For those who wonder why US economic growth this cycle significantly underperformed past cycles, the answer is simple. Investment across the economy shrank over the past several years. Whether monies spent by corporations, local and state governments, or the federal government, true Investment went backwards. And this backward movement impacted not only overall growth in the short term, but the long term Potential Growth of the economy.

A quick review of how GDP is constructed will lay the foundation as to why this drop in Investment has been so deleterious. As any first year economics student will spew forth, GDP = C+I+G+X-M, where C stand for Consumption, I for Investment, G for government spending, and X-M for exports less imports. As is clear from this equation, if I falls, then GDP falls assuming C, G, and X-M remain constant. That is the simple direct effect that anyone could understand. Unfortunately for the US, the following data show Investment stopped growing or fell for each major sub-part of Investment in the US over the past few years. Core Capital Goods spending by corporations peaked back in 2012, as derived from the Durable Goods Report, remained flat from 2012 to 2014, and fell from late 2014 onward. State and local government Gross Investment peaked in 2009 and declined every year from 2010 to 2015. Federal government Gross Investment peaked in 2012 and fell in 2013 to 2015, only beginning to rise this year. This combined fall in Investment, across the three segments of the economy, subtracted 1% or more from annual growth over the past several years as the economy experienced, what we would call, Capital Lightening or, what an economist would call, negative Capital Deepening. If one wonders why GDP growth only averaged slightly more than 2% per annum during this recovery compared to the normal 3.5% to 4.0 % growth, here is part of the missing 2%.

However, that is only part of the impact on the economy. The other clear impact is on productivity growth. When not enough is spent to maintain and grow the existing capital, Investment in the equation above, productivity growth falls. This is a common sense answer. If a business does not invest to maintain its equipment properly and to upgrade/replace it when necessary, then machines break down more often hurting the company’s output or the company does not increase its output because it is not using newer equipment. When governments do not maintain the roads properly, potholes develop or structural issues occur that require traffic to slow down or use an alternative path. This hurts the ability of a truck to move from Point A to Point B in a given amount of time, hurting productivity for the trucking company and the overall economy. And when Productivity Growth falls for the economy as a whole, then the rate at which the economy can grow falls as well. The following data from a study published by the Federal Reserve of New York in March 2001 support this common sense approach:

Growth in: ’59 – ’73 ’73 – ’90 ’90 – ’95 ’95 – ’98

Hours Worked 1.38 1.69 1.37 2.36

Productivity 2.95 1.44 1.37 2.37
——— ——— ——— ———
Growth in Output 4.33 3.13 2.74 4.73
——— ——— ——— ———
Contribution of:
Capital Deepening 1.49 0.91 0.64 1.13

Total Factor Productivity 1.01 0.33 0.36 0.99
——— ——— ——— ———
Productivity Excluding
Labor Quality 2.50 1.24 1.00 2.12
——— ——— ——— ———

As the above table makes clear, Investment drives 75% to 90% of Productivity through either adding to productive capacity or using technology to improve production. (The balance of 0.2 to 0.4 is called Labor Quality. In other words, over time workers become more highly skilled in more productive ways of doing things.) And variations in Productivity are the main factor behind changes to Growth in Output. It is well publicized by S&P 500 manufacturing oriented companies that annual productivity growth in an existing factory, without raising capital invested, is, at a minimum, between 2% and 3%, as companies continuously upgrade their machinery and processes. What the above table would call “Total Factor Productivity”. So, not only does a lack of Investment harm economic growth directly, it harms the long term rate at which the economy can grow.

As the above analysis suggests, economic growth this cycle has been severely impacted by a lack of Investment across the economy. For Corporations, the lure of buying back stock to drive share counts lower and earnings higher, proved too strong for managements that were highly incented by stock options. Thus, managements massively shifted cash flow allocations from capital expenditures to share repurchase. For the Federal Government, the addition of a new social program, the Affordable Care Act, coupled with the move to a contractionary Fiscal policy squeezed the rest of the budget, as money to fund investment oriented programs was either held flat in nominal dollars, a cut in real spending, or actually cut to pay for the social program. For State & Local Governments, the monies provided during the recession to fill budget gaps disappeared at the same time as the Federal Government forced a rising portion of the costs of social programs onto the State & Local Governments. This squeezed state and local spending forcing cuts in all the discretionary portions of their budgets. For the US as a whole, this meant a squeeze on Investment, hurting both short term GDP Growth as well as long term Productivity Growth. With rising pressure from the public to address all these shortfalls, it is Investment With A Capital I that lies ahead. (Data from Bureau of Economic Analysis, National Income & Product Accounts, and the Federal Reserve coupled with Green Drake Advisors analysis.)