San José State University
Department of Economics


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Thayer Watkins
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The Catastrophic Collapse of Investment
in Plant and Equipment in 2008-2009:
Now the wolf really is at the door!

Update for 2009II

Throughout the first eight months of 2008 the media and various politicians without any real justification were declaring the U.S. economy was in recession. Strictly speaking a recession would mean that the output of goods and services was decreasing. That was not happening. The graph below shows the real quarterly GDP (measured in the year 2000 prices).

There was not a significant decrease in real GDP until the fourth quarter of 2008, when it decreased 1.6 percent compared to the third quarter. (The real GDP did decrease slightly in the third quarter of 2008 compared to the second quarter but it was only for an insignificant 1/8 of 1 percent. The statistics are just not accurate enough to say that there really was a decrease in production.) In the first quarter of 2009 the real GDP continued that rate of decrease.

Thus the recession in output began in the third quarter of 2008. This is confirmed by the statistics on the month-to-month rate of change in total nonfarm employment shown below.

Employment was decreasing slightly from month to month up until September 2008 when the rate of decrease quadruped.

What happened in September of course was the final collapse of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). This left the holders of subprime mortgages without credit default insurance and without a secondary market for subprime mortgages. The values of the subprime mortgages and securities based upon them dropped. This left many lenders with assets far short of their liabilities. This meant they were bankrupt. The collapse was earlier than expected and the unexpectedness of it produced panic in the financial markets. Foreclosures of real estate purchased with the funds provided from the subprime mortgages resulted in a decline in real estate values. This led to abandonment of some real estate based upon prime mortgages. This resulted in chaos in the financial markets. But the state of financial markets is not the same as the state of the economy.

The financial markets are important to the extent that they make it possible for someone who wants to purchase the products of the economy to do so. If no one wants to borrow the funds to make purchases then the availability of funds in the financial institutions is irrelevant.

What is happening now is the government is focusing on saving the financial institutions while destroying any motivation for businesses to invest in increased productive capacity.

Historically output recessions in the U.S. have occurred when, for one reason or another, businesses start reducing their investment in plant and equipment. This may come as a result of businesses losing their confidence in the future growth of the economy and their sales. Such a loss in confidence becomes a self-fulfilling prophecy. The decrease in investment in plant and equipment might also come from a substantial increase in the real interest rate. It could also come as a result of an increase in taxes that reduce the profitability of increases in productive capacities.

Here is a graphical display of the statistics on the real value of the components of Private Investment. The data on investment in plant and equipment is shown as Nonresidential.

Note that the investment in plant and equipment (Nonresidential Investment) was increasing right up to the fourth quarter of 2008. Also note that the level in the first quarter of 2009 is below what it was in the first quarter of 2005. Thus all the gain from the first quarter of 2005 to the third quarter of 2008 was wiped out in the next two quarters. In contrast the real GDP in the first quarter of 2009 was down but it was substantially above what its level had been in the first quarter of 2005.

The components of nonresidential private investment show the same pattern as the total. Here is the graph of the figures along with a graph of inventory change with an expanded scale.

Whereas between 2008III and 2009I real GDP declined by 3.17 % (6.34% annual rate), investment in plant and equipment declined by 16.5 % (33.0 % annual rate). The selling off of inventory and not replacing it (negative inventory investment) increased by $74.1 billions between 2008III and 2009I. This $74.1 billion decline in inventory investment along with the $234.1 billion decrease in investment in plant and equipment accounts for 83.2 percent of the $371.5 billion decline in GDP over that period. The decrease in investment in residential housing over the period was $59.5 billion. This amount along with the declines in investment in plant, equipment and inventory account for 99.2 percent of the decrease in real GDP. There were other declines, such as $46.4 billion in consumer purchases, and some positive influences, such as an increase in net exports of $44.7 billion.

In the past there were decreases in investment in plant and equipment which led to recessions and the recessions were then declared. In 2008 a recession was declared and as a result of the financial chaos of September 2008 businesses accepted this declaration and began to reduce their investment in plant and equipment. Some also stopped replacing the goods that they sold. This then resulted in the recession in output in the fourth quarter of 2008.

