The author, a contributing editor to the Financial Times, is chief executive of the Royal Society of Arts and former chief economist of the Bank of England.
The Great Crisis of 1929 left lasting scars on investors’ balance sheets and their appetite for risk. These scars, financial and psychological, gave rise to what John Maynard Keynes called the “paradox of thrift”: the paradox is that an individually virtuous act (increased savings) was collectively calamitous (economic depression). In the 1930s, this paradox marked the beginning of the Great Depression.
Almost a century later, those same behaviors are still valid today. Risk aversion is widespread among workers, companies and governments. Security is trumping opportunity. Economies face a “risk paradox”: by trying to avoid them, we are amplifying them. The rules and regulations established to curb risk are having the same impact, paradoxically.
Recent shocks to the global economy have come in a long sequence: from the financial crisis to Covid, the cost of living shock and geopolitical tensions. The scars have worsened, leaving very little time to repair balance sheets or appetite for risk.
These psychological scars create a defensive mentality. In the face of uncertainty, the instinctive response of companies is to postpone investment decisions, especially large-scale ones that involve capital and people. Creative destruction, Joseph Schumpeter style, goes into retreat. This lack of business dynamism currently affects many economies.
One measure of this is the combined rate of job creation and destruction: the reallocation rate. Since the beginning of the century, this figure has fallen dramatically in most OECD countries and sectors. It has fallen by about a quarter among US and European companies and up to a third among UK companies.
This decline, in turn, has slowed productivity growth. Across the G7, productivity has been growing at around half its pre-crisis rates. Part of the explanation is that, in several OECD countries, business creation rates have fallen (lower creation). In the United States, business entry rates have also fallen since the 1980s. Fewer new, innovative businesses mean lower productivity.
At the other end of the life cycle, fewer companies have gone bankrupt (less destruction). Until recently, these types of bankruptcies in the United States, the United Kingdom and Europe were well below historical averages. This has resulted in a longer and longer tail of low-productivity businesses, surviving but not thriving. In the past, that queue would have been cut, freeing up resources. Today it continues to move.
This risk-averse behavior extends to financial companies, with bank and non-bank investors also shying away from risk. A generation ago, loans to businesses accounted for a third of UK pension fund assets. Today it is less than 2 percent. There has been no net new lending to UK companies by UK banks since 2008. Starving fast-growing companies of funding has also curbed dynamism.
Non-traditional investors, including venture capital, private equity and sovereign wealth funds, have filled some of the void. But the uncertainty is now causing many of them to retreat as well. Fundraising from private capital markets fell more than 20 percent last year. Venture capital and private equity funding for UK companies fell by 30 per cent.
This defensive behavior 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 percent of GDP. Many are now backtracking, making fiscal policy a drag on growth in the United States, the United Kingdom and the euro area. All of this adds up to future macroeconomic uncertainty, 1930s style.
Can something be done? Having diagnosed the savings paradox a century ago, Keynes also prescribed a solution. The government is the agent best able to withstand long-term risk. He is well positioned to act as a patient venture capitalist, investing where others fear to tread. Doing so helps heal the scars of the private sector and awaken its animal spirit.
In the 1930s, in the United Kingdom and the United States, this recipe worked. But repeating it today is hampered by fiscal rules that in many countries prioritize debt. By limiting investment and slowing growth, these measures are counterproductive. To resolve the paradox, they need to be replaced with rules that prioritize growth and seek to maximize national net worth, not minimize gross debt.
The same logic applies to the rules that shape risk in private markets. The Basel III regulatory standards for banks and the Solvency II standards for insurance companies were drawn up at a time when the risk was too high and they managed to encourage a retreat. But the current risk problem is too small, not too much.
The same applies to regulatory standards regarding competition and corporate governance. While well-intentioned, they have had a chilling effect on board risk appetite when it was already below zero. Now it is necessary to reconfigure them with growth as an equal or primary objective, not secondary, until the psychological scars heal.
Our uncertain world is generating collective caution. This means that economies experience very few changes and assume very few risks. Well-intentioned securityism is making the world less safe. Shaking Schumpeter out of his slumber requires a radical readjustment of all our risk-based rules to a wavelength that prioritizes growth.