced by paulc156. This didn't happen overnight in 2010, but is the product of many years of deregulation from Thatcher through Brown.

New Labour may have introduced the minimum wage, but it also watered down the EU Working Time Directive and Part-Time Workers Regulations. It also made it progressively easier to hire and fire workers and limited recourse to employment tribunals. Anyone who was an employer over the last 20 years knows this.

Business regulation, far from being inimical to capital investment or profit, is actually a key driver of both. Regulation raises the cost of market entry for new competitors and privileges large businesses (who can access cheaper capital) over small. This is why large companies and multinationals tend to be in favour of the EU, which is essentially a big capital lobby.

The downward trend in capital investment has been happening since the 1980s, but significantly profits have held up over the same period. This is because capital has become more profitable. Some of this is due to globalisation (e.g. investing in China), some due to a glut of commercial property for lease (so less capital is tied up in plant), but an arguably more profound factor has been the compositional change in capex caused by the growth of software relative to hardware (I disagree with Chris that technical progress has been "slower", its just taken a form that many economists struggle to understand).

http://fromarsetoelbow.blogspot.co.uk/2013/12/secular-stagnation-as-software-glitch.html

[aragon]

Investment fell and profits were sustained, because it was too easy to make a profit without investment.

Easy profit without investment.

a) Outsource manufacturing to China wholesale to UK retailers. (No investment but profit in short term)

b) Immigration, lower labour costs no need to invest in plant and equipment - profit. (also labour released by a).

c) Finance: Increases in credit as labour tries to sustain living standards in face of competition domestic and international, rising housing prices / securitisation.

All result in profits or increased profits
without requiring any investment, but none are sustainable in the long run.

Result 2008 crash and current record household debt. (Continued by the Tories)

Gordon Brown extracted some taxes from the looting of the economy by finance/the city.

No need to invest, crowded out, not by Government spending but by returns from financial manipulation, eroding of labour market power, and looting of productive capacity.

Hint: It ends in tears ...

[Doc at the Radar Station]

Aragon, you are onto something! Check this out:
http://noahpinionblog.blogspot.com/2011/08/are-we-replacing-robots-with-chinese.html

"...So here's the question: what if our slow rate of innovation is due not to an inexplicable slowdown in the arrival of new ideas, but from the fact that China has made the discovery of those ideas less urgent? If that were true (and I'm only raising the possibility), what would be our best response? Would shutting ourselves off from cheap Chinese labor force us to become like 1600s Netherlands and invent a bunch of cool robots? Or would it just cause companies to pack up and leave the U.S. entirely, rendering us a protectionist backwater? If there is a "negative labor spillover" going on, is our only choice simply to wait until it runs out? And is it already running out?..."

[Dave Timoney]

@aragon, "it was too easy to make a profit without investment". No. What happened was that the cost of investment fell. Or, to put it another way, ROI dramatically increased.

Re "lower labour costs [=] no need to invest in plant and equipment". Lower labour costs do not save on plant (i.e. factory space) and may in fact drive demand up due to labour-capital substitution.

Manufacturing continues to invest in capex, but this is increasingly marginal to the wider economy. In the UK, it accounts for 12% of GDP on 8% of the workforce. Also, bear in mind that an increasing part of manufacturing is making the robots that are now substituting for labour in China (much as German manufacturing thrived on their demand for machine tools since the 80s).

Low wages can depress capex in services (e.g. manual carwashes instead of automatic), but the bulk of labour growth (particularly immigrants) has been in areas with traditionally low levels of automation, such as restaurants, plumbing, cleaning etc.

The typical UK work environment is neither a factory nor a restuarant, but an office. Over the last 20 years, we have seen the capex cost of IT per desk plummet, both as a result of commoditisation (i.e. China and robots) and the shift from hardware to software (the Internet, the "cloud", SaaS are all examples of this compositional change).

The problem is not a lack of will to invest, but a lack of expensive investment opportunities. In the short term, this frees up cash for increased dividends, executive bonuses, and make-jobs in marketing and HR. In the long term, it can lead to stagnant productivity growth as antiquated organisational structures ossify.

This is what gives rise to the perception of a "lack of innovation". It is a morbid symptom that doesn't reflect the real transformative impact of technology since the 90s.

[chris herbert]

I think investments happen when an opportunity presents itself. Taxes and interest rates matter only when they are at punitive levels. Technology matters regarding it's impact on reducing the price of manufactured goods; otherwise, not so much. We should be building beautiful cities, but they don't pay, so we build hovels and let people live in poverty--which represents a profit center for many businesses. Keep rates at zero and euthanize the rentiers and their sycophant economists.

[aragon]

d) Privatisation, PFI

e) Outsourced IT projects see below

@Doc

Thanks for the link. A difficult issue we have faced since the rise of Japan. Sorry for the poor comment.

@FATE

"The problem is not a lack of will to invest, but a lack of expensive investment opportunities."

H.M. Government begs to differ ...

http://www.telegraph.co.uk/news/politics/10986642/Oh-dear-is-this-another-costly-IT-failure.html

"£700 million compensation bill for the failed “Connecting for Health” IT project"

"£350 million on an immigration computer system that had to be abandoned."

"Universal Credit scheme is said to have cost £500 million so far"

"The Fujitsu contract was part of an £11 billion programme designed to modernise computer systems in the NHS"

[Dave Timoney]

@aragon, you've listed examples of government projects that successfully transferred large amounts of public money to privileged suppliers. These are not "failures" but successful extortions (government incompetence as a project manager is largely a cover-story).

This tells us nothing about aggregate investment in the wider economy, unless you're supporting Jackart's contention that every £1 spent by government necessarily depresses private investment by £1.

[aragon]

No just that cost of I.T. is still large.
The Government is almost half the economy.

An £11Bn project, or £7.6Bn p.a. for ICT
or 1% of the economy.

http://www.theregister.co.uk/2014/07/25/the_odf_revolution_will_not_be_digitised/

Changes in IT are unlikely to produce significant savings for the economy. The above story suggests that SaaS like leasing is likely a more expensive option in the long run.

[Dave Timoney]

@aragon, the cost of IT per se is not large, and has been steadily falling since the 80s. Government IT projects spend only a tiny fraction of the budget on technology, in the sense of computing or comms hardware and software.

The bulk goes on consultancy and professional services, i.e. people costs, including both up-front implementation and ongoing support. These costs are vastly inflated (e.g. dim grads on £21k p.a. are charged out at £500 per diem), hence the £7.6bn gross.

The growth of the IT sector (in terms of employment) has been driven by the proliferation of management roles (project management, testing, training etc), rather than technologists. It has also been muddied by the overlap with pseudo-tech roles in marketing and PR.

Consultancy fees have risen steadily over the last 25 years as the unit costs of hardware and software have fallen. In the mid-80s, a large IT project would have an 80:20 ratio between technology and people. That has now flipped. This is not because we need more people input, but because the market can bear the continuation in top-line price. The radical impact of ICT is obscured by rent-seeking.