Greenspan’s lament: The lack of fixed investment in the U.S.
Investment in the United States
This Series on U.S. Investment picks up where the last series on U.S. consumption left off, namely, “Greenspan’s Lament.” As a result of the ongoing decline in fixed investment in the United States, as described in the below graph, both Greenspan and Kudlow have raised concerns as to the future of the United States. This series focuses on the trends of fixed investment in the United States and, in the end, considers the “constructive hypothesis” that lamenting the decline of the United States (especially in the area of fixed investment) could be overdone and ready for a significant and secular (long-term) change in trend. In the long run, this could be great news for U.S. investors with a long-term view.
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As we discussed earlier, and as reflected above, total investment in the United States has been slowing for many years. Prior Federal Reserve Chairman Alan Greenspan has often lamented and discussed this disturbing trend with CNBC commentator Larry Kudlow, describing the United States as a country with “two economies.” The concern of Greenspan and Kudlow is that the decline in investment in the United States seems to have begun in earnest after the year 2000. Plus, Greenspan and Kudlow may feel that the economic recovery in the United States of the 1980s was based on Reagan-era policies, including the Tax Reform Act of 1986. Greenspan succeeded Paul Volker as Federal Reserve Chairman in June 1987, while Larry Kudlow began his career at the Federal Reserve as a staff economist and later served in the Reagan Administration as Associate Director of Economics Budget and Planning for the Office of Management and Budget (OMB) from 1981 to 1985. Both Kudlow and Greenspan had front row seats to the Reagan revolution, and as reflected in the above graph, perhaps an appreciation for the results these Republican policies delivered (to Democrat Bill Clinton).
Greenspan’s lament: Nobody wants to invest in the future
As Greenspan points out, one economy is 90% to 92% of GDP and is doing reasonably well, while the other 8% is largely structures and long-lived assets (long-term fixed investments, as reflected 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. This is essentially the excess level of unemployment in the economy. As the downward-sloping black line in the above graph illustrates, investment as a percentage of GDP has declined by approximately 4% per annum since 1968—from the 6% level to closer to 2% today.
In other words, if fixed investment would simply return to historical levels (around 8% of GDP instead of 4% of GDP) and stay there, current unemployment rates would likely approximate the historical rates of unemployment in the United States (4% to 5% unemployment versus 8% to 9% unemployment). Perhaps this would suffice to remove the slack from the U.S. economy, which has been picked up by government spending as investment has slowed. Greenspan notes that the record profits seen in the S&P 500 companies, and associated cash flows, haven’t translated into a corresponding growth to record levels of fixed investment, which is the normal trend. (Note that the above graph reflects simple rolling averages of three years of quarterly data. For year-over-year data on Private Fixed Investment, see Cleveland Fed analysis.
Kudlow’s lament: Capital is on strike!
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 in the United States, 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, and businesses too small to have publicly rated credit. As Greenspan points out, “If it’s not AAA Corporates that are being pushed out, or even probably BBB, investment grade, there is major evidence that the extraordinary rise in the deficit is pre-empting the savings that usually fund capital investment. But… it’s heavily concentrated in those areas which pay high interest rates… To be sure, at 2% (borrowing cost), you’re not going to be stopped by anything.”
As a result, it would seem that smaller businesses with higher borrowing costs are experiencing the most hardship in the area of credit-related investment. Businessweek reports that small businesses have historically contributed just over half of the GDP in the United States. But as of 2010, this amount has fallen to around 44% of GDP. According to the U.S. Commerce department, the U.S. financial sector’s contribution to GDP has risen from just over 2% of GDP in the ’50s to 8.4% of GDP today. So you could see that the U.S. financial sector’s contribution to GDP has replaced the small business component of GDP contribution.
Are big banks to blame?
The National Federation of Independent Businesses notes that small business optimism has fallen significantly since 2007. Given 1986 as a base, this index has remained around the 100-to-105 level from 1983 to 2007—nearly a quarter of a century. However, this index fell to roughly 85% during the crisis, though it has recovered halfway from the 2009 bottom to around 92 currently. Interestingly, the main reasons cited for challenges in the current environment are taxes, government requirements, and red tape as well as poor sales. These three categories captured 58% of respondent’s number-one complaint (21%, 21%, and 16%, respectively). Finance and interest rate–related issues captured only 3% of correspondents’ number-one complaint.
So it would appear that while the U.S. financial sector—including big banks and insurance companies—may have outpaced small businesses in terms of their contribution to GDP, the main problems faced by small businesses don’t seem to be that strongly related to a lack of credit. Plus, in the United States residential housing market, credit seems to be improving—though only recently, as of early 2013. The FICA scores of approved mortgages were around 720 during 2006 and 2007, though they rose to around 757 after the bubble burst in 2009. Average FICA scores have fallen this year from 750 to 737. Like the small business optimism index, FICA scores have also recovered 50% to the pre-crisis levels. Perhaps credit supply is less of a problem than credit demand, reflecting borrowers’ perceived ability to service debt in the future—in the face of higher expected tax burdens, regulatory costs, and weak sales growth. In other words, the banks may be willing to loan to small businesses though small businesses remain reluctant to invest.
Is big government to blame?
