Revision note – Investment and MEC

Investment is spending on capital goods by firms and government, which will allow increased production of consumer goods and services in future time periods. Be careful not to confuse the economists’ definition of investment with another interpretation – that investment involves putting funds into financial assets such as stocks and shares. Marginal Efficiency of Capital Theory – As investment increases, the return on the last unit of capital employed will be less and less as a result the Law if Diminishing Returns (i.e. The MEC falls). 

The theory states that it is profitable to invest so long as the MEC (the % return) is greater than the rate of interest (the cost of funds needed to finance the investment). The OPTIMUM level of Investment is where:

% MEC = the rate of interest

At this point, the last unit of investment is covering its costs, and all previous units are profitable.

Gross and Net Investment

An important distinction to make is between gross and net capital investment spending

Net investment is positive when gross investment is higher than depreciation or capital consumption. Then there will be an increase in the nation’s stock of capital.

  • Fixed Investment – is spending on new capital machinery and plant, construction, housing, vehicles, etc.
  • Working Capital – is spending on stocks/inventories of finished goods and raw materials. The accumulation of stocks by firms, whether voluntary or involuntary, is counted as investment.

Gross Domestic Fixed Capital Formation (GDFCF) – is expenditure on fixed assets (buildings, vehicles and plant) either for replacing or adding to the stock of fixed assets.

Gross Domestic Investment Spending + Stockbuilding = Total Gross Investment

Other factors that affect investment demand

1. Expectations – the key to understanding investment decisions
The central message of economic theory and the evidence from business surveys is that capital investment is determined by the relationship between the expected returns from investment and the expected cost of financing the investment.

2. Returns to an investment project

The expected returns from capital investment are determined by the demand for and the price of the output of goods or services generated by an investment and also by the costs of production. A rise in demand for the output that capital is purchased to supply will increase the potential revenue streams that a business can expect from a new project. Similarly, a change in the costs of purchasing the capital inputs the costs of training workers to use new capital and in maintaining the capital stock will also affect the expected rate of return.

3. The importance of business expectations and uncertainty

Expectations of demand, prices and costs over the lifetime of the investment are key determinants of expected returns. There is always uncertainty about the expected rate of return particularly when demand is volatile and sensitive to changes in interest rates, the exchange rate and incomes.

The rate of return from an investment is also influenced by the rate at which an investment project is assumed to depreciate over time.

The cost and availability of internal and external finance is important, as higher costs of finance (e.g. higher interest rates) require greater returns from the investment to ensure that it is profitable.

At this point, the last unit of investment is covering its costs, and all previous units are profitable.

  • If profit levels rise, firms will have more money to spend on investment and will have a greater incentive to do so.
  • Advances in technology may encourage firms to replace less productive capital equipment.
  • The government may also encourage investment by cutting corporation tax on firms’ profits and by giving investment subsidies.

Unemployment in Denmark – generous benefits with strict controls

With unemployment at 4.2% – less than 120,000 – in Denmark it has one of the lowest rates of unemployment in Europe. Those unemployed get 90% of their former salary but there are very strict controls on those receiving these benefits. Some of them are outlined below:

  • Check-in with the government website every 7 days
  • Apply for 3 jobs each week that you are unemployed – also have to prove their efforts
  • Within two weeks after you become unemployed, you must upload and activate a CV on the government website.
  • Each month they have to attend an interview with a government job centre
  • Financial benefits maybe cut if they don’t abide by the conditions.

The video compares the French system with that of Denmark.

The paradox of Norway – fossil fuel giant and leader in renewable energies

In 1969 the discovery of oil off the coast of Norway transformed its economy with it being one of the largest exporters of oil. A lot of countries in similar positions have succumbed to the ‘resource curse’ in which countries tend to focus on a natural resource like oil. The curse comes in two forms:

With high revenues from the sale of a resource, governments try and seek to control the assets and use the money to maintain a political monopoly. This is where you find that from the sale of your important natural resource there is greater demand for your currency which in turn pushes up its value. This makes other exports less competitive so that when the natural resource runs out the economy has no other good/service to fall back on.

However it is the fall in commodity prices that is now hitting these countries that have, in the past, been plagued by the resource curse. As a lot of commodities tend to be inelastic in demand so a drop in price means a fall in total revenue since the the proportionate drop in price is greater than the proportionate increase in quantity demanded.

Norway – has a different approach.

