Policymakers shouldn’t let inflation blind them to the problem of underinvestment
We need more ‘engaged capital’, argues South African social impact investor Jonathan Oppenheimer.
Around the world inflation rates are on the rise, bringing to an end several decades of largely stable global prices. Central banks have responded by raising interest rates in a desperate bid to bring prices back under control. If we’re not careful, however, this lifeline could soon become a noose, choking off investment at precisely the time when the global economy needs it most.
By now we’re all largely familiar with the factors driving global inflation: higher energy prices spurred on by the war in Ukraine; supply chain disruptions; a tighter labour market; and the economic scars left by the Covid-19 pandemic. This combination of both supply- and demand-side shocks is uncommon in recent economic history and has left governments and central banks at a loss for what to do next.
The sheer scale of the inflation crisis means that tighter monetary policy is now unavoidable. However, by their very nature, higher interest rates will reduce businesses’ access to credit and increase the cost of borrowing, making it harder for firms to invest in productive assets. This is counterproductive when we consider that more investment is precisely what is needed to address the supply-side problems that are contributing to inflation.
Businesses need more investment to boost productivity and bring workers back to the labour force through an increase in real-term wages. This will help transform the so-called ‘great stagnation’ into a wave of new workforce participation, encouraged by better and higher paying jobs.
Investment is also needed to help businesses adjust to life after the pandemic: perhaps the single largest economic upheaval since the 2008 crash. Companies need to make changes such as reconfiguring supply chains; acclimatising to hybrid working; and providing new products in response to changing patterns of consumption. All of this requires investment if we are to avoid disruptive, inflationary bottlenecks to growth in sectors of the economy which have been hit hardest by the pandemic.
On a macro scale, investment is also needed to establish a healthier balance between savings and investment, so that once the economy recovers interest rates settle at a level comfortably above zero. This is essential if policymakers are to avoid resorting periodically to quantitative easing once they run out of room to cut interest rates.
Perhaps even more importantly, a healthy investment environment is needed if we are to address the global threat of climate change and ensure that future growth is environmentally sustainable. This means large-scale investment in new technologies and infrastructure over a sustained period of time, which cannot be achieved in the face of surging interest rates.
So, if investment is the key to spurring post-pandemic economic recovery, how can this be achieved when central banks are all tightening their belts?
The first response is for policymakers and financial investors to work together to change the way we regulate. At the moment too much financial regulation imposes frictional costs on businesses without generating revenues. This creates a wedge between the gross and net returns on investment, raising hurdles for businesses and reducing the number of investable opportunities for firms. In short it means that otherwise profitable investment opportunities are being passed up due to regulatory costs.
The remedy to this is to shift from rules-based restrictions to process-driven, goals-based regulation. With goals-based regulation the regulator sets out the ultimate objective, while allowing businesses to innovate and seek better and more cost-effective ways of achieving that goal. This, in turn, means that regulation will not only be more effective but also help to support the greater levels of investment in productive assets that are needed.
The second response to tightening monetary policy and underinvestment is to change the relationship between financial investors and the companies they back; switching from purely transactional to ‘engaged capital’.
Engaged capital is a partnership between financial investors and company managers in which both parties adopt a long-term view and focus on maximising sustainable value. This requires patience, a tolerance of risk and financial investment at a sufficient scale.
Unlike anonymous traders or passive investors, providers of engaged capital are able to encourage company managers to focus on long-term value. They are more likely to see opportunities for future growth coming out of things like the recovery from the pandemic or the fight against climate change.
Policymakers and financial investors should work together to encourage engaged capital. Financial investors should put a stop to the unquestioning pursuit of higher liquidity through high trading volumes (as this just encourages transactional capital) and instead ask themselves what their investment can build, rather than what it can buy.
As we stumble from one global catastrophe to another, the challenge of raising investment in productive assets is urgent and of fundamental importance to the health of the global economy, not to mention social stability.
Policymakers are right to be concerned about inflation and the risks that this poses to our economies. However, they must not let their efforts to stem price rises agitate the serious problems of underinvestment. Instead, like a plane with two engines, governments should drive the economy forward by focusing on increasing investment at the same time as bringing down inflation. Goals-based regulation and engaged capital are two essential tools that can help keep this plane in the air.