Iain Clacher and Con Keating

A Response to: Europe’s investment challenge: can pension funds play a role?

Iain Clacher and Con Keating

This article was first published in IPE.  Keating remarked last week

 “Given the positive vote in the German Parliament .. we have only the Bundesrat to pass and it is new German fiscal policy. Lots of implications then for Bund yields and the German Fiscal Balance – but good for German growth and by extension European”.

Jean Frijns and Anton van Nunen’s article advocates increased investment by pension funds as a solution to the issues raised in the Draghi Report, notably low productivity. However, since the Draghi Report was written and published, global geopolitics and economics have been thrown into turmoil. The problem of low productivity growth and an increasing gap with the US is common to continental Europe and to the UK. Similar to the proposals of Jean Frijns and Anton van Nunen, the UK Chancellor’s response to persistent low productivity has also been to promote investment in productive assets by UK pension schemes.

Converging and diverging productivity gaps

Until the 1990s, European nations, including the UK were actively closing the productivity gap with the US. However, this trend has not only stopped but the divergence between continental Europe and the UK compared to the US is growing. US per capita income is now some 20% higher than its equivalent in the major European economies e.g., France and Germany, and this gap is even wider in other European states.

The demographics of ageing are among the principal causes of this reversal. Europe is ageing much more rapidly than the US, and this difference in demographics is in large part due to the high levels of immigration, legal and illegal, to the US. Projections of the German working age population and old-age dependency ratio illustrate this issue. The former is expected to decline from 52 million to 43 million by 2050 and the latter to deteriorate from 34% t0 51%. Against this background, the proliferation of anti-immigration policies we are seeing in the US, as well as in Europe, though electorally rewarding, is a highly questionable and shortsighted policy economically.
Innovation and growth

It should also be recognised that the issue facing Europe is one of low total factor productivity rather than low capital intensity.

Innovation and growth among large listed European technology companies has been far lower than among their US counterparts. In the past two decades, productivity gains of the US ‘tech’ sector have been around 40% while listed European ‘tech’ firms have experienced little or no improvement. The larger productivity gains in the US have also not been limited to the ‘tech’ sector. Indeed, the large ‘non-tech’ US sectors have shown larger productivity gains over the past twenty years compared to the US ‘tech’ sector .

Over this period, the US ‘tech’ sector stands out for its huge and increasing R&D expenditures as a proportion of sales. Of course, much of this has been AI related, with stock market valuations soaring. However, it now appears that the profit and growth of the US ‘tech’ giants is decelerating, and we have seen Microsoft pull back from its proposed data centre investment projects citing concerns over the forecast economic benefits of AI.
As a countertrend, it appears that, in the past few years, the ‘tech’ giants have been able to entrench their market power, often through acquisitions, and with that slowed innovation – a failure of antitrust policy.

It is rather surprising against this backdrop, that UK Government policy is seeking to develop large scale capabilities in AI and data centres – and looking for it to be mainly funded by private investment. Particularly so, given the extremely high costs of electricity and the parlous state of the UK water utilities, the two principal operating inputs of a data centre.

An increasingly uncertain future

While uncertainty is something that is often talked about, and quite often experienced e.g., the GFC or Covid, the uncertainty introduced into world affairs by the Trump Presidency is unprecedented. If we consider first the proposal to renew and perhaps extend the tax breaks introduced by Trump in 2017, we may expect the borrowing cost of the taxes forgone to be far larger than the US Medicaid bill, as US Treasury rates are now far from the zero lower bound where they were in 2017 when these cuts were first implemented.

Those measures did provide a boost to US growth of perhaps 10% over the long run, but their cost far exceeds the incremental tax receipts from that growth – perhaps 15% of the tax cost which is estimated at $120 billion. Further cuts in tax rates will also lower the attractiveness of investment incentives. However, as with the previous cuts, they are likely to prove inflationary.