Given these factors, it’s likely that there are larger forces driving the trends in reduced investment in the United States. As described in the above graph, private investment growth rates have been slowing relative to real GDP growth rates. The averaging measure in the above graph notes that total investment to GDP has declined from 6% to closer to 2% today. Greenspan suggests that total long-term fixed investment has fallen from historical averages of around 8% to closer to 4% (also a 4% decline). Real GDP growth averaged 3.3% from 1980 to 2000. From 2000 to 2013, real GDP growth has averaged 1.9%. So it would appear that the growth in real U.S. GDP has been far below its historical growth rate. The Federal Reserve Bank of Cleveland analysis notes, “If investment is currently below its trend, GDP may be below its trend as well.” Well, we know that investment is certainly below trend, and we know that real GDP growth is below trend. The question remains, which is the cause and which is the effect?
According to Greenspan, the increase in public sector debt is the culprit. The U.S. government has dragged the United States out of the 2008 crisis via low interest rates and large deficits, and has made great progress at filling the budget gap by raising taxes. Although the U.S. budget deficit has improved from 10% of GDP to nearly 4% of GDP as a result, a very large debt overhang (the bill) remains as a result, reflected in a gross debt-to-GDP level of just over 100%. The real concern of Greenspan is on a forward-looking basis. His argument that public debt is crowding out investment seems to be based on the growth of U.S. debt—not simply the recent budget deficit swoon from -10% to -4% of GDP, but the aftermath of debt hangover, which is still on the books and anticipated to grow once again in the future.
On a forward-looking basis, Greenspan is concerned with what the Congressional Budget Office (CBO) has referred to as the “Alternative Fiscal Scenario.” Under this scenario, “entitlements” (including Medicare, Medicaid/Obamacare, and social security) are forecast to rise from the 2011 level of 10.4% to the magic number of 18.1% in 2045. Historically, U.S. government annual tax receipts have equaled 18.1% of GDP as well. So, as entitlements creep north toward 18.1% of U.S. GDP (100% of the government budget), the U.S. government has no choice but to pile on debt and further crowd out investment. Given what’s going on in Syria at the moment, shuttering the Department of Defence doesn’t seem to be a viable option.
Is slow growth to blame?
Meanwhile, the real growth rate in the United States has fallen from the historical 3.3% rate to the New World Order rate of 1.9%. As I pointed out in Part 2 of this series on U.S. consumption, academics Kenneth Rogoff and Carmen Reinhart suggest that when gross debt-to-GDP levels exceed 100%, median GDP growth rates fall by 1% and average growth rates fall by considerably more. It certainly looks like they’re right so far. Looking at three-, six-, and nine-year moving averages of real U.S. GDP growth from 1960 to date, we see average growth rates of 2.3%, 1.6% and 1.0%, respectively—well below the 3.1% average from 1980 to 2000, when slowing growth and investment seem to have crept into the U.S. economy.
Important to note is that this decline in GDP growth rates began in June 2000, and was very much in sync with domestic fixed investments, as noted in the above graph. Net government debt-to-GDP was approximately 35% in June 2000, though it has since grown to 85% as real GDP has slowed, tax receipts declined, and the country has digested an unprecedented banking crisis. You could argue that the aggressive banking lending from 2000 to 2008 was simply doing then what the government has been doing since—piling on more debt to keep the economy afloat since banks tapped out and regulators put in the leverage penalty box.
So, going forward, who are we to blame for the decline in investment in the United States? If new banking regulations under Basel III constrain the Banks’ ability to fudge their leverage ratios and they lend less in the future, that will leave the government to take their place. Simply put, things haven’t been the same since June 2000 in terms of growth and sustainable tax receipts, with the exception of the short-lived revenue pop of the Bush Tax Cuts (2001–2004). And if the shellshocked public doesn’t want to risk bailing out the big banks again, it will be harder to expect the private sector (banks) to finance this party (unless regulators let them out of the box). At over 100% gross debt-to-GDP levels, the academics suggest that Uncle Sam has well surpassed his ability to effectively finance his way out of declining growth. These developments prompt the question, who wants to get this investment party started?
Why capitalism is on strike
With real GDP growth rates declining since the year 2000, banks facing a more stringent lending environment post-2008, and the future entitlement-related debt bullet headed toward the United States, it’s without doubt very hard to get the capital in the United States committed to long-term fixed investments. The capitalist’s sentiment seems to be “Not with my money.” As a result, the government has been filling in the gap with spending on day-to-day needs (everybody’s money), and growing its debt—potentially making the capitalist even more reluctant to invest for the long term.
In the next four articles in this series, we’ll look at the components of investment in the United States and see to what extent the capitalists are on strike in each. Given the post-2000 data, it’s fairly easy to be alarmist. But in the final part of this series, there’s a silver lining to all of this. We’ll explore this upside and support a constructive interpretation of what could get capitalism back to work in the United States.
Should investors see weaker consumption, investment, and government spending continue to soften GDP growth in the near future, they may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY), Blackrock iShares S&P 500 Index (IVV), or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment.
For further analysis of how China could be affected by slowing consumption in the United States, please see China’s exports: Is the golden age of cheap labor coming to an end? For further analysis of how Japan’s export-led recovery could be affected by U.S. consumption trends, please see Why Japanese exports could break out of a 5-year slump in 2013. For further analysis of consumption trends in the United States, please see U.S. consumer spending: Sustaining the unsustainable?