The cost to construction of false optimism
May 16th, 2013
For the past five years this blog has been perceived as a purveyor of doom and gloom and sometimes criticised for being so.
I part jokingly retort that I may be gloomy, but I tend to be out-gloomed by reality. Here’s my take in 2008. There is plenty of scope I see now to have been gloomier than I was and not have been unreasonable as things have panned out.
But this post does not concern who was right or wrong about the past. That’s a dull and tedious road to travel.
This is more an observation about today and tomorrow and the dangers that lurk for those too keen to grasp at every promising-looking straw in the wind.
Five years ago we were heading into recession and, as a nation, we still generate less today in goods and services than we did then despite an increase of 3.5% in the number of people economically active.
But in newspapers yesterday and today we could read headlines pointing to economic optimism from the outgoing Governor of the Bank of England Sir Mervyn King.
Following years of downward revisions to its economic forecast, here was an inflation report that was more bullish than the previous. And how fitting that the Governor could leave his role on a sweet rather than a sour note.
It would be easy to single out the Bank of England for its poor record of forecasts. Some commentators do. But the vast majority of business consultants, banks and other independent expert forecasters have on average been greatly overoptimistic about the path of the economy.
So let’s leave carping to one side. This looks like good news.
Confidence is critical to the economy as so much rests on trust and a belief in likely outcomes. Animal spirits economists would argue are an important aspect of a functioning economy.
So pessimistic forecasts can then, justifiably, be seen as potentially having a negative effect, with bank runs being an extreme example. And I can see why my take should have attracted criticism.
However an equally important but seldom mentioned consideration is the impact of overoptimistic economic forecasts. This asymmetry seems a bit odd given the berating given to the Met Office when it promises sunshine and we are provided with rain.
What’s more interesting those who put out a pessimistic economic forecasts or analysis of likely prospects, whether their take is well founded or not, are likely to take significant flak that is seldom taken by the providers of upbeat prognostications.
So I would like to leave one thought at the door of the critics who dismiss those who challenge optimism as gloom mongers.
How many businesses have gone or are about to go to the wall in construction because they took the advice of persistent optimists suggesting things would get better soon?
Let’s look at just one aspect of how the industry works in a downturn.
Buying work. It is now commonplace in construction. It’s not sustainable long term, but it seems a not unreasonable strategy if you think things will turn around in the near future.
Now ask yourself: how widespread it is and for how long have firms been buying work in construction?
Too many and for too long is probably the most accurate assessment you can make.
So what is the consequence of this perfectly rational business approach? That is it is a perfectly rational approach is if you genuinely believe things will shortly improve.
Firstly in the short term the effects a minimal on large firms because they will still be generating cash on previously won work. Smaller firms on smaller jobs will face the pinch far quicker.
Firms with strong balance sheets can wear it for some time, those with weak balance sheets can’t wear it for long unless they have an exceptionally forgiving bank manager.
Firms that are bank financed will find after a while the cost of finance and access to finance will become tighter. Those that self-finance, as a vast proportion of firms do, will be eating into reserves or not replacing capital goods they built up in the good times.
In the end a firm can’t keep winning work and making a loss.
The brutal fact is that the construction industry has been feeding on its balance sheet fat for far too long as it has traded on the promise of recovery. Clients have received buildings at delicious prices in part because they were part funded from the industry’s balance sheet.
When I hear small family contractors saying that if they knew in 2008 what they know now they would have shut up shop, I am disturbed.
We should not be surprise if we start to see a rise in firms pulling out of the market of going bust.
We live in precarious times as an industry. There is a fine line between suicide bidding and buying work short term to keep the beast fed.
But I would lay blame at the door of those peddling an overoptimistic picture of the future. This almost inevitably will have tempted some firms into business decisions they now know they should not have made.
There is no need to be pessimistic, no need to be optimistic in ones analysis. The need is to make the best estimate you can and plan accordingly with the risks firmly in mind.
So I say welcome Sir Mervyn’s cheery forecast for the UK economy. I do. But if you are in construction take a long hard look at how soon it might be before we can expect a recovery in UK construction. Indeed whatever industry you might be in look beyond the pleasant thought of a resumption of growth in the economy.
I will leave you with one graph which is one casting of historic data and I will let you make up your own mind on what that might mean for the future of construction.
It is a scattergraph comparing growth in the economy (GDP) over three years with the corresponding growth in construction over the same three years. Each red dot is a year from 1961 to 2012.
The interesting point is that over the past 50 years or so when growth in GDP over three years has been below 7% (see the blue line) construction output growth has been at best very weak and generally output has declined, sometimes spectacularly. That 7% growth over three years equates to average annual GDP growth of more than 2%.
Even on Sir Mervyn’s more optimistic forecast it will be some while before we have a three-year growth rate in GDP of 7%.
Now that graph is taken from the past 50 years. It doesn’t necessarily follow that the future will stick to the same pattern.
The question is should construction businesses be risking their futures on the notion that things will be different this time.
Because unless firms start putting some fat back into their operations we face a very bleak period with ever more firms go to the wall. And when a weak firm goes bust it has a nasty habit of taking a few financially healthy firms with it.
This we more or less knew from the GDP first estimate figures. The fall shown in the latest output figures of 2.4% in the first quarter was more or less in line with the -2.5% figure posted within the GDP data. But because of revisions to earlier figures the industry probably saw about £100 million or so less work in the first three months than the Office for National Statistics estimated earlier.
It is the longest depression for more than a century. And with the full impact of austerity still to bite there remains the likelihood of a very bumpy and uncertain take off.
Part of this is statistical, as the latest Office for National Statistics data puts the fall in 2012 at less than first thought. But, even so, the forecasters have slightly shaded up the rate of growth for the coming year.
To illustrate this and in the name of efficiency I shall recycle some charts from a recent presentation to CIC Economic and Policy Forum. My central point then was that the Budget measures were pretty piffling given the scale of the challenge and the economic environment and expectations.
It’s true the data for UK gross fixed capital formation (GFCF) for dwellings and for buildings and other structures is measured differently from construction output. So there will be different lags in the different data series and other technical differences.
With confidence boosters like those over the past year or two you might reasonably have expected a surge in construction activity.
However, those with a foot in the infrastructure market are naturally and quite rightly more content. They have seen rising quarterly output from a fairly solid base over the past year. Admittedly there was a nasty fall at the beginning of 2012, but the sector had been riding very high up to that point.
Let’s just take the private commercial sector as an example. If the construction sector is to see growth this sector is vital.