Investment May Not Run on All Cylinders

When people hear that I am an economist, they think that I am all about the numbers. For better or worse, that is largely true. There are, however, times, when I also read lengthy reports, often produced by fellow economists, to find nuggets of information. The Federal Reserve's Beige Book is one example. It summarizes anecdotal evidence on how the economy has fared in the preceding two months. Its latest issue was released yesterday. Although yesterday's report concluded that the economy continued to grow, partially due to growth in investment, there were also signs of future weaknesses in consumption and, more importantly, investment, which still has not fully recovered. To ensure a durable investment recovery, businesses need many more customers, which will not emerge with large new tax cuts.

When people want to describe the nature of this recovery, they undoubtedly point to the fact that consumption never retreated, despite the first "job loss" recovery since World War II. This Energizer Bunny, though, may be running out of steam. The Beige Book showed a weak labor market, soaring health care costs, and declining consumer credit expansion. These are all signs that household spending will be more likely to slow than accelerate. Households simply don't see the income growth necessary to justify taking on more debt. Already spending for some items, such as cars, appears to be slowing.

As increases in household spending may shrink, economic growth has to rely more heavily on investment. After an unprecedented decline of nine quarters, business investment has increased for the last three quarters of 2003. More than 20 percent of growth in the fourth quarter of 2003 came from business investment.

However, a number of indicators suggest that investment growth may not be as strong and widespread as many economists have assumed. Josh Bivens, an economist with the Economic Policy Institute, for instance, points out that the investment boom is highly concentrated in high-tech goods. He argues that "manufacturing industries besides hi-tech continue to stagnate." These industries employ 94 percent of manufacturing workers. In the same vein, the Fed's Beige Book reported that the commercial construction sector remains "soft," suggesting that the prolonged decline in investment in structures, such as plants and office buildings, is not over. In the past three years there have been only two quarters when investment in commercial structures increased.

It is not only the present situation of investment that gives cause to worry, but also the future outlook. Capacity utilization, which is typically a leading indicator for investment, remains comparatively low. That is, firms have no real incentive to invest more. In the same vein, durable goods orders – a bellwether for the future of investment – declined in January by an unexpected 1.8 percent. Similarly, the Beige Book showed that in some parts of the country firms were reluctant to borrow more for capital spending, suggesting again that investment growth will likely not be strong. In other words, it's possible that the investment boom will fizzle before it has even really begun.

So far, investment still has a lot of catching up to do. Average investment growth in this recovery has been about one fourth of its typical increase in a recovery. Hence, despite gains, investment is as low – relative to the size of the economy – as it was in the middle of 1994. Even if investment and the economy grew from now on at the growth rates during prior recoveries, it would take almost 20 years to get the investment share of the economy back to its last high point of 12.6 percent in late 2000.

Couldn't the economy do without a lot more investment? Not really, because there is nothing else that could take its place. Consumers are maxed out on their credit cards, the federal government is already in debt up to its ears, and state and local governments are struggling to avoid the most severe cuts in services. Business investment is currently the primary engine for growth, but it appears that it is not firing on all cylinders and that it may sputter in the near future.

To insure a full recovery, businesses need more customers, not more cash. That is, further tax cuts cannot be the answer. For one, the last rounds of income tax cuts have failed to create enough well-paying jobs to avoid that households needed to borrow record amounts of money. And corporate tax cuts will only wash more money into the pockets of firms that are already flush with cash. Put differently, neither tax cuts for individuals nor tax cuts for corporations will likely create enough new customers to support a strong investment recovery. However, maintaining spending or even increasing it, paid for by repealing the tax cuts for the wealthy, would probably mean enough new customers for businesses, so that more investment actually makes sense for them. Sometimes reading lengthy reports is useful, if we want to design successful economic policy that takes into account how the economy really works.

  • Investment as Share of GDP
    Investment as share of GDP declined for an unprecedented nine consecutive quarters from the first quarter of 2001 to the second quarter of 2003. Even with a small recovery, investment’s share in the economy is still a long way away from its peak in the third quarter of 2000. With typical growth of the economy and of investment in a recovery, it would take almost 20 years before investment reached its last peak again.
    Source: Bureau of Economic Analysis, National Income and Product Accounts; National Bureau of Economic Research, Business Cycle Dates.
  • Liquid Assets as Share of Total Assets
    Non-financial corporations have increased their share of liquid assets – checking accounts, savings accounts, money market accounts, and the likes – out of total assets since March 2001. By September 2003, liquid assets amounted to 5.6% of total assets, their highest share since the end of 1966.
    Notes: Source is Board of Governors, Federal Reserve System, Flow of Funds Accounts of the United States. Liquid assets are the sum of checkable deposits and currency, time and savings deposits, money market fund shares, Security RPs, commercial paper, U.S. government securities, municipal securities and mutual fund shares.

Dr. Christian Weller is a senior economist at the Center for American Progress.