Tuesday, 11 September 2012

The State Investment Bank in Brief

There are a bunch of issues tied up with recent discussions over the investment bank, and industrial strategy and I want to condense these to the smallest passage possible, so here goes:

Much as with the housing development problem, taking care of the supply side alone is simply not sufficient. Small businesses and individuals who need loans are unlikely to get them for two primary reasons: Lack of security, and risk. Risk in this case is substantially amplified by an overall lack of expected future demand. Lack of security is always and genuinely an issue that the state can intervene to help with.

Take the example of student loans. Some students are clearly at risk of never getting employment which will allow them to pay back their loans, and deciding who will, and who won't is a difficult thing to do. Given positive externalities, the state has tended to simply extend loans to anyone able to qualify for a university course, and ignore this risk to repayment beyond that point. As to the question of security, the rich are clearly able to repay debts irrespective as to future income, and the poor are certainly not. The market would normally either refuse to lend, or charge a higher rate to compensate for the likely default rate. The state equalises the rates, and indeed under the current system charges more to those who earn more.

How much money you have has little relation to your potential, so it is right that the state acts in this way. The same problem applies with SMEs, where they, unlike many large firms, do not have sizable reserves to borrow against, and this does not necessarily predict their ability to succeed in business. Discriminating on the basis of resources would create high entry costs, and concentrate the market, potentially reducing competition and innovation, and so there is a case on this basis to help lower credit costs in some situations. The repayment risk is heavily affected by expected future demand for products and services, however, and one reason the banks have substantially reduced outgoing loans is to avoid unnecessarily risky loans.

The Government itself has, on the record, argued that the major cause of its failure to use allocated funds to support business in this way is the risk involved in many prospective enterprises.

As to targeted investment, and the channeling of pension funds into safe, high return public infrastructure investment, and so on, there is clearly a good argument there. Government investment in schools and hospitals, partly funded by pension funds achieves an increase in employment, future capital, externalities, and safe, reasonable returns for pensions. The only question is whether the money is used efficiently, effectively and appropriately, and this problem is one of decision making and oversight, and is entirely separate.

There are also industries which are clearly worth investing in. There are two main reasons for this:

a) The market won't meet needs. Due to high entry costs there may be few firms in the sector. They may not have access to infrastructure or a large pool of individuals trained to meet the needs of that specific sector. Continued increases in technical efficiency, available specialised labour and available infrastructure are likely to accumulate as an industry develops and persists over time. None of these things exist before the industry has taken root, and this can make it very expensive in emerging industries to get started. Further, where costs will come down with these investments the sector may become more competitive and profitable after being aided with investment than they could possibly be without it.

b) There are clear needs, strategic or economic. During world war II, the enigma code and the loss of food shipments from abroad gave Britain a harsh lesson in the risks of relying on imports for a vital good. Future food scarcity, lack of oil and gas, and general energy constraints may be satisfactorily predicted from climate models, the marginal cost of extraction and processing of fuels, and other factors. A strategy to develop national production may be wise in these cases even if those industries were currently uncompetitive.

Similarly, there may be areas where the UK has great commercial potential, but is hampered by a lack of support and investment comparable to that available in other states.

In Conclusion:

Neither project Merlin, nor any of the various other measures the Government has taken to support lending to SMEs are likely to be very helpful while demand is weak and future economic performance is unsure. A programme of investments may boost employment and demand while meeting needs, but will fail to address the financial constraints faced by households and sufficiently address levels of debt. Will try to jot down something slightly more detailed later.

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