Sunday, October 26, 2014
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Europe’s Hidden Stimulus

LONDON – When the European Council next meets, on February 7, it should look at private investment as a means to kick-start Europe’s stagnant economy. With the usual drivers of GDP growth constrained across Europe, the one economic sector able to spend is the non-financial corporate sector.

Indeed, publicly traded European companies had excess cash holdings of €750 billion ($1 trillion) in 2011, close to a 20-year high. Unlocking that cash would give Europe a much larger stimulus package than any government can provide. In 2011, for example, private investment in Europe totaled more than €2 trillion, compared to government investment of less than €300 billion.

And yet, while trends among European economies have varied, private investment was, overall, the hardest-hit component of GDP during the crisis, plunging by more than €350 billion – ten times greater than the fall in private consumption and four times more than the decline in real GDP – between 2007 and 2011. The magnitude of the private-investment downturn was, in fact, unprecedented – and lies at the heart of Europe’s economic malaise.

Likewise, by historical standards, the private-investment recovery is running late. In more than 40 past episodes in which GDP fell and private investment declined by 10%, recovery took an average of five years. Europe is four years removed from the onset of recession, but private investment in 2011 was still lower than its 2007 level in 26 of the European Union’s 27 member states.

To be sure, the fact that companies are holding on to their cash, rather than paying it out in dividends, signals that they expect investment opportunities to return – a far more positive situation than in Japan, for example, where companies lack cash to invest. But European companies remain hesitant, despite low interest rates, keeping private investment well below its previous peak.

Governments can help to persuade companies to let go of their cash by removing regulatory barriers such as zoning regulations in retail and a plethora of requirements in the construction sector concerning everything from the height of ceilings to the size of staircase areas. They should also address the lack of uniform standards across Europe’s internal borders; for example, there are 11 separate signaling systems for rail freight in the EU-15.

After Sweden eased planning laws in its retail sector during the 1990’s, the country posted the strongest retail productivity growth in Europe (and outstripped that of the United States) between 1995 and 2005. Standardization and liberalization in European telecoms underpinned 9% growth in value added and productivity in this period, compared to 6% growth in the US.

The largest scope for renewed private investment is in capital-intensive sectors in which government has a major presence as regulator. Even if European countries were to close only 10% of the variation in capital stock per worker at the subsector level, the impact could be more than €360 billion in additional investment – offsetting the €354 billion difference in private investment between 2007 and 2011.

Many projects, from airports to university campuses, benefit from returns over decades, which implies that weak demand in the short term will have only a limited impact on their overall viability. Even among more near-term projects, some – for example, retrofitting buildings with more energy-efficient features – could become viable with action from policymakers. Some degree of investment will add to demand, which may persuade others to invest – a virtuous circle.

This approach is not about “picking winners and losers.” It is about targeted microeconomic reforms that reduce or remove barriers to private investment, thereby encouraging the non-financial corporate sector to propel European GDP growth. But it is important to get this policy activism right.

First, governments need to focus on sectors in which action is likely to trigger renewed investment on a scale large enough to boost GDP – and quickly enough to enable private investment to drive the recovery. Governments often become enamored of innovative sectors, such as semiconductors, that account for only a very small share of total investment. Policymakers may wish to develop these sectors as a catalyst to innovation, but they should not expect that such initiatives alone can spur a recovery in private investment.

In fact, construction and real estate are the most promising candidates, as they account for roughly one-third of European fixed investment and more than 17 million jobs. Although these sectors are unlikely to rebound to pre-crisis levels in Greece, Ireland, and Spain for many years, other European economies, including the United Kingdom, Italy, and Sweden, as well as some Eastern European economies, have scope for further investment.

To meet Europe’s ambitious 2020 energy targets, retrofitting existing buildings and improving new buildings’ energy efficiency, including the use of more energy-efficient materials and equipment, could lead to roughly €37 billion in additional annual investment between now and 2030. In most European countries, action to spur private investment in local services and transport – both large sectors – should also be considered.

Governments, however, need to understand the barriers to investment: regulatory failures; weak enablers, including financial and human capital; poor infrastructure; and substandard technology. And they must undertake rigorous cost-benefit analyses, in order to ensure that any intervention translates into private investment that promotes productivity growth.

It is here – at the level of execution – that governments often perform poorly. Too often, they spend money to support private-sector projects that fail to provide a positive return for the broader economy.

Three ingredients are vital to getting it right: backing for initiatives at the highest political level; participation by all key stakeholders in deciding what action to take and driving its implementation; and establishing small, high-powered delivery units with clear mandates to coordinate interventions.

Europe’s leaders need to put private investment at the center of their growth strategy by devising policies that open the gates to large potential flows. The European Council meeting on February 7 is an ideal opportunity to make a start.

Read more from our "Zone Defense" Focal Point.

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  1. CommentedFrank O'Callaghan

    Regulations are often there for a reason. The removal of regulation often empowers the individual or company of wealth in opposition to society.

    Over-regulation is a problem. In Ireland we reduced regulation and it has been a catastrophe. The current crisis is a result of a lack of regulation.

  2. CommentedProcyon Mukherjee

    The gap in fixed asset investment in Europe by the corporate sector (as is the case in U.S.) is directly proportional to the output gap that persists; the over-capacity that still exists would only widen if further investments are made in the segments where this is the case. The three examples taken by Eric are good, that could diversify the intensity (green buildings, particularly could be a good start), but the extent of the gap in fixed investment is huge. Quite interestingly, the stimulus package on the other hand did precious little in terms of increasing fixed asset investment.

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