How to raise infrastructure investment
by Jan Mischke
Multi-decade declines in net investment have depressed demand, interest rates, and growth, and fuelled a series of debt and asset price bubbles. A fundamental rethink of structural, fiscal, and monetary policies is required to reverse the trend. This could include measures to reform public accounting standards to capitalise infrastructure investments on state balance sheets.
Advanced economies appear to be caught in a vicious cycle. Weak growth and low aggregate demand are discouraging businesses from investing and limiting household income for residential investment and consumption – further dampening economic activity.
Long-term decline in investment
A long-term decline in investment has grown more pronounced in recent years. In Europe, business, residential, and public investment declined by €260bn per year in real terms between 2008 and 2015. In the US, net fixed capital formation fell from 12% of GDP in 1950 to 8% in 2007 and 4% in 2014 (see Chart 1).
Chart 1: Long-term decline in net investment
Net fixed capital formation, % of GDP, 1990-2016 (Source: AMECO, BEA, McKinsey Global Institute Analysis)
Factors behind the decline include shorter asset lifecycles, falling prices for capital goods, shifts in industry mix, short-termism, housing markets constraints, public policy shifts, increasing risk spreads, and globalisation.
Prolonged lack of investment causes real damage to an economy, dampening demand in the short run and hollowing out productive capacity in the long run. It has also been at the heart of a 30-year fall in real interest rates creating challenging conditions for pension funds and other savers.
Declines in public investment have occured despite ultra-low interest rates. Increasing infrastructure investment is one obvious opportunity to address the problem. McKinsey Global Institute’s estimates suggest an investment gap of 0.7% of GDP for the US and 0.4% of GDP for the UK and Germany, for example (see Chart 2).
Chart 2: Public infrastructure investment gaps
a) Actual spending, % of GDP, 2008-13 b) Gap between spending and estimated infrastructure needs, % of GDP, 2016-30 (Source: IHS Global Insight, ITF, GWI, National Statistics, McKinsey Global Institute Analysis)
While bringing in private finance has been much discussed, higher levels of public investment could be encouraged, even in the face of tight budgets.
One option would be to adjust public accounting standards to capitalise such investments on a balance sheet and depreciate them over the lifecycle of the assets.
Such an approach could help end the debate between counterproductive austerity and non-sustainable (consumption-based) public stimulus. It would also allow for new government debt to focus on building up critical public assets.
Residential investment has followed a boom-bust cycle. Particularly in major cities, there is a structural shortage of housing, mostly due to land restrictions. This is driving up prices so that home ownership is slipping out of the reach of many households, depressing overall residential investment.
Critical reforms to land markets
Structural reform to unleash economies has been much discussed – usually cutting red tape in labour and product markets. But in today's environment the most critical reforms may have to target land markets.
Business investment typically follows overall demand rather than leading the recovery. Since the financial crisis, businesses in the US have evolved from users of funds to net savers. But surveys show that corporate decision-makers rarely change their hurdle rates (the minimum rate a company expects to earn when investing in a project), and their investment behaviour is largely insensitive to interest rate changes.
Policies that increase consumer demand – such as ‘helicopter money’ – would be likely to do more to stimulate investment than ultra-low interest rates or quantitative easing.
Jan Mischke is Senior Fellow at the McKinsey Global Institute. This article is based on ‘Bridging global infrastructure gaps’ published in June 2016. MGI's research is available for free at www.mckinsey.com/mgi Back