How Strong Is Business Investment, Really?

DeLong rises to defend Ben Bernanke, against claims that unconventional monetary policy in recent years has discouraged businesses from investing. Business investment is doing just fine, he says:

As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?! … As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high?

As evidence, DeLong points to the fact that nonresidential investment as a share of GDP is back where it was at the last two business cycle peaks.

As it happens, I agree with DeLong that it’s hard to make a convincing case that unconventional monetary policy is holding back business investment. Arguments about the awfulness of low interest rates seem more political or ideological, based on the real or imagined interests of interest-receivers than any identifiable economic analysis. But there’s a danger of overselling the opposite case.

It is certainly true that, as a share of potential GDP, nonresidential investment is not low by historical standards. But is this the right measure to be looking at? I think not, for a couple of reasons, one relatively minor and one major. The minor reason is that the recent redefinition of investment by the BEA to include various IP spending makes historical comparisons problematic. If we define investment as the BEA did until 2013, and as businesses still do under GAAP accounting standards, the investment share of GDP remains quite low compared to previous expansions. The major reason is that it’s misleading to evaluate investment relative to (actual or potential GDP), since weak investment will itself lead to slower GDP growth. [1]

On the first point: In 2013, the BEA redefined investment to include a variety of IP-related spending, including the commercial development of movies, books, music, etc. as well as research and development. We can debate whether, conceptually, Sony making Steve Jobs is the same kind of thing as Steve Jobs and his crew making the iPhone. But it’s important to realize that the apparent strength of investment spending in recent expansions is more about the former kind of activity than the latter.  [2] More relevant for present purposes, since this kind of spending was not counted as investment — or even broken out separately, in many cases — prior to 2013, the older data are contemporary imputations. We should be skeptical of comparing today’s investment-cum-IP-and-R&D to the levels of 10 or 20 years ago, since 10 or 20 years ago it wasn’t even being measured. This means that historical comparisons are considerably more treacherous than usual. And if you count just traditional (GAAP) investment, or even traditional investment plus R&D, then investment has not, in fact, returned to its 2007 share of GDP, and remains well below long-run average levels. [3]

investment

More importantly, using potential GDP as the yardstick is misleading because potential GDP is calculated simply as a trend of actual GDP, with a heavier weight on more recent observations. By construction, it is impossible for actual GDP to remain below potential for an extended period. So the fact that the current recovery is weak by historical standards automatically pulls down potential GDP, and makes the relative performance of investment look good.

We usually think that investment spending the single most important factor in business-cycle fluctuations. If weak investment growth results in a lower overall level of economic activity, investment as a share of GDP will look higher. Conversely, an investment boom that leads to rapid growth of the economy may not show up as an especially high investment share of GDP. So to get a clear sense of the performance of business investment, its better to look at the real growth of investment spending over a full business cycle, measured in inflation-adjusted dollars, not in percent of GDP. And when we do this, we see that the investment performance of the most recent cycle is the weakest on record — even using the BEA’s newer, more generous definition of investment.

investmentcycles_broad
Real investment growth, BEA definition

The figure above shows the cumulative change in real investment spending since the previous business-cycle peak, using the current (broad) BEA definition. The next figure shows the same thing, but for the older, narrower GAAP definition. Data for both figures is taken from the aggregates published by the BEA, so it includes closely held corporations as well as publicly-traded ones. As the figures show, the most recent cycle is a clear outlier, both for the depth and duration of the fall in investment during the downturn itself, and even more for the slowness of the subsequent recovery.

investmentcycles_narrow
Real investment growth, plant and equipment only

Even using the BEA’s more generous definition, it took over 5 years for inflation-adjusted investment spending to recover its previous peak. (By the narrower GAAP definition, it took six years.) Five years after the average postwar business cycle peak, BEA investment spending had already risen 20 percent in real terms. As of the second quarter of 2015 — seven-and-a-half years after the most recent peak, and six years into the recovery — broad investment spending was up only 10 percent from its previous peak. (GAAP investment spending was up just 8.5 percent.) In the four previous postwar recoveries that lasted this long, real investment spending was up 63, 24, 56, and 21 percent respectively. So the current cycle has had less than half the investment growth of the weakest previous cycle. And it’s worth noting that the next two weakest investment performances of the ten postwar cycles came in the 1980s and the 2000s. In recent years, only the tech-boom period of the 1990s has matched the consistent investment growth of the 1950s, 1960s and 1970s.

