San José State University
Department of Economics

applet-magic.com
Thayer Watkins
Silicon Valley
& Tornado Alley
USA

The Immediate Cause of Recessions:
The Collapse of Business Investment
in Plant and Equipment

Summary

Business investment in plant and equipment is a major element of demand for U.S. products. It is much smaller than consumer demand but it is highly sensitive to actual or proposed changes in such things as taxes and regulations. Investment purchases are dependent upon expectation of future economic growth and hence there is a feedback effect. A decrease in private investment purchases leads to a decrease in production and the decrease in production leads to a further decline in expectations of growth in production. A decrease in production leads to labor layoffs and lower consumer incomes. The lower incomes lead to lower consumer purchases and less tax revenues for governments leading to reduced government purchases. The net result is declines in private investment purchases being the cause of recessions. The election of a president who threatens to raise taxes on investors and generally does not have the confidence of investors could be enough to puncture investment plans and bring on a recession.

The Nature of Recessions

A recession is defined in terms of a decline in the production of goods and services as measured by the Gross Domestic Product (GDP) expressed in constant prices, the so-called real GDP. There are four major components of demand for U.S. output: 1. Consumer Purchases 2. Government Purchases 3. Private Investment Purchases 4. Exports (Purchases by Foreign Buyers). The table below shows the relative magnitudes of these components.

In the fourth quarter of 2011 the U.S. economy produced and sold about $15.3 trillion of goods and services. The following table provides an estimate of the relative sizes of the four components of GDP.

In the second column of the table are the total purchases by the 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 Aggregate Demand
in the U.S. in 2011 Fourth Quarter
($billions)
Category of
Purchaser
Total
Purchases
Estimated
Purchases of
Foreign Output
Estimated
Purchases of
US Output
Proportion
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 vulnerable. It is often said that investment demand is volatile, but in the context of recessions vulnerable is the better term.

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 was not the case.

Note that all of the components except private investment purchases have subsequently surpassed their levels for the first quarter of 2006. Investment purchases are still about 14 percent below their peak. They are about 25 percent below what they could have been expected to be with normal growth of the economy. The continued shortfall of investment purchases can be attributed to the impact of the Obama Administration on the level of confidence among business investors.

Further Analysis of Private Investment Purchases

Another way of showing the volatility of private investment purchases. What is shown is the ratio of the various components of aggregate demand to their values in the fourth quarter of 2007.

Private Investment Purchases consists of the purchases of plant, equipment, residential structures and increases in inventory.

The Components of Investment Purchases

In general there is a whole chain of events that leads 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 were 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 election of a president who lacked relevant experience and seemed decidedly unfriendly toward business was another factor in the loss of confidence among business investors.

Here is the plot of the data for quarterly changes in real GDP versus those of private investment from 1947II to 2010III.

The correlation is apparent and regression analysis reveals that 61.6 percent of the variation in the percentage 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.

Some might argue that the decline in private investment purchases is an effect of a recession rather than the cause of the recession. 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 explains only a negligible 7.1 percent of the variation in the percentage change in private investment.

Conclusion

Private Investment is sensitive to expectations of growth and is vulnerable to changes or even proposed changes in taxation or interest rates. It is the volatile component of demand whose decrease produces the recessions. Decreases in private investment purchases are the immediate cause of recessions. The election of a president who threatens to raise taxes on investors could be enough to puncture investment plans and bring on a recession.


HOME PAGE OF applet-magic
HOME PAGE OF Thayer Watkins