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Economic Insights

Companies, awash in cash, remain reluctant to invest in new plants and equipment. That could hamper long-term U.S. economic growth.

One of the biggest disappointments in this generally dissatisfying recovery is the relative lack of capital spending by business. All areas fall short relative to cyclical norms, whether premises, equipment, and what the Department of Commerce refers to as “intellectual property products,” mostly technology. This shortfall has profound implications, immediately because it denies the economy an engine of growth and longer term because a paucity of such spending will weaken the economy’s basis for all future economic expansion as well as productivity gains. That is true of all economies, but particularly a highly developed one like the United States, especially in the current, globalized, high-tech world.   

A Sorry Record
No matter how one parses the statistics, the sector has trailed historical experience. Real spending overall—on premises, equipment, and technology—fell 20% from the peak to the trough of the Great Recession of 2008–09. That was a steeper slide than in past recessions, to be sure, but historically the steeper the recessionary slide the faster capital spending has rebounded in the recovery. This case has been different. It took an unprecedented (except for the Great Depression) three and one quarter years from the trough for real capital spending to reach its old highs. Past cycles going back for more than half a century averaged less than two years from the cyclical trough to accomplish the same thing.  

Usually, capital spending surges in the early stages of recovery. Business certainly does not need more capacity, but presumably spends freely anyway because it sees a surge in its earnings and no doubt wants to make up for the opportunities lost during the recession. In the recoveries of the late 1950s, the early 1960s, and the 1970s, for example, real capital spending increased at an average annual rate of about 11.0% during the initial recovery period. The 1980s’ recovery saw average annual growth of almost 12.0%. In the 1990s, the recovery was a bit less impressive, but the recession also was shallower than those earlier experiences. Even then, real capital spending grew 9.2% a year on average for six years after the economy turned upward. The cyclical recovery in the early years of this century compared poorly with this historical record. Real capital spending then only averaged some 4.5% a year. But the recession that proceeded it was also far shallower than any of these earlier experiences. By contrast, this recovery, despite the steepness of the proceeding recession, has seen real capital spending growth averaging less than 5.0% a year in the recovery so far. Little wonder, then, that it took such spending so long to recover its old highs.1

The Whys
Prominent in explaining why capital spending this time has fallen so far short of historical norms is the severity of the Great Recession. Even though past rebounds were strongest after the deepest recessions, this recession’s exceptional severity seems to have created an atypical timidity among managements. It is understandable. More firms than usual came close to bankruptcy. Carrying deep scars and the fears that go with them, managements remain reluctant to hire—as has been well documented in the media and in this space—and even remain wary of mergers and acquisitions. They certainly have no appetite for the risks implicit in heavy capital-spending budgets. Instead, they have hoarded cash. According to recent readings from the Federal Reserve’s flow of fund statistics, nonfinancial firms have checking accounts equal to about 10% of their total liabilities—an astronomical figure, especially since these assets earn nothing. It all speaks to fear.

On top of this powerful impact is the effect of the ambitious legislation passed in 2010, in particular the Affordable Care Act and the Dodd-Frank financial reform legislation. Much discussion has centered round how effective or destructive this legislation is. It is, however, less a question of the merits of these laws than that they demand major changes, inevitably imposing considerable uncertainty. Business managers feel less sure about future costs than usual, in hiring, borrowing, and expansion in general. They feel less secure in their calculations of the returns likely to emerge from expansion. Evidently, the uncertainty is great enough to create a natural hesitation among managements. The fact that neither piece of legislation has fully gone into effect, even now five years after their passage, not only speaks to their complexities but also has redoubled the uncertainties they have imposed and impeded business spending that much more.

Fundamental Shortfalls
Time would seem to offer the only cure for these inhibiting influences, to allow memories of the Great Recession to fade and to clarify the provisions of these pieces of legislation. The longer this naturally slow-moving fix takes, though, the more this paucity of capital spending will impede the economy’s fundamental growth prospects. In the immediate instance, the wait simply reduces a source of demand and so limits the pace of quarter-to-quarter growth. Longer term, the lack of capital spending fundamentally will erode the economy’s productive power by limiting the base from which business and industry increase production, improve efficiency, and make productivity gains, for all inputs, labor most especially.

In weighting this longer-term, fundamental effect, the crucial thing to bear in mind is that the capital spending figures typically reported by the Commerce Department are a gross number. The new equipment, etc., serves to replace depreciated and obsolete equipment as well as expand existing facilities. Since that stock of equipment, etc., grows over time, so do the levels of depreciation and obsolescence, demanding that the economy, if it is to sustain a given growth rate, dedicate an ever greater portion of its gross domestic product (GDP) to capital spending each year. In general that has occurred. Back in the 1950s, capital spending of all kinds averaged between 10–11% of GDP. By the 1970s, that figure had risen to between 12–13%, and by the turn of this century, it was closer to 13–14% of GDP. Today’s problem is that the current slow capital-spending recovery has turned this trend around so that in recent years, new capital spending has remained well below 13% of GDP. The country is increasing its stock of productive equipment, technology, and premises at a significantly slower pace than in the past or than it needs to support historical growth rates over the longer term.

If the new pattern persists, the economy will indeed have a harder time generating historical growth rates. And because time is the only secure solution to business’ current reluctance to spend, it does indeed look as if the new, less expansive pattern will persist for the foreseeable future. To some extent, technology will help mitigate the adverse effect. The equipment, etc., used to replace the depreciated and obsolete carries with it superior technologies that allow it to offer more productive power than what it is replacing. Even so, this substandard capital spending recovery carries longer-term, fundamental impediments to growth that will become increasingly severe the longer these disappointing patterns persist.

 

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