Wednesday, February 18, 2009

Real Investment in 2008: Just a Run-of-the-Mill Recession

Copyright, The New York Times Company

The amount of productive assets in place is one of the important legacies of any economic year. And 2008 finished with more productive assets than would be expected of a run-of-the-mill recession.

One reason that the United States economy produces more now than it did years ago, and more than most countries ever have, is the vast quantity of its productive physical assets: buildings, equipment, and software. Economists refer to the accumulation of these assets — new building, the manufacture of new equipment, and the release of new software — as “real investment.”

Economics’ “real investment” is distinct from the term investment in financial jargon, because the latter refers to an individual’s purchase of stocks, bonds, mutual funds, and other financial instruments that are often merely a transfer of ownership of a real productive asset from one person to another, rather than creating such assets anew.

The higher the rate of real investment, the more productive assets we’ll have in the future, and the more that we can produce in the future. Thus, one mechanism by which a recession might create a bad legacy for the future is by doing less to enhance the stock of productive assets.

The investment mechanism is of particular concern in this recession. We all saw the banking sector’s meltdown, which was the worst since the 1930s. For good reason, many have been concerned that real investment would suffer because of a “credit crunch”: distressed banks would no longer be willing or able to lend money to business with opportunities to build new things, put new equipment to work, or develop new software.

The chart below shows the quantity of real investment in four recessions (1981-82, 1990-91, 2001, and the current recession). The chart begins with the initial quarter of each recession (as determined by the National Bureau of Economic Research), and shows how much real investment changed from that quarter up to eight quarters later. Each recession is shown as a different color. For example, the fourth quarter of 2008 was the fourth full quarter of the current recession (indicated by a green line), by which time real investment was 7.7 percent lower than it was when the recession began (in the fourth quarter of 2007).

Normally, investment increases over time, so -7.7 percent is nothing to celebrate. But the chart shows that (so far) investment has fared better in this recession than in each of the previous four –- even though two of those (1990s and 2001) were considered “mild.” Investment was down 13.5 percent in the recession that began in 1990 — almost twice the decline experienced in 2008.

As House Speaker Nancy Pelosi and others have pointed out, the 2008 employment picture looks weak even by comparison to some of the previous recessions. However, the fact that real investment is not (yet) so weak suggests to me that a credit crunch is not a fundamental cause of this recession.


DWAnderson said...

Your conclusion that "a credit crunch is not a fundamental cause of this recession" seems right to me.

Is there good reason to reject the obvious hypothesis that the fundamental cause of the recession is the housing bubble? If, in round numbers, the US housing stock was worth $20 trillion at its peak and has lost 25% of its value, then that represents a huge hit to the economy. $5,000,000,000,000 to be precise but not accurate.

The negative wealth effects have caused people consume less as they discover they are not as rich as they thought they were. Productive resources (people and capital) formerly used to build housing and to supply items to formerly wealthier people are now lying (relatively) fallow until they find other productive uses. Doesn’t this simple explanation fit with most of what we have seen over the past year or so?

Aside from the freezeup in the fall as financial institutions suddenly focused on counterparty risk, there does not seem to be much to suggest that losses in the financial sector are anything more than the realization of losses from the housing sector. Financial institutions were residual owners of a fair amount of housing and have ended up taking a hit when it declined by 25%. The leverage of many of those institutions meant that equity holders and some tranches of debt holders have been wiped out, but no productive capacity seems to have been destroyed in the process. The decline in size of the financial sector seems like a logical to a decline in the demand for financial transactions, absent evidence the profitable opportunities aren’t able to find funding.

I am sure this simple analysis overlooks many nuances (which is inevitable), but is it fundamentally flawed or inaccurate or does it miss an important part of the story?

Comment reprinted

Tino said...

Easy prediction: 2009-2010 is going to have unusually high quality of private investments and unusually low quality of public investments.

Econophile said...

I'm not sure I understand the chart. Is it total volume of investment or relative change in value? If % change, then doesn't quantity matter for something? I understood that the sheer magnitude of RE investment, including derivatives, was much more significant this time around.