San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Hard Reality of Politics and the Economy

The recent history of Greece has illustrated that when one major political party starts buying votes by promising to redistribution of income, spread the wealth and create entitlements and the other major political party begins to match those promises the end result is fiscal bankruptcy. While debt is the focus of attention in that story the other part of the story is that attempt to transfer income from the successful to the unsuccessful, or even the threat of doing so, results in recessions and unemployment.

The reason this occurs is that private investment in plant, equipment and inventory is a major element of demand for a nation's output. Such investment is highly sensitive to expectations about taxes. It is even highly sensitive to uncertainty about factors which will affect the profitability of investment projects. When businesses have an investment project and hear a politician threatening to raise taxes and/or changes the rules affecting it, they do not just cut back the project a few percent, they cancel it. Consequently investment in plant, equipment and inventory is highly sensitive to the actions and even the rhetoric of politicians.

An Elaboration of the Above Points

Supporting Material

The Importance of Private Investment in Plant,
Equipment and Inventory in Aggregate Demand

In the fourth quarter of 2011 the U.S. economy produced and sold about $15.3 trillion of goods and services. There are four categories of purchasers of the output of an economy: 1. Consumers, 2. Investors, 3. Governments, 4. Foreign buyers (Exports). The levels of the purchases by these four types are shown below.

In the second column is the total purchases by these four categories of purchasers. Some of these purchases were for foreign products. The third column provides estimates of those purchases of foreign products; i.e., imports. The total imports were about $2.7 trillion. When those purchases are deducted from the total purchases in the first column the result is the figures shown in the fourth column. The total for the fourth column is the Gross Domestic Product of the U.S.

The Components of Demand
Category of
Purchases of
Foreign Output
Purchases of
US Output
Consumers 10,858.10 1631.07 9226.97 0.603295
Private Investment 1,999.70 300.39 1699.30 0.111107
Foreign Buyers 2,121.60 318.70 1802.89 0.117880
Governments 3,018.60 453.44 2565.14 0.167719
Total 17,998.00 2,703.60 15,294.30 1.000000

So the purchases of U.S. goods and services as private investment was about $1.7 trillion and constituted about 11 percent of aggregate demand. That is $1700 billion and it is a lot of demand for U.S. production.

The Volatility of Private Investment Demand

To make comparisons over time it is necessary to have the production of goods and services expressed in constant prices. The recent statistics are in terms of the prices of the year 2005 ($2005). Here is what happened to private domestic investment purchases since the first quarter of 2004.

Private investment purchases peaked in early 2006 and are now still below that peak. There was a decline from that peak in subsequent quarters and a small rise and then again a decline, but it was not until the third quarter of 2008 that private investment began to fall like a rock. The rates of decrease at an annual rate for 2008q4 and 2009q1 were about 40 and 60 percent.

The decline in private investment purchases between 2006 and 2008 had largely to do with the decline in residential housing construction. Something entirely different happened at the end of 2008.

There are various ways of making the point that investment demand is volatile. Here is one of them. What is shown is the ratio of the various components of aggregate demand to their values in the fourth quarter of 2007.

It is possible that small changes in Consumer Purchases might have been more important than the changes in Private Investment in creating the 2009 recession. The graph below shows that this is not the case.

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