investment insights
The Need for a New, New Deal
Lombard Odier Private Bank
Key takeaways
- The pandemic has underlined the need for public spending on economic infrastructure
- Public investment is raising the role of the state in economies as stimulus packages dwarf historic ‘New Deals’
- Current government spending raises questions about debt and tax models long-term
- The challenges of transitioning to a sustainable future will create a range of investment opportunities.
Until Covid-19, for the last two decades government spending worldwide had levelled-off, leaving education programmes, transport networks, energy grids and healthcare systems labouring to cope with evolving needs. The pandemic has exposed the weaknesses of our public health infrastructure. But it is also focusing attention on a generational opportunity to invest in the decades ahead.
The pandemic has shown that current economic infrastructures, notably in healthcare, are inadequate. The time is ripe for an overhaul of the current social structure of the world economy, created 70 years ago and more. For example, the US’ social framework has not significantly altered since it was created in the aftermath of the Great Depression. Rolled out from 1933, the original New Deal initially cost the federal government nearly 6% of gross domestic product (GDP). By 1939, on the eve of World War 2, spending had almost doubled.
The fiscal and monetary responses of governments worldwide to the current pandemic are also a game changer. The role of the state in response to the demand for healthcare, income support and business subsidies is growing (see chart 1) and a bigger state may well become the new normal.
A new normal
Recent stimulus packages to cope with the economic impact of the Covid-19 pandemic, including loan guarantees and credit lines, dwarf the historic numbers as the share of government spending has risen. Fiscal spending in the US this year already equates to almost 20% of GDP, to more than 30% in Germany, and 17% in France. For the European Union as a whole, total fiscal stimulus spending, in addition to national support measures, is around 5% of GDP (see chart 2).
The International Monetary Fund (IMF) forecast in April this year that France’s total public spending-to-GDP ratio will jump from 56% in 2018 to 61% this year, Germany’s from 44% to 51%. In the US, total spending will rise from 38% to over 41%, and Switzerland’s is set to increase from 33% to 37%.
The EU launched a multi-year, multi-trillion ambition for a sustainable future. In July, the EU agreed a fiscal stimulus package, and seven-year budget, worth EUR 1.85 trillion, all of which is tied to cutting carbon emissions and a three-decade commitment to a cleaner economy and the innovative technologies needed. The 27-member state bloc has set itself a 2050 target to reach a net carbon neutral economy, transforming energy, healthcare, transport and farming.
Of the EUR 750 billion allocated to the pandemic recovery, EUR 390 billion will be paid out in direct subsidies to the worst-affected countries, led by Italy, Spain and France. The French government has announced plans for a EUR 100 billion recovery package, including initiatives in innovation, education and greener energy, 40% of which will be EU financed.
China is committed to a RMB 10 trillion (USD 1.47 trillion) investment in low-carbon infrastructure projects including a high-speed rail network, clean energy and artificial intelligence technologies. The world’s second-largest economy, which accounts for more than one quarter of greenhouse gas emissions, plans to be carbon neutral by 2060.
Private versus public
Much public spending is misallocated. The IMF estimates that worldwide, governments spent 6.3% of global GDP on subsidising energy consumption. That eclipses the 4.5% of GDP spent on education, according to the World Bank. Spending on education is one way to reduce inequality over time and, thanks to public investments in digital infrastructure, students can access learning worldwide.
However, spending on research and development (R&D) is not keeping pace with these growing needs. Total private and public spending in the member countries of the Organisation for Economic Cooperation and Development (OECD) amounted to 2.4% of their combined GDP in 2018. Within this sample, Israel spent the most at nearly 5% of its GDP, followed by South Korea and Taiwan. Two countries - South Korea and Japan - stand out in terms of business sector participation in total R&D spending where the private sector accounts for nearly 80% of the total. Unless other countries catch up, these nations will maintain a competitive edge in terms of equality, the value of their human capital, and innovation.
While private sector participation in the creation of a sustainable future is crucial, there are areas where the state can have the greater impact, as there are projects that greatly benefit from collaboration between the two.
Public-Private Partnerships for example, recently financed transport infrastructure projects such as the UK’s Silvertown road tunnel under the Thames, a railway rolling stock in Germany and the A9 motorway in the Netherlands. Such partnerships also funded social housing projects in Ireland, a school campus in Vienna and a new broadband network in the Garonne and Eure regions of France.
Partnerships with the state can pave the way for private investments. But the private sector is not going to finance a complete overhaul of these sectors. Only nation states can achieve that, although some countries are clearly better equipped to deliver efficiently on long-term targets.
Affordable, but is it sustainable?
Nevertheless, the timing is good because we have an opportunity to take advantage of cheap financing. When interest rates were at 4%, fiscal spending of 80% as a share of GDP looked affordable. With current interest rates at zero, and less, that affordable threshold may be closer to 200% of GDP. That does not necessarily mean that the spending is sustainable, if badly managed.
The IMF this week encouraged wealthy governments to take advantage of low interest rates to invest in infrastructure improvements and sustainable technologies. By increasing public spending by 1% of GDP, said the Fund, confidence in the recovery could translate into a 2.7% increase in GDP, and boost private investments by 10%, creating a 1.2% gain in jobs.
However, the composition of taxes needs modification to reduce inequality, which is an imperative for a sustainable future. Inequality levels in the US are now closer to Mexico and Brazil than to European nations. According to research by University of California, Berkeley, economists Emmanuel Saez and Gabriel Zucman, America’s middle classes have seen their average tax rate rise slowly since 1950, while for the wealthiest 0.01 percent of the US population, taxes have fallen decade-on-decade. The wealthiest Americans now pay a lower percentage in income tax than the poorest 10% of the population.
There is scope for countries to reform taxes and support a more robust, resilient and sustainable economy. The pandemic recovery is an opportunity for governments and private investors to transition to a circular, lean, inclusive and clean (CLIC™) economy that tackles inequalities and climate change stimulated by targeted public spending and multilateral solutions. As investors, we closely monitor the growing reach of states in our economies, and seek to identify those private companies best placed to contribute to a sustainable future.
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