Participants

Introduction

Consumer spending represents about two-thirds of total GDP. And, in the long run, what consumers do or do not buy determines the course of the economy. Yet a theory of consumer spending alone would provide a very incomplete version of what determines economic activity. In the short run, most of the fluctuations in the economy occur in capital spending, housing, inventory investment, exports, and imports. In the long run, productivity growth depends more on capital formation than on consumer spending. Indeed, for a given level of GDP, the higher the pro-portion of total resources devoted to investment and saving, the faster the growth rate will be.

According to the fundamental aggregate identity introduced in section 2.2, C+ I + F + G = GDP. Yet an increase in consumption does not always boost GDP.

If consumers save less, that could reduce saving and fixed investment. Also, in the short run, the rise in consumption could be offset by a decline in inventory stocks.

In some cases, the increased spending might boost the demand for imported goods, so total GDP would not change. In short, when consumption changes, we do not know what happens to total GDP until the changes in saving and investment are determined.

This chapter first discusses the logical equivalence of investment and saving. That is followed by a brief description of the principal determinants of fixed investment;

further details are supplied in chapter 16. An initial description of exports, imports, and foreign saving is also presented. The role of government saving is briefly considered, and the linkages between saving and investment are then summarized.

5.1 The equivalence of investment and saving

The previous chapter discussed the determinants of consumer spending. By defi-nition, the amount of income consumers receive that is not spent or paid in taxes is saved. But what happens to that saving?

Copyright © 2004 by Michael K. Evans

In the case of an independent entrepreneur, it often goes directly into investment.

However, that only accounts for a small proportion of total personal saving. In most cases, individuals save through financial intermediates: they deposit money in banks, or buy bonds or stocks (often through a mutual fund or their place of business) as part of their pension plan. Financial intermediaries then invest these funds.

In the long run, the growth rate of the economy is determined primarily by the proportion of GDP that is saved and invested, although other factors are also impor-tant. In the short run, cyclical fluctuations are due in large part to the imbalance between ex ante saving and investment; by definition, they must be equal ex post.

In some cases, the amount of money that businesses want to borrow to purchase capital goods could be precisely equal to the amount of money that individuals want to save. In that case, the economy would remain in equilibrium without any further adjustment. However, that rarely happens. Far more often, ex ante saving and investment are not the same, so some adjustment is required to attain ex post equilibrium.

Suppose businesses want to invest more than individuals want to save on an ex ante basis. There are several ways in which equilibrium could be reached. First, a rise in the interest rate could boost domestic saving and reduce investment. Sec-ond, more money could be attracted from abroad. Third, the government could increase its saving by cutting spending or raising taxes. Fourth, inventory invest-ment could decrease because of the unexpected rise in sales. If none of these move the economy to equilibrium, and the economy is at full capacity, the delay in deliv-ery of investment goods would cause ex post investment to fall below ex ante plans. In such a situation, which is likely to be inflationary, the central bank would presumably tighten credit conditions, which would also diminish investment.

This point should be emphasized. If ex ante investment exceeds ex ante private domestic saving, as usually happens during booms, either (a) the government deficit will decline (or the surplus will rise), (b) foreign saving will rise, which means the trade deficit will increase, or (c) interest rates will rise. If the Fed acts promptly, that increase will occur before inflation rises; otherwise inflation will rise first.

Now suppose ex ante saving exceeds ex ante investment, which is likely to occur in a recession. A decline in the interest rate could reduce saving relative to invest-ment; less money could be attracted from abroad, the government could decrease its saving by boosting spending or cutting taxes, or inventory investment could decline. Nonetheless, the argument is not symmetrical. Whereas a rise in inter-est rates, rinter-estricted availability of capital goods, or monetary stringency are quite likely to reduce ex post investment, it is far less likely that lower interest rates, quick delivery of capital goods, or monetary accommodation would boost invest-ment if business expectations have deteriorated. That is one of the main reasons that recessions occur.

Thus if ex ante private sector saving exceeds ex ante investment, either (a) the government surplus will shrink or the deficit will rise, (b) foreign saving will

decline, which means the trade deficit will shrink, or (c) interest rates will fall.

