Robert Samuelson
WASHINGTON – Suppose we could design the next phase of the economic recovery. What would it look like? Here’s one pleasing vision. Business investment in plants and equipment – factories, computers, freight cars, software, machine tools – would take the lead. This would boost job creation and productivity (aka efficiency), enabling companies to increase wages without raising prices. It’s a splendid fantasy.
But it just might come true. That’s the message from the government’s recent second-quarter report on gross domestic product (GDP), which measures the economy’s growth. Business investment rose at a strong 8.4 percent annual rate after adjusting for inflation. Although the spurt partly reflected a bounce back from a weak first quarter, some economists think it marks a significant turning point.
“Companies are beginning to spend again,” says Nariman Behravesh of IHS Global Insight. Mark Zandi of Moody’s Analytics is equally optimistic. “Businesses are shifting their focus from controlling costs to revenue [i.e. sales] growth,” he says. “This requires that … they expand their operations.”
Until now, weak business investment has undermined the recovery. Corporate profits have grown steadily; by 2013, they were up 23 percent from 2006, the pre-recession high. But plant and equipment spending has sputtered. In 2013, it was only 6 percent higher than its previous peak in 2008. (Both figures are unadjusted for inflation.) Companies have been extremely risk-averse.
“Businesses have largely held onto [their] income as retained earnings, rather than using it to finance additional investment,” wrote economists Martin Neil Baily and Barry Bosworth of the Brookings Institution in a 2013 paper. “Companies have become [lenders] to other sectors. … This is an unprecedented phenomenon; historically, the business sector has been a net borrower of funds from households in order to finance its investments.”
Similarly, a recent Federal Reserve study concluded that “investment currently looks quite low relative to profits.” Indeed, the study found that net business investment after depreciation (obsolescence and wear and tear), as a share of the existing investment base, has fallen “to its lowest level since World War II.”
The reversal of these trends would represent a big boost for the economy. Of course, it’s not a slam dunk. One obvious unknown is the need for added capacity. Perhaps the main reason that companies have curbed investment is that existing facilities were ample to satisfy demand. But that could be changing.
Although there seem to be few bottlenecks, companies could be approaching existing limits. The Federal Reserve’s capacity utilization index for industry was 79.2 in July 2014, up from 77.5 in July 2013 and way up from its 2009 low of 66.9. The index is also near its 1972-2013 average of 80.1, though it’s well below its 1994-95 high of 85.
If – as Zandi argues – businesses are shifting from cost-cutting to expanding output, they need customers to buy the added production. A second unknown is: Are the customers willing? There are grounds to wonder.
Overseas markets (Europe, Japan, China) are weak, blunting the demand for U.S. exports. Likewise, American households have spent cautiously as they paid down debt and rebuilt savings after the financial crisis. This spawned a vicious cycle – weak consumer spending meant weak investment spending. Now, the crucial question is whether the cycle is about to reverse: Will stronger consumer confidence and spending support stronger business confidence and investment?
Robert Samuelson’s column is distributed by The Washington Post Writers Group.