Understanding Consequences of Increased Importance of Intangibles in Modern Economies, for Monetary Policy and Financing Public Debt

Intangible investment has implications for both monetary policy and the costs of public debt management in advanced economies

There is some appreciation of the changed structure of advanced economies where intangibles play a much-increased role in economic activity, in terms of investment and accounting for value. Yet this radical change to the structure of the economy has neither been sufficiently recognised nor has its practical implications for the working of the economy and for macro-economic policy, been as fully explored, as its importance would warrant. Much of the public policy discussion in the UK and US, continues to focus on manufacturing, when services are increasingly dominant, accounting for over 80 per cent of output in the UK, and on the physical accumulation of traditional capital, when increasingly modern economies have value added generated through intangibles, such as brands and intellectual property rights. These hugely significant changes over the last thirty years have implications for the character and role of investment, the role of monetary policy and the costs that arise from governments using borrowing as part financing public expenditure and managing economic activity.  

Economists, at the Federal Reserve Bank of Chicago Joel David, Francois Gourio have written an interesting paper The Rise of Intangible Investment and the Transmission of Monetary Policy. This paper helps us to get a better understanding of what more intangibles may mean for monetary policy and inflation control.

Increasing proportion of business investment accounted for by intangibles

Traditionally investment was the accumulation of a physical capital stock for the purpose of being used for future production or consumption. It was represented by spending on things such as houses, cars, and plant and equipment. Modern economies increasingly exhibit a tendency to rely on non-physical assets such as patents, computer programmes and applications, as well as methods for organising businesses and production, human capital and networks for managing relationships with customers and suppliers. Not only do firms spend more on these so-called intangible assets than before, they account for an increasing share of their value from them. There has been a secular increase recorded in the US national accounts in the share of intangibles within business investment over the last thirty years. 

Intangibles are not fully scored in traditional national accounting conventions

National accountants in the US have changed the basis on which they score money spent on intangible investments. Traditional national accounting conventions score spending on such investment as an intermediate input within the national accounts and not as part of GDP, which only scores expenditures on final goods and services in calculating GDP. This accounting treatment was analogous to private commercial profit and loss accounts where spending on intangibles was treated as a cost not an investment. The accountancy profession is now trying to bring its audit practice into a closer alignment with the economics of modern business practice. Reflecting this the US Bureau of Economic Analysis BEA has tried to identify and measure intangible investment as part of the National Income and Product Accounts of the United States (NIPAs). While the BEA national accounts have made an effort to incorporate more intangible investment there remains significant spending that is not captured by the revised definitions it uses. 

Secular increase in intangible investment partly reflected in more modern US national accounting practice

Intangibles on BEA’s current accounting conventions make up around 27 per cent of investment flows, with tangibles, such as the traditional plant and machinery accounting for about 73 per cent. In the 1950s the tangible capital stock accounted for 93 per cent of investment and intangibles for 7 per cent. This dramatic change in the composition of investment is explained by lower residential housing investment and lower non-high-tech acquisition of capital equipment. Spending on intellectual property, such as patents and the acquisition of high-tech equipment with short lives accounted for the increased importance of intangibles within total investment. While the composition of capital spending has changed significantly and it exhibits the ups and downs of the economic cycle, overall investment spending has roughly averaged around 25 per cent of GDP since 1950.

Tangible and intangible investment shares of GDP

What makes the research note of the economists at the Federal Reserve Bank of Chicago interesting is not that they identify and explain the increased importance of intangible investment in the US economy, but that they try and explore its implications for monetary policy, and the transmission mechanism or the influence of money on the economy which is important for policy makers.

Previously monetary policy worked by powerfully influencing investment decisions

They do this by exploring the manner in which monetary policy modifies economic activity in the economy. What they find is that changes in policy principally act by modifying investment and consumption. Of the two investment is more sensitive to tightening or loosening in monetary policy than consumption. In a stylised analysis of a monetary tightening 100 basis point increase in the real one-year U.S. Treasury rate, which is a common measure of the stance of monetary policy, they show that both consumption and investment fall. The note reports ‘investment falls over 1.5 per cent (to its nadir), with consumption decreasing less than 0.2 per cent. To put the results another way, the investment sector accounts for the bulk of the impact of monetary policy on economic activity.’

Impulse responses of consumption and total investment to a monetary policy shock

What this analysis also shows is that monetary tightening – higher interest rates – has a powerful impact on the tangible investment in the traditional physical capital stock but little effect on intangible investment.

Impulse responses of tangible and intangible investment to a monetary policy shock

Intangible investment hardly responds to changes in interest rates and monetary policy

Investment in intellectual property rights hardly responds to a change in interest rates while high tech investment’s response is weak. As a result of the increased importance of intangibles within investment spending, its changed composition has appeared to reduce the response of investment to monetary policy by 30 per cent and may have diminished the overall effect of monetary policy on aggregate economic activity by 27 per cent around one-quarter.

Monetary policy has now a weaker influence on investment and the economy than it once did

The Chicago economists recognise that their analysis suggests that these changes in the composition of investment and the increased importance of intangibles has blunted the impact of monetary policy and interest rates on economic activity. The impact of a given rate change may be smaller than it was in the past, so larger changes in interest rates may be required to affect output by the same amount as before. They argue this ‘does not necessarily imply that the Federal Reserve has less ability to affect output than in the past; rather, it implies that the impact of a given rate change may be smaller than in the past, so larger changes in interest rates may be required to affect output by the same amount as before’. 

What is interesting about this Chicago research note into the increased role of intangible investment is that the economists do not just notice the increased importance of intangibles but interrogate its implication for the economy. Too much economic and wider policy commentary in advanced economies, such as the UK and the USA, fails to take account of the radical changes that have taken in the structures of economies where services are much more important; and things, such as brands, patents and other intellectual property rights play a much greater role in creating value added. 

The implications of increased intangible investment are not limited to the monetary transmission mechanism, including perhaps lowering the burden of public debt  

An interesting implication of this Chicago research note relates to the potential cost of public debt on future investment and growth. In an economy where an increasing ratio of business investment and capital accumulation is accounted for by intangibles that appear unresponsive to higher costs of capital, such as higher bond yields, the full economic costs of international sovereign debt may be lower. Advanced economies led by the US Treasury Department have accumulated large stocks of public debt, running significant public deficits and large government borrowing requirements. Serkan Arslanalp and Barry Eichengreen, for example, discussed the implication of this last year at the Federal Reserve Bank of Kansas’s annual Economic Symposium at Jackson Hole in a paper Living with High Public Debt.

Higher public debt may not be more manageable simply because of integrated global capital markets, but because the effect of higher rates may be less malign for an economy value is increasingly generated by intangibles

It may be that a structural increase in international bond yields arising from increases in government borrowing in sovereign markets, led by the US, is less disturbing to investment and growth in modern economies where intangibles are more important. Perhaps the much-rehearsed mantras about fiscal rectitude in the context of globally integrated capital markets are even more redundant in a world of intangibles than we have thought. This Chicago analysis also implies that in managing the continuing post covid inflationary impulse central banks should be less fearful about using monetary policy, lest it impede the potential capital accumulation of the most dynamic sectors of modern economies.

Warwick Lightfoot
19 July 2024
Warwick Lightfoot is an economist and was Special Adviser to the Chancellor of the Exchequer 1989-1992