Greenspan’s lament: Consumption is no substitute for investment
Fixed investment in the United States
The below graph reflects ongoing cycles and trends in fixed investment in the U.S. economy, as well as economic crises. The yellow line reflects the vagaries of residential fixed investment, how hard it is to be a large mortgage lender, and perhaps how well the U.S. banking system is regulated.
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Three post-war crises followed by the recent crisis
The United States left the gold standard in August 1971, and later experienced the inflationary “oil shock” of October 1973, which led to a major downward economic spike, known as “the stagflation crisis” of the 1970s.
Despite some recovery in investment post–oil shock crisis, inflation continued to creep into the economy, and peaked at 13.5% in 1981, with the U.S. Federal Funds rate peaking at 20% in June 1981. That was the second major downward spike in investment—though Volker eventually slew inflation, and fixed investment temporarily recovered after that.
The inflation-slaying high rates of the ’80s had put about two-thirds of the S&L industry into insolvency. Plus, pre–oil shock oil went from $5 per barrel to nearly $40 per barrel by 1982, subsequently collapsing to $10 per barrel by 1986. The oil-driven economy of Texas went from boom to bust, dragging many S&Ls with it, to include Lincoln Savings and Loan, headed by Charles Keating, and Silverado Savings and Loan, with Neil Bush on the board of directors. Draw your own conclusions on proactive regulation. With an estimated $100 billion to $150 billion loss attributed to the S&L crisis (about the same size of the loans made by the U.S. government to AIG during the financial crisis of 2008), we see the third major downward spike in fixed investment into 1991—though with less intensity than the oil bubble collapse or Volker rate collapse of 1982. By historical standards, these three crises were quite significant.
According to the Congressional Budget Office, as of October 2012, the $700 billion Troubled Asset Relief Plan stood at $417 disbursed with $325 billion repaid, $27 billion written off, $65 billion outstanding, and $14 billion earmarked for future disbursement. That was a real financial crisis, capturing the largest decline in fixed investment since the Great Depression. As noted in the previous article in this series, the U.S. economy has seen a significant recovery in consumption, and as noted in the above graph, fixed investment has also recovered post-2008 crisis. Also, as we’ve seen, housing starts recovered handsomely—though they’re now declining from the 1,000,000-per-month level to the 850,000-to-900,000-per-month level (a far cry from 2,000,000-per-month in early 2008). Essentially, housing starts are back on track, as replacements rates should approximate 700,000 to 1,000,000 starts per month. Normal rebuilding rates are approximately 2.0 to 3.0 per 1,000 population on an annual basis, or 6,000,000 to 9,000,000 units annually, given a U.S. population of 300,000,000. Replacements rates had peaked at 7.56 per population of 1,000 in January 2006, though they fell to a rate of 1.68 per population of 1,000 in April 2009.
Why this crisis might be worse
While housing starts seem to be back on track, consumption and investment appear to be moving out of the danger zone as well, though the question remains as to whether or not the recent recovery can be sustained, and to what extent waning government deficits will have on consumption and investment going forward. Given the persistent weakness in fixed investment post-2000, it might appear that it will be harder to emerge from the 2008 crisis in a sustainable fashion without persistently large government deficits, unless we see ongoing improvement in fixed investments. As discussed earlier in this series, it’s becoming increasingly difficult to expect sustainable prosperity from additional consumption in the U.S. economy.
As prior Federal Reserve Chairman Alan Greenspan has pointed out, he’s beginning to see the United States as having two separate economies. One economy is 90% to 92% of GDP and is doing reasonably well, the other 8% is largely structures and long-lived assets—essentially fixed investment—as described in the above graph. As Greenspan points out, if you take 50% out of the 8% of the economy, which is fixed investment, you get an additional 4% of unemployment, which is essentially the excess level of unemployment in the economy.
In other words, if fixed investment would simply return to historical levels and stay there, current unemployment rates would likely approximate the historical rates of unemployment in the United States, and perhaps this would suffice to remove the slack from the U.S. economy, which has been picked up by government spending. Greenspan notes that the record profits seen in the S&P 500 companies, and associated cash flows, haven’t not translated into a corresponding growth to record levels of fixed investment. As CNBC commentator Larry Kudlow pointed out in his conversation with Alan Greenspan, it’s as though the United States is in a “capital strike.” Capital is simply refusing to go to work, despite being generated at record levels by S&P companies. Greenspan is concerned that the federal deficit growth is crowding out long-term fixed investment, with the largest impact being felt by smaller businesses with lower credit ratings, or unrated credit.
Perhaps an ongoing recovery in fixed investment in energy and other infrastructure will be forthcoming and support the nascent, monetary and fiscal policy–driven recovery, thereby supporting the U.S. equity markets. As noted in Part 3 of this series, broad based indices with significant exposure to large U.S. blue chip companies, such as the State Street Global Advisors SPDR S&P 500 ETF (SPY), or State Street Global Advisors SPDR Dow Jones Index (DIA) and Blackrock iShares S&P 500 Index (IVV) may outperform indices with greater exposure to more domestic economy-sensitive shares, such as the Blackrock iShares Russell 2000 Index (IWM), Blackrock iShares Russell 1000 Growth Index (IWF), and smaller market capitalization companies found in the State Street Global Advisors SPDR S&P MidCap 400 (MDY). Should challenging economic conditions worsen, companies with smaller market capitalizations may find credit conditions more challenging than large companies with larger and more diversified sources of cash flow. Blackrock iShares Russell 1000 Value Index (IWD) may also provide a more defensive exposure to U.S. equities should valuations remain attractive and stable in the face of softening economic data, to include consumption and investment.
Our next series on the U.S. macro economy will further explore the trends in investment in the United States, as well has how these trends may affect U.S. equity markets.
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CHINA: For further analysis of how CHINA could be affected by slowing consumption in the USA please see CHINA SERIES—“The Golden Age of Cheap Labor Coming to an End?”
JAPAN: For further analysis of how JAPAN’s export-led recovery could be affected by USA-based consumption trends, please see JAPAN SERIES, “Why Japanese Exports Could Break Out of a 5-Year Slump in 2013.”