Investing for the Future

Being the third of an eight part series of postings on the subjects of the Virtuous Economy and the Common Good.

In the various reviews of spending reductions we have seen the greatest emphasis placed on government revenue and capital cuts, a much lower emphasis on taxation and a still lower emphasis - to the extent that it was significant at all - on direct stimuli to production and the 'rebalancing' of the economy.

This latter we must surely do. As a nation we must become more future oriented at individual, business and government levels in order to regain our former strength in engineering and manufacture, retain or regain our dwindling influence in world affairs, promote the common good and rebuild national morale.

This need to think long (a need which exists at personal as well as business and governmental levels) requires a proactive approach at national level and the bringing about of benign change - technological, organisational and, most importantly, cultural and moral - in the interest of the common good.

Change, elevated by some to the status of a cardinal virtue, is preached by politicians of every ilk - alas - but not with much success in reforming the City nor applied much to themselves or towards economic rebalancing. Change is an unequal and uneven process for people, firms and industries and some, not far from the square mile, will endeavour to remain untouched and forever in the denial stage.

The relative perform¬ance of manufac¬turing in this country raises questions about goals, ownership, decision making and questions of government policy - or the lack of it - towards industry, economic management and the balance of trade. The balance of payments depends on all internationally tradable goods and services, but while most services are not bought and sold abroad, the majority of manufactures are available for export and, no less important, import substitution.

Twenty-five years ago the country's balance of trade in manufactures went into deficit for the first time since the Industrial Revolution. And just a decade earlier than that, manufactured exports had exceeded imports by over half.

Sixty years ago Britain had a quarter of world trade in manufactures. We are not alone in this, but our decline has been more marked than most. This need not have been so. But we do have remaining strengths on which to build in both large firms and smaller enterprises.

Financial centralisation ran parallel to these adverse changes, with power piling up in London for decisions on which firms should be financed - the wrong sort of 'Capital-ism' as it were.

The City's craving to pile up money any old how has created a financial rather than a constructive industrial culture with immense social and political implications and as a consequence there developed a relentless press for ever more profit, boardroom excess and bigger bonuses.

Perhaps that is why we have a Financial Times rather than an Industrial Times. But year on year, surpluses on services and overseas income will fail to close the gap since the growth required is too great.

More than this, it's a matter of national self respect. Manufacturing rather than military might (now also cut back of course) is the acid test of whether you can cut it as a country. In all of this, wise investment directed at economic rebalancing towards a manufacturing revival is essential to construct capital rather than merely to bolster balance sheets. It is vitally important to ensure that investment decisions take a longer view and are made in the interests of the common good.

But first it is worth considering the question of the charging of interest and the implications of high rates. This is a question that is relevant at all levels in the economy from the individual citizen upwards. Of course, there are moral issues here aplenty and the taking of interest has long been a contentious subject. But Maimonides, writing in 1200 saw a connection between interest bearing loans and economic growth.

In the Industrial Revolution, interest was seen simply as one of many prices, as was the view in Roman times, although Roman law held that debt was personal and consequently did not allow it to be transferred. But there have been less detached attitudes. The Medieval Christian Church saw banking as usurious regardless of the rate of interest applied, and the Old Testament (Deuteronomy, 23: 19 & 20) allowed interest charges to be made only to foreigners! And Islamic opinion includes the view that overt charges made for the use of money can be sinful in some circumstances and Islamic banking principles eschew the charging of interest - and indeed excessive risk taking, a point well worth noting today.

In Victorian times thrift, saving and so the receiving of interest were hailed as virtues. But over a century later, there have been periods when the individual consumer has risked ridicule if they don't have to pay interest - supporting the view that interest rate reductions stimulate demand.

Since the 1970s governments have attached great weight to interest rates as an economic regulator, in some cases as the overt regulator, although since the latest financial crisis it is now recognised that a broader range of tools is needed though there is precious little discussion of worthwhile major capital investment projects.

Demonised by some and idolised by others, interest is simply important for economies, companies and individ¬uals. But it is not just the rate of interest that is important. It is the method of its calculation - the compounding of interest - that can add remorselessly to national, corporate or personal debt when prudence is lacking or circumstance overwhelming.

