Investing for Widespread, Productive Growth

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    The parlous state of the U.S. economy weighed heavily on Americans’ minds as they headed to the polls this past November, with 63 percent citing the economy as the most important issue facing the country this election—well above the second most frequently mentioned issue, the war in Iraq, which 10 percent of respondents thought was the most important. And no wonder, amid bank failures and bailouts, rising job losses and lengthening unemployment lines, a volatile stock market and plummeting 401(k) account balances. With a new Congress and the Obama administration taking office in January, Americans are more than ready to see Washington swiftly enact policies to bring about an economic recovery that would ease the financial pain families are experiencing.

    Such stimulus steps are necessary and proper, but policymakers and the American people must recognize that the economic mess we are in did not happen overnight, and that the path to strong and durable long-term growth will not be a short jaunt. Two critical aspects of the long-term structural weaknesses of the U.S. economy are low business investment and declining productivity growth. These two trends go hand in hand. Business investment is one critical ingredient in faster productivity. And faster productivity growth is an important precondition to address some of the nation’s largest looming economic problems—low or even negative income growth, massive trade deficits, and the demographic challenges of generating payroll tax income to cover Social Security payments for the aging Baby Boom generation.

    How are business investment and productivity growth related? If a local restaurant spends money on upgrades in the kitchen, for example, it can cook food more quickly and thus generate more sales with the same number of workers in the same amount of time as before—the definition of productivity. This kind of 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.

    Over the long run, the gains from faster productivity growth should be equitably shared, such that higher productivity growth feeds into more jobs and more income for more workers to spend on more consumption items. This extra revenue will provide businesses with an incentive to increase their investments again in their buildings and equipment, thereby laying the foundation for even higher productivity in the future.

    This 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 and in most years even declined. And now that the power of the U.S. consumer to continue to drive the economy probably has reached its limit, it is even more apparent that a virtuous cycle is in danger of becoming a vicious cycle. Slow to nonexistent income growth does not give business executives an incentive to invest more money in growing their businesses, which in turn hampers the chances for stronger productivity growth in the future, thereby possibly reducing future income growth.

    The current crisis is an opportunity to take stock of past policies that contributed to this growing business investment and productivity crisis and, more importantly, to design and implement economic policies that could help the U.S. economy turn the corner on business investment and productivity growth. This paper reviews the existing evidence on business investment and productivity growth and concludes the following:

    • Productivity growth slowed in the 2000s. Labor productivity (measured as output per hour, the standard definition of productivity) gradually slowed after 2002. Labor productivity, for instance, fell below its long-term average of 2.2 percent for three years in a row, from 2005 to 2007. With growth slowing markedly in the second half of 2008, it is likely that this year will also show productivity growth below 2 percent—a nadir not experienced since the four-year period ending in 1991.
    • Business investment was low throughout the current business cycle. From March 2001, when the current business cycle started, to September 2008, business investment averaged 10.5 percent of GDP—the lowest average investment level since the 1960s.
    • Investment in this business cycle rested largely on commercial construction. Investment in commercial structures such as office buildings, hotels, hospitals, and mines soared to 4.0 percent of gross domestic product in the third quarter of 2008, its highest level since March 1986. In contrast, over the course of the current business cycle, the ratio of business investment in equipment and software fell from 9.0 percent of GDP in March 2001 to 7.0 percent in the third quarter of 2008, its lowest point since September 1992.
    • Businesses struggle to replace obsolete capital. Net investment—total new investment minus depreciation—as a share of GDP averaged 2.0 percent for the entire business cycle, the lowest level of any business cycle since World War II. Businesses invest more in computers, software, and other information technology assets that are necessary but also depreciate more quickly than other investments they made in the past. Businesses must now spend more to replace obsolete equipment, and thus more money must be spent in total, before the nation’s capital base actually begins to expand. The combination of low overall investment and quick depreciation means that the productive asset base in the United States is growing more slowly than in the past.
    • Declining investment in our knowledge-based economy. While investments in information processing and software equipment expanded relative to GDP by 1.6 percentage points during the 1990s, they have declined by 0.9 percentage points since March 2001. Additionally, during this 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 89.1 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 127.9 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 September 2008, consumer expenditures increased by an annualized inflation-adjusted rate of 2.5 percent—the lowest consumption growth rate of any business cycle since World War II. In addition, much of the past consumption increases was funded out of new debt, burdening consumers with record amounts of debt and making a quick recovery in consumption less likely.
    • Investment and productivity growth may be linked. Since 1947, faster productivity growth has been preceded by business investment expansions relative to GDP. Similarly, periods of stronger investment growth were typically followed by an acceleration of productivity growth over a span of five years. Given the low levels of 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 74.8 percent of economic growth during this business cycle—the highest share of any business cycle since the 1950s. But this consumption was largely driven by an unprecedented and unsustainable debt expansion that appears to have ended. If investment growth were to rebound to the levels of the 1990s, when it contributed to over one-fifth the total GDP growth rate, investment growth could then substitute for faltering consumption growth.

    Boosting business investment 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. Faster investment growth alone will not fix all of the nation’s economic woes, but it would be one of many steps in the right direction. In essence, it would start putting the economy on a more sustainable economic path than the debt-driven growth of the past seven years. And over the long run, faster investment growth could help lay a stronger foundation for innovation—the key but elusive measure of our nation’s overall ability to address a number of large and sometimes even growing challenges, such as declining incomes, an aging population, and large trade deficits.

    Policymakers face many challenges in helping the economy recover, and this area is not an exception. Businesses will not invest unless Americans’ incomes rise faster than they have recently. Fundamentally, policymakers need to ensure that workers will begin to see job growth and that the economy will reverse the decline in jobs throughout 2008. 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 as well as consider some worrying trends in all four of these interconnected arenas. In the pages that follow, we will revise and update our first examination of these issues, “Ignoring Productivity at Our Peril: Slowing Productivity Growth and Low Business Investment Threaten Our Economy,” which was published in August 2008 by the Center for American Progress, and then detail why more robust business investment growth and higher income growth are necessary for our economy to spark innovation and new economic opportunities to help pull the United States out of its current economic downturn, focus again on our long-term needs, and ultimately provide a path for employees, employers, and the overall nation to grow forward together.

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