The Keynesian doctrine suggests that stimulatory fiscal policy – increasing the deficit – and stimulatory monetary policy – reducing interest rates and increasing the availability of credit – will be sufficient to bring recessions to an early end. Most of the time that is true, but the positive short-term stimulus of a bigger government deficit must be offset against the possibility that business confidence will be fur-ther eroded, hence causing a furfur-ther decline in ex ante investment. In that case, the business cycle contraction could continue indefinitely. In particular, note that an attempt to raise taxes during a recession could have a severe negative impact on the economy, since such a move would decrease consumption without providing any offsetting stimulus to investment.

Because of the way the national income and product accounts (NIPA) are con-structed, saving is identically equal to investment on an ex post basis. Hence if the economy slumps because of a reduction in planned investment, ex post saving must necessarily decline as well, even if individuals and businesses did not plan to save less. That might occur if output, employment, and income decline, thereby reducing consumer saving because income has declined. Also, government saving would decline as tax receipts drop and countercyclical transfer payments, such as unemployment benefits and welfare payments, rise. Finally, foreign saving would usually decline because imports would drop as domestic demand fell. The only reason that would not occur would be if the recession in the US spread around the world, hence reducing international demand for US exports.

Suppose, however, that stimulatory fiscal and monetary policy do not boost the growth rate very much. In such a situation, consumers might plan to save more, and businesses plan to invest less, because of reduced expectations. Assume the government is determined to keep the budget balanced, and hence does not reduce saving. Also assume that exports decline as much as imports, so foreign saving does not drop. In that case, how would equilibrium be reached?

The answer is that the recession would have to become so severe that con-sumers, businesses, and the government would all be forced to save less. Seen in this light, the sharp rise in the budget deficit is an important automatic stabi-lizer that keeps recessions from turning into depressions. The significant decline in imports during recessions also cushions the blow, since some of the drop in demand is shared around the globe. In addition, aggressive monetary easing reduces interest rates, reducing consumer saving and mitigating the decline in fixed investment. Most economists now realize these are important linkages that help stabilize the economy; without them, recessions would be more frequent and more severe.

5.2 Long-term determinants of capital spending

Consumers purchase goods and services because they derive utility, or pleasure, from these items. Most consumers are subject to a budget constraint, although for

most people that can temporarily be bypassed by borrowing. Some consumers derive more pleasure from saving than others do but, in the aggregate, con-sumers save only a small proportion of their total income. When correctly adjusted for spendable income, the personal saving rate usually averages between 5% and 10% of disposable income.

The decision to invest by firms is made for quite different reasons. Firms will purchase plant and equipment if they think the rate of return earned on that invest-ment will be higher than the rate of return that could be earned on alternative investments, such as in the bond market. In a world of perfect capital markets and perfect information, the amount of money firms have on hand is irrelevant; it is the expected future rate of return that is important. However, firms are subject to liquidity constraints just as consumers are.

As a result, capital spending decisions depend on the comparison of the expected future rate of return with the existing rate of return on existing assets. Even if firms have billions of dollars in cash and liquid assets, they will not invest in more plant and equipment unless the rate of return is expected to be larger than could be earned by investing in some other company or in government securities, or by repurchasing their own shares of stock.

Of course, businesses do not know what the future rate of return will be; they must make educated guesses about how much their sales and costs will grow in the future. This involves predicting both the increase in volume and the increase in prices. For example, if oil companies thought the price of oil would double over the next decade, they would boost capital spending sharply even if they did not expect the volume to rise at all.

When considering the interest rate that must be paid, firms also estimate the future rate of inflation to determine the amount of payback in real terms. For example, if the bond rate is currently 12% but the expected rate of inflation is 10%, firms will be much more eager to borrow than if the bond rate is 12% but the expected rate of inflation is only 4%. Hence in determining the cost of funds, firms look at the real rate of interest – the current rate of interest minus the expected future rate of inflation – rather than the nominal rate of interest. For many firms, the cost of equity capital is also important.

Firms must also consider the expected growth in the volume of sales relative to their existing capacity to produce these goods and services, which is usually measured by the current rate of capacity utilization: if excess capacity currently exists, the rate of return from additional investment will generally be less than if the firm is fully utilizing all existing plant and equipment. Finally, firms are more likely to replace equipment during periods of rapid technological advance than during periods when new machines offer only a slight competitive advantage.

