RDP 2023-03: Doing Less, with Less: Capital Misallocation, Investment and the Productivity Slowdown in Australia 2. Capital Flows, Investment and Productivity

2.1 Declining investment

Investment is a key contributor to growth in output and labour productivity. If the amount of capital workers have to use increases (capital deepening), it will generally enable them to produce more output and so be more productive. While slower growth in MFP has been the key driver of slower labour productivity growth in recent decades (Duretto, Majeed and Hambur 2022), slower capital deepening has also contributed.

More generally, investment was somewhat weaker than expected in Australia in the 2010s (Debelle 2017; Heads of Treasuries 2017). Despite accommodative monetary policy, investment remained at low levels, reaching a historically low share of non-mining output (Figure 1).

Numerous explanations have been put forward to explain the weakness in non-mining investment. Hambur and Jenner (2019) show that the decline reflects broad-based weakness in average investment across firms and industries, rather than any sectoral shift towards less-investment-intensive industries. This is also evident in Figure 2, which shows that non-mining firms' average investment intensity (investment-to-output ratio) declined fairly consistently from 2005 to 2017, even once accounting for compositional changes in firms' age, industry and size (orange line), or firm-specific factors (red line).^[3]

Various other explanations have been put forward in the Australian context: risk aversion and uncertainty; pessimism about future outcomes (‘animal spirits’); sticky hurdle rates; less demand for non-mining investment to support the mining boom; slower depreciation of capital; and lower MFP growth (e.g. van der Merwe et al 2018; Hambur and Jenner 2019; Edwards and Lane 2021).

Similar declines in investment have been documented overseas (e.g. Chen et al 2019). Guttiérez and Philippon (2016) test numerous explanations in the US context, including: financing frictions; the rise of intangibles; globalisation; declining competitive pressures; regulatory barriers; and short-termism. They find evidence that a combination of factors likely weighed on US investment, including intangibles use, short-termism and declining competition.

2.2 Declining dynamism

Numerous studies have documented a slowdown in business and economic dynamism both in Australia (Deutscher 2019; Andrews and Hansell 2021; Andrews et al 2022) and overseas (e.g. Calvino, Criscuolo and Verlhac 2020). This has included evidence of: slower adoption of new frontier technologies (Andrews, Criscuolo and Gal 2019; Akcigit and Ates 2019); declining firm entry rates (Gutiérrez and Philippon 2019); and a slowdown in the efficiency of resource reallocation (Decker et al 2020).

Particularly relevant to this paper, Andrews and Hansell (2021) show that the rate at which labour has flowed from less to more productive firms (within an industry) has slowed. This suggests that labour may not be being allocated as efficiently, and the authors show that the weakening link between firm employment growth and firm productivity can account for around a quarter of the slowdown in aggregate labour productivity observed in recent decades. In turn, Hambur (forthcoming) shows that the link between employment growth and productivity weakened more in industries with growing mark-ups, suggesting a role for declining competitive pressures.

2.3 Capital allocation

Several of the potential explanations for slower investment growth and economic dynamism overlap. For example, financial frictions that prevent investment may also prevent firms from expanding and therefore slow labour reallocation. Similarly, declining competitive pressures that blunt firms' incentives to improve and expand, or exit, might also affect their incentives to invest. More generally, if more productive firms become slower to expand their stock of labour they may also be slower to invest and expand their capital stock.

This raises the question, is there a common driver of declining dynamism and slower investment in Australia? And could the economic effects of weak investment be compounded by it being allocated less efficiently?

As a simple first step, Figure 3 reproduces the orange line in Figure 2 that showed the average decline in firm investment intensity, but shows it separately for firms in each quartile of the (within-industry) productivity distribution. The declines in investment intensity have generally been larger for firms outside the lowest MFP quartile. So not only is aggregate investment falling, proportionately more of it is being done by the least productive firms. This provides some evidence that declining dynamism and investment may be linked and caused by similar factors.

To explore these results more formally, as well as considering their drivers and implications, we turn to a regression framework in Sections 4, 5 and 6.

Footnote

We focus on data up to 2017 to align with the mark-up estimates from Hambur (forthcoming). Future work could potentially extend both the mark-ups and this analysis to 2019. [3]