“…most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits–of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities…if the animal spirits are dimmed and the spontaneous optimism falters… enterprise will fade and die,” – J.M Keynes: The General Theory of Employment, Interest, and Money
Don’t blame the consumer
If the U.S. economy does slip into a recession, and it’s not clear that it will (as of 7.13.01), we may already know the culprit: businesses have cut back on investment.
Mixed messages – no recession yet?
The most recent data (7.27.01) on the total production in the economy shows that the gross domestic product (GDP) grew at an annual rate of 0.7% in the second quarter. This was down from 1.3% in the first quarter, and was the slowest growth rate in several years, but it was still positive.
The unemployment rate stands at 4.5% in June (up from 4% at the end of last year, but stable since April). In addition, employment seems to be leveling off (see graph) but not yet substantially declining.
In addition, there have been several months of declining production in the industrial sector of the economy, and weaknesses in other areas as well.
If there is indeed a recession on its way, what might be the cause?
It appears that consumption is holding up well, but investment appears to be dragging the economy down.
The following graphs show investment and consumption growth rates over the past couple of years. The big outlier appears to be the recent decline in investment. (Fixed non-residential investment is primarily investment by firms). Residential investment has been growing over the past two quarters.
These graphs suggest that the slowing of the economy is the result of reductions in investments, rather than a reduction in consumer spending. (But see note 1 below).
Putting it together: components of GDP.
Gross Domestic Product (GDP) is the most common measure of the economic output, and can be broken down into components. The basic idea is that supply equals demand. Supply is the total amount of goods and services produced (Y) as measured by GDP, and demand is measured by the sum of consumption (C), investment (I), government expenditures (G), and net exports (exports, X, minus imports, M).
This relation is easily described by Y = C + I + G + (X – M).
Each year each of these components will change by a certain amount, and so we can decompose a percent change in GDP into a change in each of the demand components. The following graph shows such decomposition for the past two years. As you can see, the reduction in the growth rate of output, especially in the last quarter is associated with a drop in investment. (But see note 2 below).
Explanations for weak investment:
Of course, even if we conclude that a decline in investment was the cause of a slowdown, what was the cause of the decline in investment?
One idea is that firms saw a decline in consumer consumption in the future and decided to reduce investment now. However, since consumption has held up well, this story seems unlikely.
A second idea is that the higher interest rates that resulted from Fed policy in early and mid 2000 caused the decline. Since monetary policy works with a time lag, the investment reduction may be in part a response to higher interest rates from last year.
However, since then, the Fed has worked aggressively to lower rates and the recent decline in investment should have been mitigated by the recent actions of the Fed. This might lead to another explanation – once the Fed began to lower interest rates, firms could reasonably conclude that rates would fall even farther and would therefore delay investments until the rates hit bottom.
Some observers have suggested that firms “over-invested” last year and prior to 2000 (in part because of fears of the Y2K bug). The current decline in investment may simply be a correction to the excesses of the past.
Yet another idea has to do with the stock market. Since the stock market has fallen considerably since last year, it is reasonable to conclude that the level of investment will fall as well. (If you remember Macro 101, this is just Tobin’s-q theory of investment).
The election turmoil of last year would also seem to be a candidate since it may have added a degree of uneasiness to people’s perceptions of the economy. However, throughout the election mess one thing was always clear: either a democrat or a republican would be in office in January. In this respect, this election was no different than most.
Finally, as the Keynes quote above would suggest, the decline in investment might simply represent “animal spirits,” and a decline in optimism might create a self-fulfilling prophesy.
Most likely it is a combination of these effects.
For a comprehensive and up-to-date collection of macroeconomic data I highly recommend the national economic trends publication by the St. Louis Fed.
Click here for a discussion of some basic investment theory including Tobin’s q.
Note 1: Since investment by its nature is forward-looking, a decline in investment can come about because of a forecast of future declines in consumption. So, a decline in investment could in principle be a result of producer’s gloomy forecasts of consumers. However, there seems to be little it in the macro data that would suggest that gloomy forecasts would be the result of lower consumer spending (especially with the tax cut on tap).
Note 2. It also appears that a drop in exports may also be part of the story, although it appears that the reduction in imports offsets this change.