On the importance of investment for the Eurozone economy
According to the European Commission’s most recent forecast, real economic activity in the Eurozone is expected to recover at a moderate pace until 2015, and to remain significantly weaker than in the US (European Commission 2014a).
One driving factor behind the differences in the growth outlook for the Eurozone and the US is investment. Investment constitutes an important component of aggregate demand, accounting for around 20% of real GDP in the Eurozone (21% of GDP in the US). So it comes as no surprise that the sharp fall in investment following the financial turmoil in 2008 contributed substantially to the severe economic downturn in the Eurozone. Investment is now picking up, but only slowly. While the investment to GDP ratio is projected to go back to its long-term average in the US, it is set to remain below it in most Eurozone Member States until 2015, with the shortfall particularly large in the more peripheral countries (see Figure 1).
Figure 1. Developments of real gross fixed capital formation to GDP ratios
Source: European Commission.
Note: The group of stressed countries consists of Greece, Ireland, Italy, Portugal, and Spain.
Weak investment spending has important consequences for the short-term outlook via its impact on aggregate demand. But it also has important consequences for medium-term growth via its impact on the capital stock, thus affecting medium-term productivity prospects through the diffusion of new technologies and innovation. We estimate that a 5 percentage-point reduction in the investment rate leads to a reduction in potential growth of nearly 0.5%.1
It’s the accelerator, stupid! Or is it?
The sluggish growth outlook is clearly hampering investment through the traditional accelerator effect (Chirinko 1993). Accelerator models relating investment to GDP usually show a reasonably good fit for the Eurozone (see Figure 2). Of course, the accelerator model should not necessarily be interpreted as showing causality running from GDP growth to investment. But overall, it is clear that lower GDP growth compared with previous cycles has reduced the need for businesses to expand capacity.
Figure 2. Investment regressions using the accelerator model for the Eurozone
Source: European Commission.
Note: Estimations based on an EA-12 sample using real gross fixed capital formation to GDP ratios.
One might argue that the weakness of investment is related to the restructuring process of Eurozone economies due to the necessary reduction of overcapacities. In Spain, for instance, it is well known that the crisis has led to a sharp adjustment in the construction sector, resulting in a substantial fall in residential investment. However, lacklustre investment is not limited to the housing sector.
The need to deleverage and reduce overcapacity has weighed on investment in many advanced economies. Commission studies show that deleveraging by households and non-financial corporations can have strong short- and medium-term impacts on the investment rate, as private agents cut investment and other forms of spending to fund the repair of their balance sheets (Cuerpo et al. 2013, Ruscher and Wolff 2012). This is illustrated by the strong negative correlation between the change in corporate investment since the crisis and the accumulation of debt by non-financial corporations in pre-crisis years (see Figure 3).
Figure 3. Non-residential investment and non-financial corporations’ debt
Source: European Commission.
In the Eurozone, three additional factors in particular continue to weigh on investment:
- The decline in public investment,
- Financial fragmentation, and
- High levels of economic uncertainty.
Capital formation in the Eurozone is being affected by the decline in public investment, which accounts for about 12% of total investment in the Eurozone. The decrease is largely the result of the sovereign debt crisis, which triggered significant fiscal adjustment across the Eurozone. To some extent, it also reflects the continuation of the trend towards shifting parts of public sector investment to the private sector – in areas such as health, education, and transport infrastructure – which began before the crisis.
While the cut in public investment is therefore partly a response to previously excessive spending, short-term budgetary pressures have in many cases led to myopic policymaking in which governments slash public investment in order to achieve savings. Today, there is a clear need to re-prioritise public spending towards more growth-friendly areas and to maximise its efficiency. That, together with a more neutral fiscal stance, should contribute directly and indirectly (via the accelerator) to strengthen investment.
The sluggish rebound of investment can also be explained by the financial fragmentation in several Eurozone Member States. Fragmentation restricts the supply of credit to the real economy, starving investment of its oxygen. Financial markets in the EU – most notably sovereign and equity markets – have strengthened in recent months, but bank lending rates have so far not improved to the same extent. In peripheral Member States, such as Spain and Italy, there is hardly any evidence of bank lending rates falling, and the financing conditions of the private sector remain much less supportive in these countries than in Germany or France.
Finally, investment activity is probably also being impeded by high levels of economic uncertainty (Bernanke 1983, Dixit and Pindyck 1994). High uncertainty weighs negatively on private spending and economic growth by offering agents an incentive to postpone investment, consumption, and employment decisions (European Commission 2013a). Elevated uncertainty becomes all the more damaging for growth and investment because it magnifies the effects of credit constraints and weak balance sheets by forcing banks to reign in credit further and deterring companies from investing, so as to minimise the risks of irreversible decisions.
Standard indicators of policy uncertainty and financial market volatility have come down significantly since the acute phase of the sovereign debt crisis – a development which should support investment spending in the coming quarters. Nevertheless, uncertainty in the Eurozone has not yet returned to its standard cyclical level. Downside risks to the growth outlook remain significant not only because of the external environment, but also because of the possibility that the structural, fiscal, and institutional reforms that are necessary to ensure a sustainable recovery could stall.
