Failure to invest could kill recovery

The second part of our series on the economy looks at the danger of inflation if companies are encouraged to pay dividends rather than invest in the future

With the economy shaping up to be a key electoral battleground, one of the fronts on which the Labour Party will be making a concerted push is investment - or rather, the lack of it in the UK.

Investment is the dog that has not barked in this recovery. If there is a danger that interest rates might have to rise to guard against rising inflation, it will be because Britain's industrial capacity is woefully inadequate, according to the Labour Party.

After only a few months of faster economic growth, surveys show that companies are already troublingly close to full capacity.

Total investment spending across the economy increased by a third in the 1986 to 1989 boom. But it declined sharply during the following three years, and has expanded so little in the four years since the bottom of the recession the level of spending is still a 10th below its 1989 peak.

On the face of it, businesses are not giving the future of the "Enterprise Centre for Europe" much of a vote of confidence. The picture is particularly disappointing in manufacturing, where investment spending fell sharply in real terms in the first half of this year.

There are two possible explanations for this lacklustre performance by British business. One explanation - which is backed by research carried out two years ago by the Bank of England and the Confederation of British Industry - is that companies have not adjusted the rate of return they demand from investment projects to take account of lower inflation.

The Bank of England's economists have found that companies have been only approving projects which have a return of about 20 per cent after tax, in money terms - a very demanding rate when inflation is only at a level of between 2 to 3 per cent.

Almost three-quarters of the companies that were surveyed in March 1994 had not adjusted their investment criteria to take account of the lower inflation rate.

This hurdle to investment should by now have come down, to the extent that business people are confident inflation will remain low and stable.

But the second obstacle has been uncertainty about the level of demand. After strong growth during 1994, the economy slowed again last year, and manufacturing toppled back into a mini-recession from which, by all accounts, it is barely emerging.

On both counts, prospects for increased investment next year look bright. Most forecasters reckon Britain is poised for the strongest performance since 1988. In fact, the key areas of private sector investment have already begun to rise sharply.

The economy-wide measure has been depressed by the massive cuts in public sector investment not remotely made up by the Private Finance Initiative.

Remove the very depressed construction sector and the reduced investment spending by the privatised electricity and gas industries, and the picture looks brighter still. Investment by the corporate sector grew by more than 10 per cent in the year to the April-June quarter, although this was inflated by a surge in imports of aircraft from the US.

So in the run-up to the general election the prospects for investment look bright. But the longer-term concerns remain. The share of investment in total GDP is lower in the UK than in other industrial countries.

This factor leaves the economy vulnerable to inflation whenever growth picks up from a fairly low rate.

The Labour Party has some policies to increase British investment. These centre on discouraging takeovers and short-term shareholding. The party would probably also restructure corporate tax to reduce the attraction of paying dividends to shareholders, rather than retaining profits for investment purposes.