What makes for good growth? In recent years, gross domestic product (GDP) growth has been driven by consumption, rather than being balanced with investment. This is less than ideal.
After all, consumption-driven growth tends to be more anaemic. On average, annual GDP growth is more than half a percentage point lower when it is led by consumption. In addition, such growth may borrow from the future. Research suggests that an extra year of consumption-based growth now leads to consumption being more than a percentage point lower in five years. Finally, with inflation on the rise, and real incomes being squeezed, we can’t necessarily rely on consumption to drive healthy headline GDP growth over the next few years. So why has consumption dominated, and what can we do about it?
Growth patterns have changed
From 2003 to 2007, as the world economy recovered from the fallout of the dotcom boom, consumption and investment made similar contributions to headline growth. In contrast, consumption has been a far stronger driver across many economies in the past few years. It added up to one percentage point (pp) to GDP growth in 2015-16 in the advanced economies, well above investment’s 0.3pps contribution.
The story is similar for a number of major emerging markets. In China, for example, the pace of consumption growth has exceeded GDP growth in each of the past three years. This trend is perturbing policymakers because, as Bank of England (BoE) Governor Mark Carney has pointed out, evidence over the past quarter century suggests that episodes of consumption-led growth “tend to be both slower and less durable.”
Strong consumption today can mean economic weakness tomorrow
There are three reasons for this. First, debt-financed consumption may constrain future spending. Credit growth could hinder the economy down the line if it triggers a financial crisis, or if households borrow more than they are able easily to repay. So a borrowing-financed, consumption-led expansion now could end up hurting future demand because households eventually need to devote a larger share of income to meeting debt commitments.
Second, consumption-led growth may be driven by so-called “wealth effects” particularly related to housing. If house prices rise rapidly, property owners may decide to spend part of their capital gain, boosting GDP growth. But if incomes grow more slowly than house prices, or if the housing market subsequently slumps, owners then rein in spending, lowering GDP growth.
Finally, consumption may not play a causal role at all. It could simply be that investment is weak, perhaps because firms see few growth opportunities. Unlike investment, consumption tends to be “sticky” as households smooth their spending over time by dipping into savings when they feel the need. So growth can be both consumption-led and anaemic without one necessarily driving the other.
The first two reasons may be addressed by ‘macro-prudential’ policies, but weak investment is proving a tougher challenge. The BoE’s Financial Policy Committee was set up to identify, monitor and take action to remove or reduce risks that threaten the resilience of the UK financial system as a whole. The U.S. Financial Stability Oversight Council and the European Systemic Risk Board fulfill some of the same functions. Whether they will succeed in allowing borrowing and spending to remain at healthy levels while averting future financial crises remains to be seen, but they are at least a step on the path.
In the meantime, it is investment - with the flipside of relatively strong consumption - that is still stubbornly disappointing.
In the meantime, it is investment - with the flipside of relatively strong consumption - that is still stubbornly disappointing. And this matters. Had UK investment, for example, continued to grow at its long-run pre-crisis average pace in the period since 2007, the private sector’s capital stock would now be around £250 billion ($312 billion) larger in real terms. Perhaps the UK’s productivity performance, upon which future prosperity depends, would have been stronger.
Why has investment been so weak?
A third of companies responding to a recent BoE survey felt they had underinvested in the past five years. Of those, over 60% cited external financing constraints – such as an inability to obtain the full amount of finance applied for, or collateral issues – as a reason for their reluctance to spend. But non-financial constraints were equally important.
Despite the historically low level of policy interest rates since the financial crisis, firms’ estimated investment hurdle rates have remained stable. This implies that they are looking for a higher return (over the risk-free rate) than would have been the case before 2007. Over 80% of the underinvesting firms surveyed reported “uncertainty” as an obstacle to such spending; and “scarring effects” from the financial crisis may still be heightening risk aversion, even a decade on.
Another challenge for policymakers
There’s a price to be paid for consumption-led growth. Not only that, but even if we were willing to ignore the downsides, consumption can’t be relied upon to drive future GDP growth in a higher-inflation world. However, investment looks unlikely to spring back of its own accord. The BoE’s survey suggests that policy initiatives to address underinvestment need to look beyond financing constraints.
But if “uncertainty” is, as it appears to be for the UK at least, a significant factor, then policymakers’ challenge may be about to become greater still. After all, the outlook for investment, like the outlook for the economy more generally, depends on how households and firms react to Brexit - and the twists and turns of the accompanying negotiations. And that process is only just getting under way.
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