The writer, an FT contributing editor, is chief executive of the Royal Society of Arts and former chief economist at the Bank of England
The Great Crash of 1929 left lasting scars on investors’ balance sheets and risk appetites. These scars, financial and psychological, gave rise to what John Maynard Keynes called the “paradox of thrift” — the paradox being that an individually virtuous act (greater saving) was collectively calamitous (economic slump). In the 1930s, this paradox ushered in the Great Depression.
Almost a century on, those same behaviours are in play today. Risk-aversion is rife among workers, businesses and governments. Security is trumping opportunity. Economies face a “paradox of risk” — in seeking to avoid risks, we are amplifying them. Rules and regulations put in place to curb risk are having the same, paradoxical, impact.
Recent shocks to the world economy have come in an elongated sequence — from the financial crisis to Covid, the cost of living shock to geopolitical tensions. The scars have been compounding, leaving too little time for balance sheets or risk appetites to be repaired.
Such psychological scarring generates a defensive mindset. Facing uncertainty, the instinctive response of business is to defer investment decisions, especially large-scale ones involving capital and people. Creative destruction, Joseph Schumpeter-style, goes into retreat. This lack of business dynamism is currently plaguing many economies.
One measure of this is the combined rate of job creation and destruction — the reallocation rate. Since the start of the century, this has fallen sharply across most OECD countries and most sectors. It is down by about a quarter among US and European companies and by as much as a third among UK businesses.
This slump has, in turn, slowed productivity growth. Across the G7, productivity has been growing at around half its pre-crisis rates. Part of the explanation is that, in a number of OECD countries, rates of business start-ups have fallen (lower creation). In the US, rates of company entry have also fallen since the 1980s. Fewer, new innovative companies means lower productivity.
At the other end of the lifecycle, fewer businesses have been going bust (lower destruction). Until recently, such bankruptcies in the US, UK and Europe were running significantly below historical averages. This has resulted in a lengthening tail of low productivity companies, surviving but not thriving. In the past that tail would have been cut off, releasing resources. Today it continues to wag.
This risk-averse behaviour extends to financial companies, with bank and non-bank investors also retreating from risk. A generation ago, business lending was a third of UK pension funds’ assets. Today it is less than 2 per cent. There has been no new net lending to UK companies by UK banks since 2008. Depriving fast-growing companies of finance has also damped dynamism.
Non-traditional investors, including venture capital, private equity and sovereign wealth fund investors, have filled some of the gap. But uncertainty is now causing many of them to retreat as well. Fundraising from private capital markets fell by more than 20 per cent last year. Venture capital and private equity financing of UK companies fell by 30 per cent.
This defensive behaviour has now reached governments. They have run large deficits to protect economies from the effects of recent shocks, causing public debt in the G7 to rise to more than 100 per cent of GDP. Many are now beating a retreat, leaving fiscal policy a drag on growth in the US, UK and euro-area. This all adds to future macroeconomic uncertainty, 1930s-style.
Can anything be done? Having diagnosed the paradox of thrift a century ago, Keynes also prescribed a solution. Government is the agent best able to bear long-term risk. It is well placed to act as a patient venture capitalist, investing where others fear to tread. Doing so helps heal the private sector’s scars and stir their animal spirits.
In the 1930s in the UK and US, this recipe worked. But repeating it today is hindered by debt-first fiscal rules in many countries. By constraining investment and stunting growth, these are self-defeating. To resolve the paradox, they need to be replaced with rules that prioritise growth and seek to maximise national net worth, not minimise gross debt.
The same logic applies to the rules shaping risk in private markets. The Basel III regulatory rules for banks, and the Solvency II rules for insurance companies, were crafted in an era when risk was too high, and were successful in encouraging a retreat. But today’s risk problem is too little, not too much.
Ditto for the regulatory rules around competition and corporate governance. While well meant, they have had a chilling effect on boardroom risk appetite when it is already sub-zero. They now need to be reconfigured with growth as an equal or primary, not secondary, objective until psychological scars heal.
Our uncertain world is generating collective caution. This leaves economies experiencing too little change and bearing too little risk. Well-intentioned safety-ism is making the world less safe. Stirring Schumpeter from his slumber requires a radical retuning of all our risk-based rules to a growth-first wavelength.
