Neil O’Brien: How can we make the economy grow faster?

14 Dec

How can we make the economy grow faster? That’s going to be a big question in 2021 as we bounce back from an unprecedented recession, and start trying to make up lost ground.

There’s lots of things we need to look at. Obviously the big questions are about whether we get an EU deal and how fast we recover from the virus. But one of the other places to look is how we turn our savings into investments.

Rishi Sunak’s clearly interested. Recent weeks have seen him announcing a new infrastructure bank; reviewing Solvency II (regulating insurance firms investments); creating Long Term Asset Funds and extending a tax break to encourage investment. During his first weeks as Chancellor, he mandated the Bank of England to work on “the supply of productive finance, in all regions and nations of the UK” to “assist the Government’s levelling up agenda.”

They’re all welcome moves, because this is a huge issue for the UK.

One recent review noted that “the proportion of UK start-ups which scale into large businesses lags significantly behind the US”, and lots of start ups complain about access to finance. From a macro point of view, Britain has long had a lower stock of capital than other similar countries – at least when it comes to tangible, physical stuff. More machinery, better IT, more automation and stronger infrastructure would help us be more productive.

These are long-running challenges. Previous attempts to address them include the Myners Review (2001), Kay Review (2012), and Patient Capital Taskforce (2017) plus various select committee reports.

So what might be getting in the way of successful matchmaking between opportunities and funding?

1) Regulation and market structures

Riskier, longer term investments have higher returns. Pensions, banks and insurers face complex rules governing their investments, to control the share of their investments in such things.

In some cases, UK investors are putting less of their money into these growth areas than firms elsewhere. As Anna Sweeney from the Bank of England notes, “UK insurance companies only allocate around two per cent of their assets to unlisted equity. This is a smaller share than many of their European peers.”

By reviewing regulations like Solvency II, as the Chancellor is, we could refine the rules to safely enable more growth, not least because it was designed to fit the EU as a whole, not tailored to each country. We could also reshape regulations to make it easier to invest in long term funds. That’s the thought behind the plan to create Long Term Asset Funds.

And on top of the regulations, there might be related factors we could fix. As the Bank of England Financial Stability Report notes, the current industry norm is to value pensions (a long term investment) in ways that force them to behave like short term investors: “Daily trading and pricing is also common practice for [Defined Contribution] schemes, which is another constraint on investment in illiquid assets.”

The Bank should be prepared to act radically: tackling these barriers could mean more money for long term investment and more in your pension because of it.

(2) Public listed companies & short termism

We shouldn’t be too doomsterish about short termism. Plenty of money is being piled into tech firms that have never turned a profit, so clearly there are investors out there prepared to wait and accept risk in the hope of a good return.

But there is a real problem, particularly for public companies. It’s striking that privately owned companies invest somewhere between four to eight times more than public listed companies of the same size.

There’s long been concerns that relentless quarterly scrutiny of returns faced by public firms pushes managers towards short-termism: cutting investment in R&D or entry into risky new markets means profits will be better today, but worse tomorrow. But if your remuneration is based on your share price today, its tempting to go short term.

Managers agree there’s a problem: A survey of over 400 executives found three quarters would give up a project with a positive value in the longer term to smooth out earnings.

Investors agree too: in a CFA Institute survey of European investors 70 per cent said short-period evaluation cycles by asset owners are an impediment to long-term investing. Two-thirds of members of the National Association of Pension Funds said investment mandates encouraged short-termism.

If the investment gap between public and private firms reflects short termism, the economic costs of it would be pretty huge. As a paper by Andrew Haldane, the Bank of England’s Chief Economist and others, notes: “the elimination of short-termism would then result in a level of output around 20 per cent higher than would otherwise be the case.” That’s a big number.

Trying to escape short termism has led to two trends.

First, more and more public firms being taken private. “Public-to-private” deals where publicly-traded firms are taken private, plus fewer public listings (at least until this year), has been leading to “de-equitisation”. Across the US, UK and Eurozone the number of public listed companies has declined. But publicly listed firms remain a huge part of the economy, so if there is a short-termism problem there, it’s still going to have a huge economic impact.

Second, in the US new tech firms increasingly set up voting structures to keep founders in charge through dual-class share structures. Mark Zuckerberg has special shares with ten times more votes than ordinary shares. US firms like Google, Lyft, Pintrest and Snap use this kind of structure, allowed there since the 1980s. But in the UK dual class structures aren’t able to get premium listings. If this model particularly suits tech firms with hard to value intangible assets, perhaps that should change?

3) Tax?

One of the biggest, but hardest to fix distortions is the differential taxation of debt and equity. The fact that you can get tax relief on debt but not equity means firms load up on debt more than they otherwise would, and invest less overall. The Institute for Fiscal Studies’ landmark Mirlees Review suggested creating an “Allowance for Corporate Equity” to fix this.

But the cost to the Exchequer of such taxbreaks would be huge. Alternatively, any rebalancing by reducing the tax relief on debt would probably have to grandfather this debt somehow, as firms have borrowed heavily on the assumption of relief. It’s a very, very hard problem to crack, but that doesn’t mean a (very) long term solution is impossible.

4) Small business lending and equity

The most common financing problems MPs hear about is bank lending to small businesses. The problem’s a long running one.

The truth is that it’s a low-margin business for banks to analyse the finances of zillions of small firms, yet the provision of such loans has wider benefits to the economy. That’s why over decades governments have created a succession of bodies to support lending: from ICFC to 3i to the British Business Bank (BBB) we created in 2012. With the Bank of England predicting large numbers of unlisted firms will need to raise equity to grow (given their post-pandemic debts), it’s encouraging to see the BBB now growing its role in providing equity too. It’s a success story, and we should continue to support its growth.

As the economy bounces back next year, lots of firms will be in debt. But there are also real opportunities to reform regulation and market structures to help money flow into new opportunities. It’s a great place for the Chancellor to be looking to get growth going.