The business cycle

Investment, financial risk and the stability of the European Union

By August 24, 2018 January 16th, 2019 No Comments

There has been a great deal of talk lately about what constitutes a profitable investment and what will eventually lead to “significant or excessive” financial risk.

It appears to us that we cannot engage in this assessment if we do not first clarify the (ideal) investment horizon of an agent. Modern economies are the result of the interactions between five broad entities: families; (non-financial) companies; the State; local banks; and non-residents. Banks,de facto, are mere intermediaries, and non-residents are also transitory agents for countries: sometimes they invest, sometimes they divest. So, the key players are families, companies and the State.

These three have very different investment horizons, by virtue of their very different “life expectancy”. An individual lives, on average, 80 years, and he/she will often aim to maximise the opportunities and wealth of their children, so we could say that families have a horizon of 100-120 years; thus, their investment may be evaluated on the returns it generates over a decade or more. The State, bar the particularly extreme scenario of war and/or the redrawing of national borders, lives forever theoretically. As a result, the investment return should be assessed over several years and, ideally, two-to-three decades. Why? Because the “return of an investment” from the perspective of a government should take into consideration the near-term GDP or income gains, as well as the repercussions that it will have on the life of its citizens and how it will affect the desire of its citizens to remain in the country, prosper in the country and pay taxes to the State. Companies, on the other hand, have relatively short life expectancies. On average, a company “lives” 20 years, 30% of start ups close before their 3rd birthday (according to the economist the average lifespan of US quoted companies was 18 years as of 2017, SMEs probably tend to have longer lives but their profitability often drops as the owner gets close to retirement if new management is not introduced and, of course, exceptions exist). The investment return for a company must thus be as fast as possible: one-to-five years, at the most.

Returning to the original question of what constitutes a profitable investment and the amount of genuine financial risk it implies cannot avoid these considerations. This is the fatal flaw in the current fiscal rules in the European Union: it imposes rolling three-year budget planning, which is ideally suited to a company, but that makes no sense for States and even less sense for citizens. By doing so, it fosters short-termism and suboptimal investments. This is the critical complain of the Italian government today, and not because it is the only country that has a problem with the fiscal rules, but as it is the Member State that is experiencing the biggest downsides from almost 20 years of suboptimal public sector investment decisions at this juncture.

This is a very serious structural failure of the EU today. The ECB’s QE buys time for another year, while the 27 governments negotiate on Brexit, the EU budget, and with the US on the trade disputes. However, this is not a sustainable equilibrium. Either the EU will eventually agree to another form of significant liquidity injection into the Union to address the lack of long-term investment in the Union (we see the need for another EUR 1trn over the next decade), or exchange rate and interest rates volatility will escalate in the coming three years and the Eurozone will begin to fragment. In economics, things that are not sustainable break eventually, it does not matter how much we pretend not to see the problem. Companies would do well to begin planning for both scenarios.