In his book The Sleeper Awakes H G Wells showed the dramatic effect of compound interest applied over very long periods. In the story, an investor wakes from a sleep of two centuries to find that the value of his assets, with compounding and no withdrawals, has made him the owner of the world! This Wellsian futurology is yet to be realized, but it speaks volumes for the presumed stability of Victorian financial institutions!

In the compounding process, interest attracts in¬terest. Think, for simplicity, of an account that pays 10% in which you deposit ,l00. After one year you will have ,110, all of which earns interest in year two since you and a new depositor investing ,110 should be treated equally. So the total at two years is ,121, and after three years with no withdrawals your account will stand at ,133.1. These multiples of the ,100 principal: 1.1, 1.21 and 1.331 are future value factors.

With borrowing at a rate of 15% compound, in the absence of repayments, the debt will double over five years, quadruple over ten years and increase sixteen fold over twenty, so breaks in interest payments should be viewed with extreme caution. The ¬effects of interest rate changes over long periods can be enormous too - a doubling of the interest rate from 15% to 30% increases liability nearly twelve times.

Putting off the evil day can cause enormous increases in the sum due. At 30% ,1 becomes over ,190 after 20 years and an astonishing ,2,620 after 30 years. The lesson here is that debt rescheduling must be carefully constructed to tame the tiger of exponential growth.

The positive side of all this shows the value of early pension fund contributions (now in jeopardy as people postpone austerity to old age) and the value of a policy of reducing interest charges for struggling firms. While 30% may seem high¬, such returns are often looked for by venture capital firms.

The very nature of investment of course means outlay before income. But to add costs and returns separated in time and ignoring interest doesn't compare like with like. So for each cost or return an equivalent present value is obtained by dividing by the future value factor and then summing up.

This principle has a first recorded reference in a book published in 1582. Before that, there were manuscript compound interest tables in the fourteenth century, and an understanding of the principles of compounding can be inferred from Babylonian tablets.

The higher the rate of interest or the greater the number of years, the less weight is given to a future cost or return. At 15% a five year return has a present value less than half that of an immediate return. A firm discounting at 30% gives only one eighth of the ¬weight to tenth year returns compared to one discounting at 5%, so discounting at high rates biases against projects where the high returns come later.

Excessive discount rates are a potent force for short-termism (broadly defined as a culture of high dividends and low investment). In contrast, patient money reaps long term reward in both strategic and political terms.

Over-discounting can be critical for future generations - as for example in the future decommissioning costs of nuclear power stations or the failure to maintain other capital assets. At 15% a cost 30 years ahead is given only a quarter the weight of the same cost at 10% discounting. And at 30%, the weight of a 30 year cost is zero to three decimal places.

In personal finance charges of 20% or greater annual rates are common even when bank rate is at its lowest possible level - and far more is charged quite legally. A survey by Birmingham City Council showed that annual interest rates of over 100% were commonly charged quite legally. At 100% interest, debt doubles yearly and it is not just 'loan sharks' who are a menace to society, it is legal lenders too.

In fact the Birmingham survey found loans with equivalent annual interest rates of over 1,000% - with debt increasing tenfold in a year. There was one case of loans being charged at 4,822% - at which rate the liability from borrowing ,1 now, would in the absence of repayment, in eight years exceed the entire gross national product of the United Kingdom! Unpleasant dreams for a Wellsian sleeping borrower!

The main influence on decisions to invest in manufacturing is profitability rather than interest rate levels, but higher profits don't always feed through quickly to investment. Profitability also depends on the demand for the firm's product. So an environment of deep national cutting, with many other countries adopting, or being pressed to adopt, the same flawed strategy will not produce demand, and hence neither profits nor investment or the associated employment.

Historically in this country we have paid ourselves in dividends a much higher proportion of company profits than have many other countries and there have been long periods where dividends grew many times faster than investment - a totally unsustainable difference.

Lower interest rates should give a companies a lower cost of capital. How much so depends on the nature of funding and how other things have changed, but lower it should be. But interest rate reductions don’t always feed through in full to target yields required by companies or to charges for mortgages. The market fails to value future cash flows properly.

Why is it that high discount rates and short term thinking have been so prevalent in this country? There are two things of particular note. Other countries have short-term pressures, but they may be better able to manage short and long term together, through previous high quality investment.

