One economic trend of recent years, more than any, begs the question of whether we as an economy have lost our edge. As the FT reports:
Profits in the US are at an all-time high but, perversely, investment is stagnant.
According to GMO, the asset manager, profits and overall net investment in the US tracked each other closely until the late 1980s, with both about 9 per cent of gross domestic product. Then the relationship began to break down. After the recession, from 2009, it went haywire. Pre-tax corporate profits are now at record highs – more than 12 per cent of GDP – while net investment is barely 4 per cent of output. The pattern is similar, although less stark, when looking at corporate investment specifically.
This change is profoundly odd. Economic theory says investment is driven by profitable opportunities on one side and the cost of capital on the other. High profits suggest there are decent opportunities to make money; historic lows in interest rates and highs in the stock market mean that capital is dirt cheap. Yet investment does not follow.
“We have this strange thing that the return on capital really does seem to be high, the cost of equity capital is low, and yet we’re getting a lot of share buybacks and not much investment,” says Ben Inker, co-head of asset allocation at GMO. “It just feels a bit weird.”
Simply put, big corporations are no longer investing in innovation, despite having the money to do so. The breakage of the link presents a new economic puzzle based on economic history and theory.
Two potential explanations for this are that 1) there are no innovative projects to invest in; and 2) there are such projects, but big companies do not have the incentive or access to invest in them.
For the purposes of this blog, we will assume the first is just not true: Startup tech activity suggests that people are more entrepreneurial than ever.
We will explore the second explanation in several subsequent posts.