When Businesses Don’t Invest

Finance professor Raghu Rajan summarizes my view pretty nicely:

But this recession is not a “usual” recession. It followed a period of ultra-low interest rates when interest sensitive segments of the economy got a tremendous boost. The United States had far too much productive capacity devoted to durable goods and houses, because consumers could obtain financing for them easily. With households recovering slowly from the overhang of debt resulting from the binge, and with lenders extremely risk averse, it is unrealistic to expect households to spend beyond their means again, and unwise to try to tempt them to do so.

If households are going to want fewer houses, industries such as construction will have to shrink (as should the financial sector that channeled the easy credit). A significant number of jobs will disappear permanently, and workers who know how to build houses or to sell them will have to learn new skills if they can. Put differently, the productive capacity of the economy has shrunk. Resources have to be reallocated into new sectors so that any recovery is robust, and not simply a resumption of the old unsustainable binge. The United States economy has to find new pathways for growth. And this will not necessarily be facilitated by ultra-low interest rates.

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More important, the United States also has a problem of distorted supply. Prices in the economy should reflect the past misallocation of resources and move resources away from areas like housing and finance. A lot of people have to be retrained for the jobs that will be created in the future, not left lamenting for the jobs they had in the past. A Fed that keeps real interest rates at a sustained negative level will stand in the way of the needed reallocation.

Much of the business investment of the last decade has been devoted to construction. Otherwise it’s been flagging or, at the very least, inadequate. Business investment today creates the space in which the new enterprises of tomorrow take root. Too much policy has been directed towards a return to the status quo ante, trying to make home construction return to its former glory or ensuring that the financial sector doesn’t shrink as it must if the economy is to right itself.

I thought of writing a satirical post, describing the moves the Roosevelt Administration would have taken had it used the same strategy as the present one has. Presumably, subsidies to carriage manufacturers. In 1930 (or even 1950) roads capable of sustaining auto and truck traffic were the the equivalent of 1960’s aerospace and today’s Internet. That’s not the case anymore.

Yves Smith sounds a similar note (also here):

Unbeknownst to most commentators, corporations in the US and many advanced economies have been underinvesting for some time.

The normal state of affairs is for households to save for large purchases, retirement and emergencies, and for businesses to tap those savings via borrowings or equity investments to help fund the expansion of their businesses.

But many economies have abandoned that pattern. For instance, IMF and World Bank studies found a reduced reinvestment rate of profits in many Asian nations following the 1998 crisis. Similarly, a 2005 JPMorgan report noted with concern that since 2002, US corporations on average ran a net financial surplus of 1.7 percent of GDP, which contrasted with an average deficit of 1.2 percent of GDP for the preceding forty years. Companies as a whole historically ran fiscal surpluses, meaning in aggregate they saved rather than expanded, in economic downturns, not expansion phases.

The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies.

I attribute that to a combination of tax policy and businesses increasingly seeing themselves as financial speculators rather than providers of goods and services. I think that last is an artifact of low interest rates over a protracted period, increased regulation making hiring people to actually do things increasingly burdensome, and more MBAs in top management positions. People tend to do what they’re trained to do and what they’ve got a passion for. If their passion is making hamburgers, they’re going to make hamburgers and, possibly, like Ray Kroc they’ll make money doing it. If their passion is making money, they don’t much care whether they make hamburgers or not. Buying and selling stock or other financial instruments will do just fine.