How to unleash investment spending?
The policy agendas for investment and growth are closely linked. The ongoing strengthening of world demand and the gradual rise in consumption projected in the Eurozone should support investment spending over the next few quarters. However, without further policy action, investment growth will continue to disappoint.
Additional structural reforms are therefore needed in all Eurozone Member States to support the investment outlook, despite the achievements reached in some – particularly the more vulnerable – Member States over the past year. This would boost investment not only via the accelerator effect, but also via contributing to a faster re-allocation of labour and capital from the slow-growing (deleveraging-constrained) sectors to those which benefit from better demand conditions. We have conducted model simulations that show that Eurozone GDP could be up to 3.6% higher after 10 years if Member States adopted measures to halve the gap vis-à-vis the average of the three best-performing EU Member States in different labour and product market reform areas (European Commission 2013b).
The economic literature shows that reforms to foster a pro-competitive environment in Europe and increase the efficiency and supply of product and service markets are of particular importance for investment. In this context, a further deepening of the Single Market – not only in manufacturing, but also in financing and network industries (such as energy, transport, and digital markets) – would be highly welcome.
The Eurozone economy would also benefit from measures to further reduce policy uncertainty. A credible implementation of the enhanced fiscal framework is imperative to bring debt ratios in a number of countries to sustainable levels and thereby remove any uncertainty surrounding the necessary consolidation process. The focus on a growth-friendly consolidation strategy should minimise the short-term costs. To reduce uncertainty regarding the robustness of the recovery, policymakers also need to stick to the reform commitments made in the context of the European Semester, the EU’s annual cycle of policy coordination.
Financial sector reforms, including the ‘Banking Union’, also rank at the top of the policy agenda to boost investment. Important and necessary steps have already been taken at EU level to set adequate framework conditions and restore lending to the economy. The completion of a fully-fledged Banking Union is a key building block of the EU’s efforts to improve its financial sector. However, further measures are needed to make our financial sector more efficient and less dominated by banks. In this context, the latest Commission initiatives to support long-term investment – for instance by improving the access of funding of Small and Medium-sized Enterprises (SMEs) – are central (see European Commission 2014b).
The ongoing deleveraging process in the household and corporate sectors is painful but necessary, and needs to be properly managed. It could be supported by reforming inefficient bankruptcy frameworks so as to facilitate the necessary consolidation and significantly reduce costs. The recent Commission Recommendation on a new approach to business failure and insolvency (European Commission 2014c) provides minimum standards to encourage Member States to put in place frameworks that enable an efficient restructuring of viable enterprises in financial difficulty.
It is even more important to tackle these issues given the size of the investment gap in the EU in a number of areas. There is a clear need for infrastructure investment – estimated to be on the order of €1 trillion for trans-European networks for transport, energy, and telecoms up to 2020 only. The EU budget has increased the availability of financial instruments for such a purpose. An investment partnership at the EU level would be an important catalyst at the current juncture.
In brief, there is no place for complacency. Tackling the remaining challenges, keeping the reform momentum alive in all Member States, and using the synergies through an investment partnership at the EU level remain crucial – not only for the Eurozone’s investment, but also for its medium-term growth performance.
Bernanke, B (1983), “Irreversibility, uncertainty and cyclical investment”, Quarterly Journal of Economics, 98(1): 85–106.
Chirinko, R (1993), “Business fixed investment spending: modelling strategies, empirical results, and policy implications”, Journal of Economic Literature, 31: 1875–1911.
Cuerpo, C, I Drumond, J Lendvai, P Pontuch, and R Raciborski (2013), “Indebtedness, deleveraging dynamics and macroeconomic adjustment”, European Economy Economic Papers 477, European Commission.
D’Auria, F, C Denis, K Havik, K Mc Morrow, C Planas, R Raciborski, W Röger, and A Ross (2010), “The production function methodology for calculating potential growth rates and output gaps”, European Economy Economic Papers 420, European Commission.
Dixit, A and R S Pindyck (1994), Investment under uncertainty, Princeton University Press.
European Commission (2013a), “Assessing the impact of uncertainty on consumption and investment”, Quarterly Report on the Euro Area, 12(2): 7–16.
European Commission (2013b), “The growth impact of structural reforms”, Quarterly Report on the Euro Area, 12(4): 17–28.
European Commission (2014a), “European Economic Forecast – Spring 2014”, European Economy, 3/2014.
European Commission (2014b), Communication from the Commission to the European Parliament and the Council on “Long-term financing of the European Economy”, 27 March, COM(2014) 168 final.
European Commission (2014c), Recommendation on “A new approach to business failure and insolvency”, 12 March, C(2014) 1500 final.
Ruscher, E and G Wolff (2012), “Corporate balance sheet adjustment: stylised facts, causes and consequences”, European Economy Economic Papers 439, European Commission, February.
1 The estimations are based on an EA-12 sample. They reflect a lower bound estimate, assuming that lower investment goes along with unchanged employment and only incorporates the productivity effects stemming from lower capital intensity. The Commission currently uses an output elasticity of capital of around 0.35 (D’Auria et al. 2010).