Thus the long-term factors that determine the rate of capital spending under equilibrium conditions are the current nominal rate of interest, the expected rate of inflation for the overall economy, the expected rate of inflation for the particular goods or services it produces, the expected growth in the volume of sales, the current rate of capacity utilization, and the underlying growth rate of technology.

The formal theory of optimal capital accumulation, which incorporates these and other factors, is presented in the appendix to this chapter.

Yet in practice, an equation used to explain capital spending with the above variables generates very poor predictions. Several key factors are still missing. First, short-term timing decisions will depend on changes in the availability of credit.

Second, expectational factors may cause projects to be advanced or postponed.

The stock market plays an important role in both these decisions. Third, even if firms decide to order new capital goods immediately, there will be lags in deliveries that may depend on the stage of the business cycle. In some cases, such as jet aircraft or electrical generating equipment, the lag between orders and deliveries is several years. Fourth, changes in the tax laws affecting investment and corporate income may also influence investment decisions – or at least the timing of those decisions.

Each of these factors is now considered.

5.3 The basic investment decision

The deployment of capital resources is one of the critical decisions senior business executives must make regardless of the line of business. Should a firm expand its existing line of business or not? Should it enter a different business, and, if so, should it build facilities itself or buy them from someone else? No intelligent decision can be made without considering the cost of capital.

In the broadest sense, a firm invests in plant and equipment because it expects to increase its profit. More specifically, it compares the cost of an additional cap-ital good – including interest and depreciation, and adjusted for taxes – with the additional revenue that it expects to receive from the additional goods and services produced with that capital good.

Since the investment will be used for several years, the price of the investment itself is not the same as the annual cost. Of course, the price of the capital good is relevant. However, the key factor is the cost per time period, compared to the extra revenue produced in that time period. For purposes of exposition we assume the time unit is one year.

For example, suppose a machine costs $10,000,000, and can produce goods that generate an extra $1,500,000 per year in income after all variable costs have been paid. Is that a good investment?

With only the numbers given above, it is impossible to tell. More information is needed.

Suppose the interest rate is 7%.¹Then interest costs will be $700,000 per year. We emphasize these costs will be incurred in an economic sense whether or not the firm actually borrows the money. For if it were to use its own funds, they could be invested elsewhere at 7%, thus bringing the firm an extra $700,000 per year if the investment was not undertaken. That is why the investment being considered must provide a higher rate of return than alternative opportunities.

The amount of depreciation must also be considered. The manager needs to know how long the capital good is expected to last. Suppose the machine purchased has a ten-year life, after which it becomes obsolete, either because it wears out or will be replaced by better technology. That means $1,000,000 per year must be set aside to replace the machine.²

Thus the increased revenues are $1,500,000 per year, but the increased cost of cap-ital is $1,700,000, generating an annual loss of $200,000. The investment is not worth it – even though it brings in an extra $1.5 million each year on an EBITDA basis (earnings before interest, taxes, depreciation, and amortization). The money would be better spent on other projects, or invested through financial intermediaries at the market rate.

Now, however, suppose the interest rate drops to 3%, so annual interest costs fall from $700,000 to $300,000. That leaves a profit of $200,000 even after considering the cost of capital, so it is worth undertaking the investment.

Hence the more interest rates decline, the more investment projects will be under-taken. That is the basic idea underlying the inverse correlation between interest rates and capital spending. In fact the investment decision is much more compli-cated, because other factors affect the cost of capital. Nonetheless, the negative correlation between interest rates and capital spending is a valid one.

Some economists have tried to use the same approach to explain housing starts.

When interest rates decline, housing starts rise both because builders can obtain credit more readily and at a lower cost, and because more consumers can qualify for a mortgage on a house of any given price. However, short-term fluctuations in hous-ing are more closely tied to the availability of credit than its cost. Builders generally borrow the money for relatively short periods of time, so for them availability is more important than cost. While homeowners often have 30-year mortgages, rates are increasingly tied to short-term market rates. Furthermore, availability of credit is often the determining factor for whether a would-be homebuyer can obtain a mortgage. Thus the comments about the cost of capital apply primarily to capital spending rather than housing. We now examine this concept in more detail.