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.


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.

8 comments… add one
  • steve Link

    Duy, via Thoma has another take. I have said here and in my own writings may times that something changed in the 1980s. Since then we have not been creating jobs like we should. We have run up debt even when the economy was, seemingly, performing well. I am not sure what factor or combination of factors changed, but we have been in a structural change with this crisis exacerbating it and probably caused by some of those same factors.


  • steve Link
  • Since the point made by Mark Thoma is a point I’ve been making for the last 30 years which, as he acknowledges, was largely pooh-poohed by Mark Thoma, other economists, and most political leaders, it would be silly of me to start arguing against it now. I’ve worked for manufacturing companies and seen the transition from manufacturing and engineering here to manufacturing overseas/engineering here, to manufacturing and engineering overseas. I’ve seen it in my clients.

    That’s how I happened to work in Germany. The company for which I worked moved first its manufacturing and then its engineering (including me) to Germany.

    What changed in the 1960’s? Lots of things. First, we’d paid down the debt we’d incurred during WWII. Congressmen discovered that they could engage in fiscal stimulus (either of the spending or tax-cutting variety) by borrowing and would pay no penalty at election time for borrowing. We implemented Medicare and Medicaid which at the very least and from the very start raised the cost of employment. Government largesse began to reach segments of the population that had frequently been skipped before (mostly African Americans).

  • My old eyes misread your comment about 1980s as 1960s.

    Here’s what happened in the 1980s:

    • China changed its economic policy away from autarky in 1979. That has made moving manufacturing to China a viable alternative to capital investment here.
    • The consistent growth in healthcare costs had reached the point at which it was really beginning to bite. Cf. my point about costs of employment above.
    • The Tax Reform Act of 1986 removed the tax benefits from capital gains. That gave a relative advantage to consumption over investment and savings.
    • Ma Bell was broken up in 1984. This resulted in a number of technological advances.
    • The technological advances in telephony and computing made some business practices possible that among other things greatly reduced the amount of inventory a company needed to stock. That made capital significantly more efficient than it had been.
    • For tax, social, and other reasons much of the money that freed up were taken in the form of profits.
  • Drew Link

    Three Points.

    1. I agree with Prof. Rajan that the continuing interest rate subsidy will only delay the inevitable and necessary restructuring. But one does have to consider what a central banker worries about: a deflationary spiral. Steve V?

    2. Mr. Smith bores. Yes, it is true that quarterly earnings expectations are a fact of public corporation life, but I think greatly over rated. Its the cheap and easy criticism. Public corporations really, really do like to grow. It creates power, status, management income etc. The academic argument a couple decades ago was that management were nothing but drunken sailors, spending money for their own personal advancement at the expense of shareholders. Now, when they conserve cash, they get the opposite criticism. I suspect management is fairly rational in both settings. Anyone considered that their are relatively good and bad investment environments?

    3. But if you don’t like public equity, here I am! If I were to describe in one sentence what we do, it would be: we acquire family owned or corporate orphaned businesses (read: risk averse and underinvested), and then we apply our capital and operating expertise to fully extract the potential of these suboptimizing businesses, creating growth in revenues, earnings and employment. And yes, we don’t have to worry about quarterly earnings; so we can take a 3-7 year view. Its a nice setting.
    We are growth machines. (Hold on a second, I’ve got to go put on David Bowie’s “Heroes” at max volume.)

    I’m back. And yet, with all the faux hand wringing about investment, we have politicians and pundits desiring to increase the taxation on private equity. Brilliant move there.

    “………we could be heroes…..just for one day….”

  • I agree with Prof. Rajan that the continuing interest rate subsidy will only delay the inevitable and necessary restructuring. But one does have to consider what a central banker worries about: a deflationary spiral. Steve V?

    I think these fears are somwhat over-rated. Yes, in looking at the CPI there is some evidence we had some deflation, but it doesn’t seem to be an on-going problem. As such all of our policies that are aimed at getting contstruction/finance going again are largely trying to prevent the inevitable restructuring we need before we’ll grow again.

    As for manufacturing what happened? My first guess would be technology happened. We used to be a world where the dominant job was agriculture…now a mere fraction of the world’s population engages in that activity and in industrialized countries the percentage of the population that does it is even smaller.

    I’ve heard that manufacturing employment is on the decline worldwide. This would fit with the technology hypothesis, IMO, since technology is not constrained by national borders. Here is one paper that looks at manufactuing in OECD countries.

    Are we going to stop or reverse this trend? No more than we can go back to an agrarian based economy…sure we could in theory, but lets not waste time talking about complete Bravo Sierra.

  • Hmm…and no responses. Okay, we’ll call it settled then and all this hand wringing about manufacturing jobs can be devoted to something else. Good.

  • steve Link

    LOL, to be continued another time.


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