Borrowed funds are often used for 'financial engineering' rather than manufacturing engineering. Stock market ‘efficiency’ is usually taken to mean ef¬ficiency with information, the view that news should be quickly and fully reflected in share prices.

But the market does not reflect all information equally well. Another problem is with long term expenditure - such as research and development - that raises fundamental value, but if this doesn't show up in share price, the investment may well not be made under a short-termist outlook.

And efficiency doesn't mean that a firm's assets are valued for all possible uses or users, which is one reason for takeovers, although more compelling reasons can be found in the remuneration and psychology of the managers involved.

Takeovers distract firms from productive changes in the way that they work. Mere haggling in a corporate bazaar, sometimes encouraged in the past by appropriate accounting, is no more likely to improve the quality of businesses than horse trading will improve the quality of horses.

On staffing and the persistence of rampant executive remuneration, performance related pay may base staff rewards on short run results rather than long term goals. If targets can't include quality and wider value, then don't set them.

There are also of course political motives in economic management with the effect of required returns being raised to reflect the consequent increased risk. Policy stability is a desirable objective, though the gains must feed through to discount rates.

But it is not just interest rates that matter, it is the burdensome and off-putting conditions of lending - such as the imposition of a requirement to repay on demand, the imposition of demands for personal property as collateral in loans to small companies and the use by banks of a narrow range of financial criteria. Venture capital is by no means always adventure capital. There is little genuine risk capital here, with much "venture" capital going to low risk firms in the South-East.

We have had a much higher proportion of accountants than engineers in company management here than in Germany, though whether this is a cause of short term financial preoccupations or an effect of them is unclear. Balance sheet profits are not the best measure of long-term benefit - for the company, for the country or for the common good.

On the subject of 'leadership' there have been more self-serving theories promoted than sense rooted in the common good. But wildly disparate treatment of people with its attendant high social cost must come to an end. In its place there should be a stress on openness, empowerment and trust.

Employees should be seen as problem-solvers not problem-causers and within a strategic framework, leadership can let employees find solutions. Management must learn to fully use employee intelligence, maximise morale and minimize obligatory routine, and add value, broadly defined, for all involved.

For their part, large firms should review their appraisal methods, required returns, time horizons and intangible benefits. Strategy should refocus away from take-overs towards more productive links and into growing underlying businesses. Lending institutions - private or public - should be made to ensure more reasonable conditions for loans to smaller firms.

A remedial dish to address these deep seated inadequacies has both conventional (if currently unfashionable) ingredients discussed in section eight and some less orthodox psychological elements - including a dash of sauce, a hint of Jung or Freud to taste and, by way of grace, some ethics by implication.

Analysis takes many forms. A little time on the chaise-longue could be well spent to ease the profits grasping and risk taking neuroses in Markets, Banks and the Treasury and avoid anxious reactions that restrict recovery. The psychoanalytic metaphor has some useful mileage as neurosis often springs from unstable relationships. The cure involves confidence, which in turn calls for consistency. Investment consistency should displace dividend consistency.

Confidence involves lasting understandings and a willingness to share proprietary knowledge that can be seen as appropriate self-revelation. Many neurotics exhibit dependency traits, and financial dependency on present markets needs easing. Neurosis also involves anxiety. The threat of takeover and the defensive, short-term decisions it breeds, needs to be reduced. And the lack of self restraint - greed in particular - is an infantile trait found in some neurotics and more than a few boardrooms.

By analysis or otherwise this must cease, and corporate stakeholders should mature to mutual confidence, determination and patience in a culture of commonality that includes the many individuals with little power who are their customers. Qualities such as fairness, trust, commitment and loyalty define a healthy frame of mind for people and for industry itself - bonds of a different ilk as it were.

The country needs a new industrial psychology as well as an effective industrial strategy to curb the prodigal coarseness of the 'loadsamoney' culture that has infected the economy for so long and which has brought us to the state that we are now in.

The gains from such a Quality Capitalism, against the alternative of still meaner, grasping and morally barren variants, go well beyond an improved manufacturing industry. They will enable the rebuilding of national morale, and the personal and mutual self respect and security that contribute to the real feel good factor. In these ways, Wells' sleeper could wake to a confident and united nation that sees a virtuous economy bringing about the full promotion of the common good.