What's going to happen to business investment in 2011? This question holds the key to whether the economy can avoid another recession next year. The reason for this is simple: the prospects for all the other components of demand are bleak. Overall government spending is planned to fall by 1.2 per cent in real terms in 2011-12, and economists expect real government consumption – that is, spending on goods and services – to fall by 0.7 per cent next year.
And the outlook for personal spending isn't much brighter. Graeme Leach, chief economist at the Institute of Directors, expects households' disposable income to fall next year as taxes rise, the public sector cuts jobs and wages grow only slowly. So, if spending is to grow, households will have to reduce their flow of savings. But as the savings ratio is already low – just 3.2 per cent in the second quarter – this might not happen.
Nor even is there much hope that we can export our way to prosperity. The danger here is not so much that demand in the eurozone – our main trading partners – will be hit by the fiscal tightening. It's quite possible that a recovery in German consumer spending alone will be enough to offset that. The problem is that the supply chain is globalised, so if we are to export more we must also import more parts and materials. And this means net exports can't rise much. The consensus amongst private forecasters is that these will add just half a percentage point to GDP growth next year.
This leaves only business investment as a plausible driver of economic growth. Luckily there are reasons for optimism here. Companies have been building up cash for years. In the last two years alone non-financial firms’ net lending – the excess of retained profits over capital spending and inventory accumulation – has been £109.7bn. And in the past four quarters it reached a record 4.8 per cent of GDP. Firms "are sitting on an unprecedentedly large cash surplus" says Mr Gabay.
However, while the returns on this cash are negative in real terms, the returns to investment in equipment seem high. Official statistics show that non-oil, non-financial firms’ return on capital was 10.5 per cent in the second quarter. Although this is below the cyclical peak of 13.9 per cent, it is higher than it was in the early 1990s, when the economy was last emerging from recession. It should, then, be high enough to tempt firms to part with their cash and start investing.
So, why haven't they done so? Business investment actually fell in the third quarter. It could be due to concerns about the likely effects of the fiscal squeeze. But as these become clearer, simply through the passage of time, the fog should lift and so spending should resume. If this does happen, the impact on the economy will be much greater than the mere statistical contribution of investment to GDP. As firms invest, they usually hire more workers who in turn spend their wages. Sadly, though, this is not at all certain. Four things (at least) might hold back investment.
1. Spare capacity. The CBI estimates that 64 per cent of manufacturers are working below full capacity. Why add to capacity when you already have sufficient?
2. Uncertainty. Economists agree that the end of the 'great moderation' has caused a rise in uncertainty. And this alone is a reason for companies to wait and see rather than invest.
3. A dearth of investment opportunities. Companies were building up cash piles long before the recession began. This raises the disturbing possibility that investment opportunities have become scarcer.
4. Capital constraints. It is a cliché that economic growth depends on new, small companies. But clichés contain lots of truth. Although banks' lending standards are becoming easier, they are still preventing newer, smaller firms from starting up or expanding. This creates a danger that UK companies comprise two groups: large, old ones with cash but no investment ideas, and small new ones with ideas but no cash.
On balance, most economists expect the forces for increased capital spending to just about outweigh the forces against it. No-one, however, can be very confident about this; capital spending is more unpredictable than other components of GDP. Since 1998, the average error in GDP forecasts made in December for growth the following year has been one percentage point. This suggests there is a significant risk – roughly one in six – that the economy will grow less than 1 per cent next year.
Yes, the risk of a 'double dip' is small – though company bosses trying to excuse poor results will no doubt invoke the term. But the risk of disappointingly sluggish growth is large.