So I don’t think it’s time to hang the “Mission Accomplished” banner up on Maiden Lane quite yet.

As DeLong says, it’s not surprising that business investment is weak given how far output is below trend. But the whole point of monetary policy is to stabilize output. For monetary policy to work, it needs to able to reliably offset lower than normal spending in other areas with stronger than normal investment spending. If after six years of extraordinarily stimulative monetary policy (and extraordinarily high corporate profits), business investment is just “where one would expect given that the overall recovery has been disappointing,” that’s a sign of failure, not success.

 

[1] Another minor issue, which I can’t discuss now, is DeLong’s choice to compare “real” (inflation-adjusted) spending to “real” GDP, rather than the more usual ratio of nominal values. Since the price index for investment goods consistent rises more slowly than the index for GDP as a whole, this makes current investment spending look higher relative to past investment spending.

[2] This IP spending is not generally counted as investment in the GAAP accounting rules followed by private businesses. As I’ve mentioned before, it’s problematic that national accounts diverge from private accounts this way. It seems to be part of a troubling trend of national accounts being colonized by economic theory.

[3] R&D spending is at least reported in financial statements, though I’m not sure how consistently. But with the other new types of IP investment — which account for the majority of it — the BEA has invented a category that doesn’t exist in business accounts at all. So the historical numbers must involve more than usual amount degree of guesswork.

Is Capital Being Reallocated to High-Tech Industries?

Readers of this blog are familiar with the “short-termism” position: Because of the rise in shareholder power, the marginal use of funds for many corporations is no longer fixed investment, but increased payouts in the form of dividends and sharebuybacks. We’re already seeing some backlash against this view; I expect we’ll be seeing lots more.

The claim on the other side is that increased payouts from established corporations are nothing to worry about, because they increase the funds available to newer firms and sectors. We are trying to explore the evidence on this empirically. In a previous post, I asked if the shareholder revolution had been followed by an increase in the share of smaller, newer firms. I concluded that it didn’t look like it. Now, in this post and the following one, we’ll look at things by industry.

In that earlier post, I focused on publicly traded corporations. I know some people don’t like this — new companies, after all, aren’t going to be publicly traded. Of course in an ideal world we would not limit this kind of analysis to public traded firms. But for the moment, this is where the data is; by their nature, publicly traded corporations are much more transparent than other kinds of businesses, so for a lot of questions that’s where you have to go. (Maybe one day I’ll get funding to purchase access to firm-level financial data for nontraded firms; but even then I doubt it would be possible to do the sort of historical analysis I’m interested in.) Anyway, it seems unlikely that the behavior of privately held corporations is radically different from publicly traded one; I have a hard time imagining a set of institutions that reliably channel funds to smaller, newer firms but stop working entirely as soon as they are listed on a stock market. And I’m getting a bit impatient with people who seem to use the possibility that things might look totally different in the part of the economy that’s hard to see, as an excuse for ignoring what’s happening in the parts we do see.

Besides, the magnitudes don’t work. Publicly traded corporations continue to account for the bulk of economic activity in the US. For example, we can compare the total assets of the nonfinancial corporate sector, including closely held corporations, with the total assets of publicly traded firms listed in the Compustat database. Over the past decade, the latter number is consistently around 90 percent of the former. Other comparisons will give somewhat different values, but no matter how you measure, the majority of corporations in the US are going to be publicly traded. Anyway, for better or worse, I’m again looking at publicly-traded firms here.

In the simplest version of the capital-reallocation story, payouts from old, declining industries are, thanks to the magic of the capital markets, used to fund investment in new, technology-intensive industries. So the obvious question is, has there in fact been a shift in investment from the old smokestack industries to the newer high-tech ones?

