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Tuesday, December 3, 2019

Reduced Investment Is No Recession Warning

It is easy to misinterpret current trends in the U.S. economy. One thing is increasingly clear, though: that business investments take a breather is not a sign of a recession. On the contrary.

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On November 25 the Wall Street Journal reported (print edition p. B1):
Many of the biggest U.S. companies are moderating their spending on equipment and other capital investment, as an uncertainty business environment prompts some to postpone or shelve otherwise promising projects. That could pose a continuing drag on economic growth.
I am not going to blame the Journal for coming to the wrong conclusion here. Yes, it is correct that we have seen a cooling-off in investments - I have discussed it here on several occasions in the past six months - but its cause is not one of growing uncertainty. Instead, it has to do with the rapid capacity expansion that took place in the aftermath of the Trump tax reform.

Journalists and analysts tend to misunderstand the nature of business investments. Reports and comments often rely on the false premise that businesses invest at some steady pace; they don't. They invest for two reasons: to keep their capital stock up to date, and to expand capacity. The investments we have seen since the Trump tax cuts, that have now tapered off, is of the second kind. 

Suppose GDP grows in cyclical phases, as the blue function suggests in Figure 1. Suppose also that the capital stock, K, used to produce that GDP, is initially constant (grey function). When businesses anticipate that demand for their products will exceed their existing production capacity, they decide to add new offices, manufacturing facilities, warehouses, equipment and machinery. This addition is marked by I. The phase-in of new capacity, forming the staircase in Figure 1, gradually expands capacity until businesses feel confident they have the capacity they need for the near-term future: 

Figure 1
Once businesses reach the capacity they determine they need for now, they terminate the part of investments aimed at growing capacity (see red ellipses above). All that remains is the investment activity that keeps their current capacity up to date. 

If overall economic activity showed signs of decline, it would be reasonable to expect the termination of capacity-enhancing investments to be guided by rising uncertainty. Suppose, in Figure 1, that the blue function continued downward after its first peak. In this situation businesses in general would find themselves sitting on excess capacity. We saw a glimpse of this scenario this past summer, when I warned that we were looking at an economic breather that could grow to a recession. 

Later I explained that the possibility of a recession hinged on two things: that consumers showed weakness in the holiday spending season, and that manufacturers plateaued investments beyond the first quarter of next year. The latter depends in part on the former, and since consumers thus far have shown strength in their holiday spending, it is likely that manufacturing investments will pick up again in the spring of next year (possibly earlier, but not likely).

Employment numbers confirm that the threat of a recession is remote. Since the macroeconomic trends in the U.S. economy remain strong, what we are seeing in terms of investments is a plateau in capacity expansion, not a sign of rising uncertainty. 

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