What’s driving (the lack of) investment?

 There’s been plenty of recent coverage of the fact that Britain needs more investment for a sustained, balanced recovery. Why aren't firms investing more? Many firms are flushed with cash. Interest rates are at a record low. As The Economist notes, profits have been booming in America, reaching the highest proportion of GDP since the second world war. Given such buoyant conditions, you might imagine that businesses are investing like crazy to take advantage of all those great opportunities. Not a bit of it. The ratio of business investment to GDP has picked up since the depths of the financial crisis, but is still close to the lows of previous cycles. Instead, businesses are handing cash back to shareholders, a tactic once reserved for executives who had run out of ideas. In 2011 the value of British share buy-backs was equal to 3.1% of GDP.

 Enter a new theory shedding light on this puzzle – why might investment be so low?

According to the article, Andrew Smithers, an economist, argues that the main cause has been management incentives. Executives are now paid largely in the form of bonuses rather than salary. These bonuses are often tied to the share price, which in turn depends on the ability of the company to meet its quarterly earnings-per-share target. Buy-backs tend to boost earnings per share; investment plans may dent them. Mr Smithers writes that “The result of the increased importance of bonuses and the use of these measures of performance is that managements are now less inclined to take short-term risks, such as cutting profit margins, and more inclined to take the longer-term risks involved in lower investment and the possible loss of market share that will result from higher margins.”

A 2004 survey found that the majority of managers questioned would not proceed with a profitable long-term project if it meant that the company would miss the consensus forecast of profits in the current quarter. A 2013 study found that publicly quoted companies where executive compensation is linked to the stockmarket invest considerably less than private firms and are less responsive to new investment opportunities. The authors state that “our results are most consistent with the view that public firms’ investment decisions are affected by managerial short-termism.”

That’s perhaps quite a worrying conclusion, with significant implications for policy makers.

The lack of corporate investment has also had broader effects. Companies have preferred to increase output by adding labour rather than capital. This may go part way towards explaining the productivity puzzle: why the productivity numbers in America and Britain have been unusually poor in recent years – they normally rise as firms move out of recession.

(There is of course evidence that we might be about to turn the corner. The Guardian has just covered a report by Deloitte, entitled Companies ready to splash the cash as appetite for risk returns.