In Norway hydrocarbons account for half of its exports and 19% of GDP and with further oil fields coming on tap Norway could earn an estimated $100bn over the next 50 years. Nevertheless there is a need to wean the economy off oil and avoid not only the resource curse that has plagued some countries – Venezuela is a good example as approximately 90% of government spending was dependent on oil revenue – but also the impact on climate change. Norwegians have been smart in that the revenue made from oil has been put into a sovereign wealth fund which is now worth $1.1trn – equates to $200,000 for every citizen. This ensures that they have the means to prepare for life after oil.

The Economist – Ecowarriors bankrolled by oil – 8-2-20

What are they doing?

  • 98% of electricity is from renewable energies and technologies
  • Heating with oil is to be banned this year
  • 50% of new cars are to be electric
  • Oslo has set a ceiling every year for its greenhouse gas emissions
  • Oslo removed nearly all parking spaces from the city centre – now bicycle docks / benches
  • Norway is hoped to be completely emission-free shipping fleet over the next couple of decades – this accounts for almost all of Norway’s oil consumption
  • Sovereign wealth fund will sell its shares in companies dedicated to oil and gas exploration

Norway and Liberia – Coarse Theorem

Coarse Theorem – Ronald Coarse argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like pollution.

An example of this was the a deal between Liberia and Norway. Norway will give $150m in aid in return for Liberia stopping the destruction of its forests. The stick approach of trying to force Liberia to stop cutting down its trees might give way to a more effective carrot approach by paying Liberia to do so. This makes both sides better off. Liberia still gets the aid and Norway gets to preserve biodiversity and take a small step against climate change.

Norway’s challenges

This being said there needs to be more emphasis on the service sector as an earner of GDP – this sector already accounts for 55% of GDP. According to The Economist Norway faces 4 challenges:

  • Reduce it focus on gas and oil
  • Increase its productivity through the use of technologies
  • Reduce carbon emissions to meet the Paris agreement goals on climate change
  • Create 25,000 jobs a year so that oil workers can find meaningful employment

Source: The Economist – Ecowarriors bankrolled by oil – 8-2-20

Developing countries green policies and investment

Here are some FT journalists answering questions around the impact of green policies on the growth of developing countries. The main points are:

  • Under the Paris climate agreement there is currently no obligation for developing countries to implement green policies.
  • It is unfair for developed economies to ask developing countries to stop their oil and gas industry when they themselves has accrued the benefits of energy extraction.
  • China has invested hugely in solar energy – this is seen as the next industrial revolution
  • Over last decade China has committed over $780bn to wind and solar energy
  • In 2019 29 countries spent $1bn or more on renewable energy – indicative of it becoming cheaper.

Developing countries bigger spenders than Developed countries

Developed countries were the first to embrace non- hydro renewables, back in the last decade, offering subsidies to encourage deployment. However, the sharpest increases in electricity demand, by far, are taking place in developing countries. The figure below shows that up to 2014, the majority of renewable energy capacity investment was in the developed world, but that every year since then, emerging economies have been dominant. In 2018, developed economies invested $125.8 billion, some 10% more than in the previous year, while developing countries committed $147.1 billion, down 24%. However, the different shades of green in the chart reveal that the latter change was entirely due to China and India. Investment in those two giants, taken together, fell 36% to $99.6 billion, while that in “other developing economies” rose 22% to a record $47.5 billion.

Developed vs Developing Countries – Investment in renewable energy 2004-2018 $bn

Source: Frankfurt School – UNEP Collaborating Centre for Climate & Sustainable Energy Finance. Global Trends in Renewable Energy Investment 2019

Developing economies growth 2010 – 2019

Below is a graph from the FT site that shows growth rates in leading developing countries and it makes a good comparison with the Eurozone and the World. Some emerging economies have, nevertheless, achieved high economic growth rates in recent years. China has witnessed particularly rapid economic growth and has become the second largest economy in the world behind the US. China’s increase in output has been driven by increases in investment and exports. This has been helped by a fall in the renminbi which makes Chinese exports cheaper. India’s growth rates has also been significant because of an increase in the labour force and advances in IT. Remember that ‘economic development’ is the process of improving people’s economic well-being and quality of life whilst economic growth is an increase in an economy’s output and the economic growth rate is the annual percentage change in output.

Japanification – how to cope with low interest rates.

Economists use the term Japanification as shorthand for the situation where economic growth remains stagnant even with significant monetary easing – lower interest rates and increased government spending. With interest rates already at record low levels it seems that a lot of economies are going the same way as Japan. However as discussed in the video below from the FT, Japan is a nice place to live and has a very high life expectancy. The concern for central banks is what other policy instruments do they have after really low interest rates – they are running out of ammunition. To boost growth in the USA is a lot different than in Japan according to Ben Friedman. He states that Japan does not have the problems of widening inequality and the stagnation of the middle income groups.

