The blue line is a measure of the cost of finance for risky investments: it’s the profits of UK-quoted companies relative to their market value (debt as well as equity). The graph shows that, despite a protracted and significant decline in risk-free interest rates, firms have had to generate significantly more profits than in the past to raise a given amount of finance. The spread between the two lines is a measure of the risk premium on new investments, and it’s gone up significantly in the past few years, including since the EU referendum in 2016. Chart 11 carries a similar message. Here the orange line is a similar measure of that spread, between the rate of profit for private-sector firms11 and the yield on gilts. The blue line is the rate of growth of their investment spending. 10  In the simplified way that macro-economists sometimes use to describe the supply side of the economy, using a so-called “production function”, the elasticity of productivity with respect to the cost of capital – the proportionate response of the first to the second – is the product of two numbers: the share of national income going to capital (as opposed to labour), and something called the “elasticity of substitution” between the two inputs. In the data, the first is around one third; empirical estimates for UK put the second at around one half. Multiply the two and you get a figure of around one sixth. 11 The two charts use slightly different measures of profitability.
The spread between the rate of return on risky investments and the risk-free rate of interest has been historically high since the financial crisis. I think this has probably contributed to lacklustre investment and weak productivity growth over that period. But the risk premium seems to have taken another leg up since the EU referendum in 2016. And if you believe the surveys, the perceived downside risk in this case – the thing the firms seem to view most negatively – is a no-deal, no-transition outcome to Brexit. The economics also tells you that the value of waiting for relevant news – and therefore the disincentive to invest in the meantime – is higher if you think that news is going to arrive relatively soon. This helps to explain why the impact of Brexit uncertainty on investment seemed to intensify as we got closer to the assumed exit date of March 2019. It also explains why the firms most reluctant to invest have tended to be those that expect an early resolution to the Brexit process. It would be wrong to conclude from this that the best thing for investment is to resolve this uncertainty as soon as you can, by any means necessary. Deliberately choosing the outcome firms say they view most negatively is more likely to mean that capital projects that have so far been deferred are then simply cancelled. And however long the process actually lasts, investment is likely to perform better if firms don’t continually expect an early resolution in the meantime.