One problem is defining investment. The accounting rules followed by American businesses generally allow an expense to be capitalized only when it is associated with a tangible asset. R&D spending, in particular, must be treated as a current cost. The BEA, however, has since 2013 treated R&D spending, along with other forms of intellectual property production, as a form of investment. R&D does have investment-like properties; arguably it’s the most relevant form of investment for some technology-intensive sectors. But the problem with redefining investment this way is that it creates inconsistencies with the data reported by individual companies, and with other aggregate data. For one thing, if R&D is capitalized rather than expensed, then profits have to be increased by the same amount. And then some assumptions have to be made about the depreciation rate of intellectual property, resulting in a pseudo asset in the aggregate statistics that is not reported on any company’s books. I’m not sure what the best solution is. [1]

Fortunately, companies do report R&D as a separate component of expenses, so it is possible to use either definition of investment with firm-level data from Compustat. The following figure shows the share of total corporate investment, under each definition, of a group of six high-tech industries: drugs; computers; communications equipment; medical equipment; scientific equipment other electronic goods; and software and data processing. [2]

hitech

As you can see, R&D spending is very important for these industries; for the past 20 years, it has consistently exceed investment spending as traditionally defined. Using the older, narrow definition, these industries account for no greater share of investment in the US than they did 50 years ago; with R&D included, their share of total investment has more than doubled. But both measures show the high-tech share of investment peaking in the late 1990s; for the past 15 years, it has steadily declined.

Obviously, this doesn’t tell us anything about why investment has stalled in these industries since the end of the tech boom. But it does at least suggest some problems with a simple story in which financial markets reallocate capital from old industries to newer ones.

The next figure breaks out the industries within the high-tech group. Here we’re looking at the broad measure of investment, which incudes R&D.

techsectors

As you can see, the decline in high-tech investment is consistent across the high-tech sectors. While the exact timing varies, in the 1980s and 1990s all of these sectors saw a rising share of investment; in the past 15 years, none have. [3]  So we can safely say: In the universe of publicly traded corporations, the sectors we think would benefit from reallocation of capital were indeed investing heavily in the decades before 2000; but since then, they have not been. The decline in investment spending in the pharmaceutical industry — which, again, includes R&D spending on new drugs — is especially striking.

Where has investment been growing, then? Here:

hitech_oil

The red lines show broad and narrow investment for oil and gas and related industries — SICs 101-138, 291-299, and 492. Either way you measure investment, the increase over the past 15 years has dwarfed that in any other industry. Note that oil and gas, unlike the high-tech industries, is less R&D-intensive than the corporate sector as a whole. Looking only at plant and equipment, fossil fuels account for 40 percent of total corporate investment; by this measure, in some recent years, investment here has exceeded that of all manufacturing together. With R&D included, by contrast, fossil fuels account for “only” a third of US investment.

In the next post, I’ll look at the other key financial flows — cashflow from operations, shareholder payouts, and borrowing — for the tech industries, compared with corporations in general. As we’ll see, while at one point payouts were lower in these industries than elsewhere, over the past 15 years they have increased even faster than for publicly traded corporations as a whole. In the meantime:

Very few of the people talking about the dynamic way American financial markets reallocate capital have, I suspect, a clear idea of the actual reallocation that is taking place. Save for another time the question of whether this huge growth in fossil fuel extraction is a good thing for the United States or the world. (Spoiler: It’s very bad.) I think it’s hard to argue with a straight face that shareholder payouts at Apple or GE are what’s funding fracking in North Dakota.

 

[1] This seems to be part of a larger phenomenon of the official statistical agencies being pulled into the orbit of economic theory and away from business accounting practices. It seems to me that allowing the official statistics to drift away from the statistics actually used by households and businesses creates all kinds of problems.

[2] Specifically, it is SICs 83, 357, 366, 367, 382, 384, and 737. I took this specific definition from Brown, Fazzari and Petersen. It seems to be standard in the literature.

[3] Since you are probably wondering: About two-thirds of that spike in software investment around 1970 is IBM, with Xerox and Unisys accounting for most of the rest.