It's widely believed that the past few years have seen a savings glut - a huge supply of savings, largely from Asia. This explains several important facts about the world economy: the surprising ease with which the US financed its current account deficit; banks' rush to supply mortgage securities to meet a high demand for high-yielding assets; and low real interest rates even in the face of massive government borrowing.
There is, however, an important aspect of the story of the savings glut that often gets overlooked: if there is an excess supply of savings, what is the excess relative to?
The answer is: a demand for capital from companies. The flip side of the excess supply of savings is a deficiency of capital investment. As Federal Reserve governor Ben Bernanke said in a famous speech which popularised the notion of a savings glut, there has been a "dearth of domestic investment opportunities" in developed economies.
One sign of this dearth is that the share of capital spending in UK GDP has been trending downwards for years. Even before the recession began, business investment accounted for just 10 per cent of GDP, its lowest proportion since records began in the 1960s; it's now 8.5 per cent.
Granted, this has been in part a reflection of the fact that prices of capital goods - such as software - have fallen relative to prices generally. But it's unclear how relevant this is. It merely raises the question: why didn't companies respond to falling capital goods prices by spending even more?
Now, you might object that it makes no sense to speak of a lack of investment opportunities because profit rates have been high for years; in the second quarter of last year, non-oil, non-financial companies' net return on capital was 10.8 per cent - so, even in the worst recession since the 1930s, profit rates were higher than at any time in the 1970s or early 80s.
This objection, however, overlooks an important distinction - between existing investments and potential new ones. It's quite possible for capital in place to earn big returns while prospective new projects are expected to have low returns. There's no reason to suppose that what Keynes called the marginal efficiency of capital is close to the average profitability of existing capital; the idea that macroeconomic entities are stable, identifiable and smoothly differentiable is a pedagogic device, not (necessarily) an empirical reality.
Sadly, we can't directly observe the marginal efficiency of capital. However, the possibility that it is low - that there is indeed a dearth of investment opportunities - explains several important facts about the economy in recent years, for example:
1. Why did the government run budget deficits even in the years before the recession?
One possibility is that governments have less control over their finances than politicians pretend, and that, in fact, government borrowing depends more upon private sector decisions and less upon governmental ones.
Because of the dearth of investment opportunities, non-financial firms invested less than they retained in profits even in the good years; in 2006 and 2007 they ran a financial surplus (an excess of savings over capital spending) equivalent to 2.1 per cent of GDP. And if one sector of the economy runs a surplus, another must run a deficit; this is an accounting identity. That other sector happened to be be government.
2. Why did the 'noughties' see bubbles in housing and commodities but not equities?
One reason is that housing and commodities had stories - about increasing numbers of households or about 'supercycles' and peak oil - that apparently justified high prices. But equities had no such story. It just hasn't been possible to envisage a scenario about companies - outside of mining and oil - in aggregate enjoying strong future growth.
3. What caused the recession?
There are, of course, numerous candidates - and there needn't be a single cause - one of which is bubble behaviour prompted by the savings glut. However, another candidate is the obverse of that glut, the lack of investment opportunities. A recent paper by economists at US Federal Reserve banks has estimated that over half the variance in US GDP between 1954 and 2004 could be explained by fluctuations in the marginal efficiency of investment. Why should we believe, then, that a decline in this efficiency was not a contributor to our latest recession?
Herein, though, lies a problem. There's no reason to suppose that the dearth of investment opportunities is receding. In the third-quarter last year, the volume of business investment was 19.9 per cent down on 12 months previously. This was a far larger fall than we saw in the recessions of 1980-81 or 1990-91. Yes, some of this decline was because the few firms that have good opportunities have been starved of finance. But when banks say the lack of lending to firms reflects a lack of demand rather than a lack of supply, they are not wholly engaging in special pleading; there's some truth in what they say.
So, what would it mean if the lack of investment opportunities persists?
One thing would be that trend, long-term economic growth is not as high as the 2.75 per cent a year that the Treasury believes it to be.
In the long run, economic growth depends upon labour productivity, which in turn depends heavily upon investment in new equipment and techniques. If this investment is lacking, the economy will grow only slowly. Yes, we could get a growth spurt as old capital is replaced, or as demand rises to fill existing capacity. But sustained growth requires new investment opportunities.
This in turn has a potential implication for equities. In one important sense, these are now quite expensive. At 3.2 per cent, the dividend yield on the All-Share index is below its post-1988 average of 3.6 per cent.
But how can shares be expensive if future growth will be low?
One possibility is that the dearth of investment opportunities exists for unquoted firms, or for ones that don't exist. If so, the dearth is good for the stock market, as it means incumbent firms face less competition from potential newcomers.
The other possibility, though, is simply that shares are overpriced.