Until recently, most academic analyse of trade dependencies focussed on imports from China. It is clear that there will be differential trade effects from tariffs. For highly substitutable goods such as food, agricultural products, and motor vehicles, the effects on European exporters are likely to be challenging. However, it is worth noting that there is a pronounced imbalance in complex and therefore non-highly substitutable goods, by one estimate the US relies on the EU for 32 strategically important products, while the EU relies on the US for only 8. The suppliers of these goods should be relatively unaffected by tariffs.

Come what may in terms of the split of the tariff costs among supplier, importer, and consumer price rises, it is clear that tariffs will also prove inflationary. Moreover, as experience has shown, inflation is sticky and getting back to target is increasingly difficult – the last 1% above target is hard to shift. Anything that pushes inflation up at this point in the cycle constrains the Fed and prolongs the challenge of dealing with inflation. Consequently, investment in US importers will prove less attractive internationally.

The German economy

The German economy is presently undergoing significant challenges, and this is a major problem not just for Germany but also for the rest of Continental Europe. The problems of the German economy have their roots in the energy crisis of 2021 and are a function of the energy intensity associated with much of German industry, notably the chemical industry. The declines in German production have been much more pronounced than its EU counterparts.

The most obvious cause of Germany’s economic woes is the decline in the output of the automotive industry. For the German economy, the automotive sector is twice as important as this sector is to its European neighbours. The decline is predominantly a problem of Chinese competition with China producing more affordable EVs at scale. However, the effects of competition from China were also felt by the wider German export trades. Prices have been pressured upwards, first by the energy crisis, and latterly by wage increases.

It should also be recognised that there are pronounced spill-over effects from Germany to the other EU countries, and that these are not symmetric among countries in magnitude.

The sick man of Europe

Leaving continental Europe and looking to the UK, there is a unique UK issue: the rising labour share of national output. Since the mid-1990s, the labour share of national output has been increasing, which of course reduces the share of GDP available to capital and the gross operating surplus of companies. Since the mid-1990s this has increased by 8.17%. While in the US labour share has fallen by 9.84% and across Europe, only France has seen labour share rising but by a modest 1.08%.

Pensions figure large in the Office for National Statistics explanations of this trend.

“Several factors may have contributed to the large increase [of labour share of national output] including:
• an increase in the participation rate in workplace pension schemes from 47% in 2012 to 79% in 2021 after the phased introduction of auto-enrolment between October 2012 and April 2018;
• payments of deficit reduction contributions to reduce the shortfall and risk in employer-sponsored pension funds;
• higher contribution rates of employer National Insurance contributions (NICs), changes in income thresholds, and the phasing out of rebates for employers offering “contracted out” pension schemes.”

Against this background it seems likely that the wage settlements with doctors and rail workers, together with the budget changes to minimum wages and more importantly, employer national insurance contributions will result in further growth in the labour share of GDP in the UK. In the absence of exceptional growth in productivity in the UK, this will result in an even lower gross operating surplus in UK plc.

Of course, this makes the UK far from attractive as an investment proposition. It would also help to explain the exceptionally low confidence in business prospects expressed by business leaders in recent CBI surveys.

Can pension funds play a role in driving growth?

In looking at these various structural issues both in Continental Europe and in the UK, it does not look like auspicious timing to invest in either continental Europe or the UK. Moreover, with the exception of France, Europe’s infrastructure is old and rapidly ageing, its net capital stock declining. This is a product of prolonged under-investment; Germany’s investment in infrastructure had fallen from around 1% of GDP in the early 1990s to zero recently. Add to this the competing demands of increased defence spending, and the fiscal strains are substantial.

It is clear that investment is needed both in Continental Europe and in the UK, but whether pension funds will be able to come to the rescue in the face of these economic factors and one of the most uncertain geopolitical times post-1945 remains a very open question. Pension funds can rebalance their existing asset portfolios, but it is new money which is needed.

Postscript:

Since writing this article, we have seen a proposal from Friedrich Merz, which appears to have been accepted by the major parties for the creation of a €500 billion infrastructure investment fund and exemption of defence expenditure in excess of 1% of GDP from Germany’s fiscal ‘debt brake’. These measures will go far in stimulating growth in the German economy, though there are questions as to how these measures will be financed and the time scales over which this will be delivered.