Ignoring Productivity At Our Peril
Investing in our nation’s future can mean different things to different people. Members of local school boards understand that functioning heating and air conditioning systems help students learn. College coaches know that a bigger stadium with more comfortable seats and better vendors will make for a more enjoyable experience that, in turn, will result in higher revenues and more competitive athletic programs. And broadcast executives invest in new, high definition cameras to give viewers superior picture quality to build program loyalty. These types of investments have one thing in common—they allow schools, sports teams, and TV stations to be more productive. Teachers, athletes, and newscasters can generate a more enjoyable experience and more revenue in the same amount of time.
That’s the definition of higher productivity. Similarly, business investment is related to a company’s productivity and ultimately to the entire economy’s performance. More business investment can lead to higher future productivity growth via an enlarged capital base. The rewards of higher productivity growth come in the form of more money for workers to spend on consumption items. This extra money will provide businesses with an incentive to invest more in their buildings and equipment, thereby laying the foundation for even higher productivity in the future.
The virtuous cycle of higher investment, rising productivity growth, and growing income helped lift almost all economic boats in the late 1990s. Since the turn of the century, however, investment growth has been anemic, productivity growth has declined, and income growth has stagnated. A virtuous cycle is in danger of becoming a vicious cycle. Slow income growth does not give business executives an incentive to invest more money in growing their businesses, which in turn hampers productivity growth, thereby reducing future income growth.
Our national economy is not necessarily locked into such a vicious cycle, but government policymakers are currently ignoring these trends at our peril. This paper reviews the existing evidence on business investment and productivity growth and concludes the following:
- Productivity growth has slowed since the 1990s: At the end of the 20th century, both labor productivity (measured as output per hour, the standard definition of productivity) and so-called multifactor productivity (economists’ approximation of innovation in the economy) grew rapidly—on average by 2.4 percent annually between the end of 1995 and March 2001, compared to 1.5 percent between 1973 and 1995—leaving decades of slow productivity growth behind. After 2002, however, productivity growth gradually slowed, and in 2006 the figure reached its lowest level—1.6 percent—since 1997.
- Business investment has been low: After reaching 12.6 percent of gross domestic product in 2000, business investment fell to 9.7 percent in March 2004, its lowest level since September 1992. Business investment then rebounded, reaching a level of 10.7 percent of GDP in the third quarter of 2006, before declining to 10.5 percent in the first quarter of 2007.
- The recovery in investment was a result of a building boom and not an equipment gain. Much of the recovery in business investment, small as it was, during this business cycle was due to investment in structures rather than in equipment. To date, investments in equipment and software have not recovered. Equipment investment dropped to 7.2 percent in the first quarter of 2004, down from a high of 9.4 percent in the third quarter of 2000. By the first quarter of 2007, equipment investment stood at just 7.3 percent of GDP.
- Net investment as a share of GDP has been declining: Net investment—total new investment minus depreciation—is barely keeping pace as businesses invest more in computers, software and other information technology assets that depreciate more quickly than in the past. Now businesses must spend more money to replace obsolete equipment, and thus more money must be spent in total, before the nation’s capital base actually expands. During the current business cycle, which started in March 2001, net investment as a share of GDP fell to a historic low of 1.5 percent.
- Little investment in the knowledge-based economy: While investments in information processing and software equipment expanded relative to GDP by 1.3 percentage points during the 1990s, they have declined by 0.7 percentage points since March
- 2001. Over that same period the capital stock in information processing equipment and software, net of depreciation, declined relative to GDP for the first time since the early 1950s.
- Businesses used money for share repurchases and dividends instead of capital expenditures: The share of pre-tax profits used for net share repurchases and dividend payouts was 84.2 percent during the current business cycle, larger than it was for any previous business cycle. The share of after-tax profits used for net share repurchases and dividend payouts was 120.7 percent, another record high for any business cycle.
- Consumption growth did not provide sufficient incentives for businesses to invest: Throughout the current business cycle, from March 2001 to March 2007, consumer expenditures increased by an annualized inflation-adjusted rate of 3.2 percent, below the consumption growth rate of the 1980s and the 1990s. In addition, consumption so far this business cycle has been fueled to a much larger degree by new debt. Household debt grew more than four times faster in this business cycle than in the 1990s.
- Investment and productivity growth may be linked: Since 1947, faster productivity growth was preceded by business investment expansions relative to GDP. Periods of stronger investment growth were typically followed by an acceleration of productivity growth over a span of five years. Given low business investment levels in the United States in the 21st century, government policymakers may soon discover that the reverse is also true.
- Business investment could replace consumers as the driver of the economy: Stronger business investment growth could give the economy new momentum as consumption growth slows. Consumption has contributed to 83.9 percent of economic growth during this business cycle. But this consumption was largely driven by an unprecedented debt expansion that is now coming to an end. If investment growth were to rebound to the levels of the 1990s, when it contributed to over one-fifth of the total GDP growth rate, investment growth could then substitute for the waning momentum of consumption-led economic growth.
Boosting business investment to overcome indications of a vicious productivity cycle taking hold in our economy would have positive effects for the economy both in the short term and the long term. In the immediate future, faster investment growth could give the economy a much-needed boost as consumer spending slows in the wake of a massive debt run-up and as households concentrate on repaying their record-level debt. Over the long term, faster investment growth could help lay a stronger foundation for innovation—the key but elusive measure of our nation’s overall competitive advantage in the global economy.
Policymakers, however, face a dual challenge. Businesses will not invest unless incomes rise faster than they have recently, which means policymakers need to ensure that workers can see more gains from a growing economy in the form of faster job growth and higher wage growth. At the same time, policymakers must create additional incentives for companies to invest in new technologies appropriate for a creative U.S. economy that remains on the cutting edge of global innovation.
This paper will examine the links between investment, productivity, income, and economic growth, and consider some worrying trends in all four of these interconnected arenas. We will then detail why more robust business investment growth and higher income growth are necessary for our economy to spark innovation and new economic opportunities for employers and employees alike.
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