The question is why Japanese society seems to cope with an economy that doesn’t respond to very low interest rates and increase government spending? The FT look to Robert Pringle’s book ‘The Power of Money’ and suggest three reasons:

  • Long established business – 5500-odd companies that are 200+ years old, more than 3,000 are Japanese. They are much more resilient to change and have less of a focus on short-term profits but too service, patience and a disdain for pecuniary motives.
  • Immaterialism – unlike a lot of western countries (US in particular) money in Japan is less significant in showing success. Therefore there is less social conflict.
  • Japanese version of capitalism – US = individualism and democracy. Japan = individual is part of a group and discourage competition = a stable society.

Source: How Japan has coped with Japanification

Gold prices – 9/11 to Qassem Suleimani

Over the years the store value of notes and coin hasn’t maintained its value like gold. Gold has been seen as a way to pass on the wealth of one generation to the next. What are some other reasons why gold goes up in price:

  • The US dollar is seen as the reserve currency and when its value drops there tends to be move towards buying gold as security and this ultimately increases its price. After the GFC of 2008 the price of an ounce of gold went from approximately $1,000 to $1,900.
  • Geopolitical uncertainty also sees people look to gold for relative safety – a good example was the drone strike that killed Qassem Suleimani, leader of the Quds Force of Iran’s Islamic Revolutionary Guard Corps. The price of gold rose around 3% one week after the event. The events of 9/11 saw gold rise by 6% – see Economist graphic.
  • Gold is also very prevalent in the culture of some countries. India is one of the largest gold-consuming countries and it mainly used for jewellery.

Below is a clip from the Corporation Documentary where commodities trader Carlton Brown gives his reaction on the trading floor when the events of September 11 were unfolding. He talks of the price of gold ‘exploding’.

GDP or GPI – Genuine Progress Indicator

HT to former colleague Kanchan Bandyopadhyay for this piece on the Genuine Progress Indicator. Most economics courses will include the topic of limitations of Gross Domestic Product as an indicator of standard of living. US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile.

Genuine Progress Indicator (GPI) is designed to include the well-being of a nation and it incorporates environmental and social factors which are not included in GDP. The GPI indicator takes everything the GDP uses into account, but adds other figures that represent the cost of the negative effects related to economic activity (such as the cost of crime, cost of ozone depletion and cost of resource depletion, among others). The GPI nets the positive and negative results of economic growth to examine whether or not it has benefited people overall. The figure below shows the aspects of Social, Economic and Environmental variables.

US senator Robert F Kennedy pointed out 50 years ago that GDP traditionally measures everything except those things that make life worthwhile.

The introduction of the living standards framework in New Zealand takes into account environmental resources, individual and community assets, ‘social capital’ – which includes cultural norms and how people interact – and human capital, such as people’s health, and their skills and qualifications.

By living standards, the NZ Treasury means more than income; it’s people having greater opportunities, capabilities and incentives to live a life that they value, and that they face fewer obstacles to achieving their goals.

Limitations of GDP as a measure of standard of living – see list below.

  1. Regional Variations in income and spending
  2. Inequalities of income and wealth
  3. Leisure and working hours
  4. The balance between consumption and investment
  5. The shadow economy and non-monetised sectors
  6. Changes in life expectancy
  7. Innovation and the development of new products
  8. Defensive expenditures

Internet Penetration vs Use of Cash

The Economist produced some interesting statistics about how the most digitised countries use less cash and the impact of government in moving towards as cashless society. Most transactions are still carried out with cash but the use of it has fallen:

Use of cash – 2013 = 89% and 2019 = 77%

The graph shows the correlation between Internet users and the % of transactions conducted in cash. Nordic countries lead the way and by 2016 it was estimated that 4 out of 5 transactions were done online. In Denmark the extent of the cashless environment has led the payment app called MobilePay to be the top spot as the most “indispensable” app on smartphones – overtaking Facebook, Messenger etc. MobilePay was launched by Danske Bank in 2013 as a peer-to-peer transfer service.

Italy still had 85% of transactions done by cash with 61% internet penetration. Greece with its significant informal economy still has a very high percentage of cash use as it is very hard to trace.

How do countries promote less use of cash?

  • Banks can improve systems that make transfers faster and cheaper
  • Firms promoting the use of credit cards with loyalty schemes
  • Banning the use of cash on public transport – London and Amsterdam
  • Filing tax returns – payments or refunds by Internet banking
  • Making goods cheaper if paying by card

Source: The Economist – August 3rd 2019