San José State University
Department of Economics
& Tornado Alley
The Collapse of Business Investment
In general there is a whole chain of events that lead up to an event like a recession. Here recession strictly means a substantial decline in the real level of sales and hence output (GDP). When some adverse event occurs the level of consumer purchases or government purchases or exports may decline but that decline is just a few percent. When business investors decide there is no need for any increases in productive capacity investment in plant and equipment goes from some substantial amount to near zero. Likewise inventory investment goes from some positive amount to a large negative amount as businesses sell off inventory and do not replace it. In other words, when something happens that discourages the other component of demand the adjustment is marginal, but business investment goes into free fall. The loss of confidence on the part of business investors thus creates a self-fulfilling prophesy.
In the case of the Great Depression of the 1930's the level of private investment declined by 90 percent between 1929 and 1932. The loss of this source of demand for goods and services led to a drastic increase in the unemployment rate and all of the other terrible consequences. In that case the collapse of investment was driven by record high real interest rates, which in turn were due to deflation brought about by mistakes in monetary policy by the Fed. Later the real GDP began to increase but at a rate too low to absorb the pool of unemployment that had been created by the earlier recession in production. The condition was deemed a depression because of production being substantially below its potential. It did not end until the increase in demand involved with the entry of the United States into World War II.
In the case of the recession of 2008-2009 the level of real GDP did not start declining significantly until the third quarter of 2008. This was after there was public declarations of the U.S. being in a recession. These declarations, such as by the National Bureau of Economic Research (NBER), were based upon an entirely different definition of recession. According to the NBER a recession is when there are adverse changes in a broad range of economic indicators. It just happened that real GDP was not declining when the NBER declared the U.S. was in a recession that started in the fourth quarter of 2007. That was undoubtedly a factor in business investors deciding to reduce their investment in capacity and their restocking of inventory. This then resulted in private investment going into free fall, dropping at annual rates on the order of forty to fifty percent per year.
There had been a financial crisis in September of 2008 but that in itself was not what caused national sales and production to decrease. It was the loss of confidence on the part of businesses about the future of the economy that produces the decline in demand. The finance crisis was an influence on the loss of confidence, but it was the loss of confidence itself which was the cause of the recession in production.
The previous recession was in 2001. It was not much of a recession and did not last long.
Likewise there was a slight recession in 1990 and it did not last long.
A more substantial recession occurred in the early 1980's as a result of Paul Volcker's monetary program to curb inflation.
The previous recession occurred at end of Gerald Ford's administration and continued into the beginning of Jimmy Carter's administration in 1975.
In each of these recessions the decline in real GDP occurred in the same quarter as the decline in private investment. In order to establish the general proposition that recessions occur only when business investment collapses one must establish in the historical record that real GDP did not decline before private investment.
Here is the plot of percentage change in real private investment versus the percentage change in real GDP in the previous quarter.
Visually there appears to be very little correlation between the two variables and regression analysis confirms this. The percentage change in real GDP the previous quarter only explains 7.1 percent of the variation in the percentage change in private investment.
On the other hand, because private investment is a major component of aggregate demand a decline in investment necessarily corresponds to a decline in GDP. Here is the plot of the data for 1947II to 2010III.
The correlation is apparent and regression analysis reveals that 61.6 percent of the variation in the persentage in real GDP. Private Investment now constitutes only 13.6 percent of GDP so its effect on GDP is not merely as a component of aggregate demand.
Private Investment is sensitive to expecations of growth and is the most volative component of aggregate demand. Its decrease produces the recessions. This decrease is the immediate cause of recessions.
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