Basic textbook economics tells us that finance flows to the companies that have the best investment opportunities. The reality, however, is somewhat different – which raises doubts about the pace and sustainability of the coming upturn.
Three facts cast doubt over that textbook story. First, banks don’t lend much to small firms. Bank of England data show that their stock of lending to SMEs outside the financial and real estate sector is just £133.3bn. That’s only one-eleventh of their residential mortgage lending, Secondly, there has historically been a strong link between changes in retained profits and change in investment. Rises in retained profits in the early 1990s, mid-2000s and in 2009-10 all led to more capital spending, while falls in 1990, 2007-08 and in 2019 all led to less. This suggests that it is the availability of finance, rather than of profitable investment opportunities, that drives investment. Thirdly, Salman Arif and Charles Lee have shown that investment booms lead to earnings disappointments and weaker growth – which is the exact opposite of what we’d see if investment was driven by the availability of genuine profit opportunities.
None of this, of course, is new. Way back in 1931 the Macmillan Committee complained that the financial sector was failing to fund industry properly. While venture capitalists have partly filled that gap since then, they do not seem to have fully done so. Useful financial innovation is a slow process.
Which brings us to a problem. Think of companies’ access to finance as being a pattern: some have lots of it, some little. And think of their profitable investment opportunities as being another pattern: some have lots, others none.
The pandemic has shaken up both these patterns. It has forced some firms (especially small ones) into debt thus constraining their access to future finance while giving others, such as food retailers, a stronger financial position. And it has created uncertainty and spare capacity in some sectors, thus depressing the need to invest in those while also creating extra demand elsewhere – such as in online shopping.
What matters is the overlap between these two patterns. If there’s a good match between access to finance and investment opportunities then then we’ll see a boom in capital spending.
But what if the match isn’t good – if the firms with profitable projects are not those with easy access to finance? We then face two different dangers.
One is that we won’t get a recovery in capital spending, as the firms that should invest won’t have the finance while those do have the finance don’t have the opportunities to use it.
The other possibility is that we get a repeat of what Lee and Arif describe – an investment boom driven by firms’ over-optimism and desire to offload cash balances rather than by genuine profitable projects, which leads eventually to a slump.
Most forecasters expect a short-lived rise in capital spending: the Bank of England foresees a small rise in business investment this year, followed by a 12 per cent surge next, before it falls back. There is, however, a lot of uncertainty around this, in part because so much depends upon the enormous differences in experience and outlook from company to company. Macroeconomics, then, does not tell us much.
