For most of our recent history, the United States has been like Aesop's grasshopper. We have depended more on consumption and less on business investment for our economic growth than most advanced countries. But for a brief time in the '90s, we became industrious ants: Business investment and the use of new information technologies increased sharply, leading to higher productivity, growth, and incomes. Now we may be reverting, and that places our struggling recovery at risk.
No one can doubt the key role of business investment in the uber-prosperity of the '90s. Led by turbocharged spending on IT, business fixed investment grew 10 percent or more every year from 1993 to 1999. From 1993 to 2000, the increase in business investment accounted for 36 percent of GDP growth, compared to 16 percent during the Reagan expansion. Business investment can often be a virtuous kind of economic activity. When companies buy new computers or build new factories, demand increases, productivity gains often follow, prices can moderate, and everyone benefits.
It's no surprise that capital spending has been sinking since the boom ended in 2000. Economic slowdowns always cramp business investment. Lower profits leave companies less to invest, while falling incomes, rising unemployment, and high consumer debt drain demand for the goods that investment can produce. The result: Business investment fell more than 5 percent in 2001 and another 3 percent so far this year.
But there are new reasons why business investment has fallen so precipitously this time—it's dropped eight straight quarters, a record. First and foremost, demand for information technologies slowed. The newest technologies, broadband and 3G wireless, haven't provided compelling reasons for firms and consumers to overhaul their equipment. Nor are IT producers, many saddled with overcapacity from the late '90s, a source of new demand themselves. The IT industry is starting to look more like a mature sector, such as autos, where demand depends on old customers replacing their worn-out equipment, than like a young and vibrant market attracting waves of new customers with cutting-edge products.
The possibility of war in Iraq also restrains business investment, since a sharp increase in energy prices would cut demand for everything else. Capital spending may also be discouraged by the corporate scandals, which have left some bankers more reluctant to lend to firms. Perhaps most important, the return of large, structural budget deficits is keeping the cost of long-term business borrowing relatively high. The Federal Reserve has cut short-term rates 80 percent since July 2000, but the yield on AAA corporate paper has fallen less than 20 percent. By comparison, in the slowdown of the early '90s, when the deficit outlook was improving rather than degrading, the Fed cut short-term rates by 60 percent, and business borrowing rates came down 30 percent. With relatively high borrowing costs and less retained earnings, companies don't have the wherewithal for more investment.
So, how can the Bush administration encourage business to do more? Don't bet what remains of your 401k that any of the administration's proposed policy fixes will boost investment. There's talk about sweetening the tax breaks for business investment passed after 9/11. But those breaks haven't worked yet and aren't likely to: The economy's excess capacity discourages investment more than the tax breaks encourage it. There's also talk about reducing the tax on dividends. But if dividend payouts go up, the retained earnings used to finance a lot of business investment will decline.
Some in the administration claim that accelerating the Bush tax cuts would boost business investment by jump-starting demand. This is unlikely. Middle-class Americans have already received most of their Bush tax benefits. Most of the gains from acceleration would go to high-income Americans, precisely those people least likely to spend a tax windfall. And the last time supply-siders promised that large tax cuts for wealthy people would fire up capital spending, business investment's share of GDP dropped from 13.2 percent in 1980 to a postwar low of 9.7 percent in early 1992.
The good news is that we may be able to achieve reasonable growth without strong business investment—at least for a while. In the '80s, we grew faster and richer than many European countries while our firms invested relatively less. Our less-regulated markets drew more people into the workforce and allowed businesses to make better use of their investments. And investment may increase even without strong growth. A recent OECD study found that investment can accelerate, for example, when real interest rates are low and the price of investment goods falls relative to the price of other things, making investment cheaper. IT is our largest category of investment goods, and its relative price has been falling sharply for more than a decade.
For now, we're still reaping the productivity benefits of the '90s business investment boom. Over the last 12 months, productivity has increased 5.6 percent, the fastest pace in 36 years. Since productivity is just output per hour worked, these gains reduce unit labor costs, which helps earnings and profits. Unfortunately, in an economy growing at only a moderate rate, these gains also cost jobs. Let's do the math: If the economy grows 3 percent and productivity increases at a 5 percent rate, the inescapable result is that total hours worked will fall at a 2 percent rate. That's why unemployment has been rising, even as the economy grows.
Persistently rising unemployment, along with slowing consumption spending, has many economists worried. And there's not much else to cheer about. Alarming signs are emerging in housing, the sector that led the Reagan recovery and helped keep the recent recession mild. The dollar has remained stubbornly high despite all the interest-rate cuts, swelling the trade deficit and holding back domestic growth. And industrial production, which headed up in the first half of this year, has been negative or flat since July. That brings hopes for a strong expansion back to business investment.
There's no magic formula to boost capital spending. Certainly, with short-term rates at 1.25 percent, the Fed has done virtually all it can—though some of the boost from lower interest rates has not yet worked its way through the economy. Fiscal stimulus is a crude mechanism and usually badly timed, but shifting some of the Bush tax cuts from the future to the present and phasing them out as the recovery gathers force, could support demand today and lower long-term rates later. What's left are measures to restore confidence, especially once the conflict with Iraq is resolved. Strong steps to ensure that companies comply fully with new financial and accounting standards could help confidence—and certainly won't hurt the economy.
The best tonic for business investment would be tackling our new structural budget deficits. Erasing the future red ink would cut real interest rates today and encourage capital spending. That's what Bush's new economic advisers should concentrate on—if they want to be ants, not grasshoppers.