The Chairman of the Federal Reserve Board, Ben Bernanke, on May 5, 2009 said he sees the economy improving by the end of 2009. San Francisco Federal Reserve Bank president, Janet Yellen, echoed Bernanke's view. There is absolutely not a shred of theory or empirical evidence for this view. This is just baseless wishful thinking. As presented above the crucial element of investment in plant and equipment is in free-fall toward zero. Business is selling off inventory which is not being replaced at a rate of significantly upwards of $100 billion a year. As the venerable Robert M. Solow puts it:

No one can possibly know how long the current
recession will last or how deep it will go.1

It took the collapse of financial markets in September of 2008 to destroy business confidence; it is going take more than unfounded forecasts of tepid recovery by the likes of Bernanke and Yellen to resurrect business confidence. Timothy Geithner asserted that the problems of the banks will be resolved by the end of 2009. The Treasury and the Fed may take steps to make sure that lenders have plenty of funds for business borrowers but that effort is of no consequence if the borrowers are just not there. The ongoing collapse of business investment in plant and equipment indicates that the borrowers will not be there. The accelerated selling off of inventory without its replacement indicates that the upturn in consumer purchases in the first quarter of 2009 may not translate into increases in production. The Wolf is now really at the door and the people who should be dealing with it realistically are behaving like pollyannaish Little-Bo-Peeps.


1 Robert M. Solow, "How to Understand the Disaster," The New York Review of Books, (May 14, 2009), p. 4.


Update for the second quarter of 2009

On July 31st the Bureau of Economic Analysis (BEA) published its advance estimate of the real GDP for the second quarter of 2009. For the second quarter the BEA switched to the use of 2005 prices. According to that estimate the real GDP of the U.S. decreased 0.255 of 1 percent over its level in the first quarter of 2009. If that same rate of decrease continued for four quarters the decrease would be just slightly over 1 percent. This 0.255 of 1 percent decline is in contrast to the decline of 1.6 percent in real GDP (6.4 percent annual rate) for the first quarter of 2009 compared to the fourth quarter of 2008.

On August 27, 2009 the BEA published its second estimates of the real GDP for the the second quarter of 2009. The rate of decrease of real ($2005) GDP in the second estimate is the same as in the first Advance estimates.

While the decline in the second quarter is not so bad as that of the first quarter, this lack of really bad news is not actually good news. There is nothing in the statistics that says that the output recession has ended. The rate at which businesses sold off inventory without replacing it increased from 113.9 billion ($2005) per year to 141.1 billion ($2005) per year. If that rate of increase continued for four quarters it would be a 95.5 increase. There is even less basis for saying that the employment recession has ended. Even if the output recession ends the unemployment rate will continue at its current high rate and may well increase.

The level of investment in plant and equipment, given as Nonresidental Investment, decreased according to the Advance estimates by 2.22 percent from 2009I to 2009II. According to the second estimates (August 27, 2009) that decrease was 2.85 percent, or about 11.4 percent on an annual basis.

This is much less of a decline than the 11.7 percent decline from 2008IV to 2009I (46.8 percent annual rate) but it is still a decline. In real ($2005) terms the level of nonresidential investment is in 2009II less than it was in 2004IV, nearly five years ago. It is down 20 percent from its peak in 2008II.

As of the third and final estimates of real GDP for the third quarter of 2009 the investment in plant and equipment is still declining but at only about 6 percent per year. This is still a decline. The Administration and the Fed is declaring the recession to be over because the third quarter real GDP showed a 0.55 of 1 percent (2.2 percent annual rate) over the figure for the second quarter of 2009. To the extent that this increase is real it is due solely to one-shot stimuli programs of the Federal Government. Businesses are apparently not yet seeing an end to the recession.

The Bureau of Labor Statistics reports that total nonfarm employment is still decreasing although at a slower rate. So the Wolf is still at the door; he is just not howling as loudly.

For more on current economic conditions see Survey of Current Economic Conditions, the Employment Recession and The End of the Recession or the End of Reliable Economic Statistics.


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