Post-Keynesian Observations

Understanding the Macroeconomy

4. PHYSICAL INVESTMENT AND THE BUSINESS CYCLE

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[NOTE: Be sure you have read part 3 before this one! This is part of a series of posts that explain the operation of the macroeconomy and the current crisis and they build on one another.]

To reiterate, what I was saying in part 3 wasn’t quite true, but I figured it would be easier to follow the argument if I focused first on consumption. Really, business investment is the key to economic prosperity. The stuff I said about consumer durables is true enough and certainly adds to the problem, but it’s secondary.

By investment, I don’t mean buying stocks and bonds, but physical investment, or the addition to productive capacity. This can be something as substantial as building a new factory or restaurant, or as simple as a stapler or office chair. But in any event, it is THE driver of economic activity. There have been six recessions since 1970. The average increase in investment during those recessions was -13%. During the intervening expansions, investment rose by an average of 37%. In addition, declines in investment tend to occur just before recessions, consistent with the argument that they cause them. No major macroeconomic number is more volatile than business investment, a fact that fits well with Keynes’ volatile uncertainty-versus-animal spirits view.

Firms invest because they think they can earn a profit from doing so. After the panic of an intial downturn wears off and a recession has hung on for a while, a number of factors combine to start the upturn by causing firms to think it’s time to add to capacity:

1. Equipment wears out;

2. Technology changes;

3. Entrepreneurs’ animal spirits recover as the memory of the crisis that led to the recession fades;

4. Entrepreneurs find themselves with less debt since they haven’t been doing a lot of spending during recession;

5. Bankers’ animal spirits recover as the memory of the crisis that led to the recession fades;

6. Bankers find themselves eager to lend after the lean period represented by the recession;

7. Consumers have less debt and a junky old car they want to replace.

So, eventually, a new expansion starts as firms decide they’d like to add to capacity and banks are eager to accommodate. The new purchases create jobs and income and soon consumer spending is adding to the expansion. Everyone gets all excited and not only are firms investing with a vengeance, but the story about consumer durables from part 3 kicks in–as does the part about animal spirits getting well out of line with what is really reasonable to expect.

Eventually, firms no longer think it’s profitable to continue investing. This is not to say that they don’t think they will earn profits overall or that bad times are ahead, but that they just don’t feel the need to build any more factories, etc., at the moment. They believe they have adequate capacity to meet demand and, besides, they are in debt from constructing them. However, laying off all those construction workers has an unintended consequence: now that it’s possible to make more cars because they have a shiny new factory (for example), people can’t afford to buy them! The construction workers had been laid off already, and as they weren’t spending money then people at the shops they used to frequent also get laid off. It’s no coincidence that the Great Depression followed right on the heels of the Roaring 20s–the latter caused the former. There was a massive increase in firms’ investment over the 1920s and by 1929, we had the capacity to produce goods and services on a scale never before seen. But, with investment starting to fall and consumer durables sales declining, actual profits did not match what animal spirits had suggested they should be and the economy collapsed and people panicked. The 1930s should have been period of unparalleled prosperity in America if you went by how much productive capacity we had. Instead, unemployment reached 25%.

The lesson here is very similar to the one about consumer durables: we can quickly saturate the market for physical investment and when we do, spending in that sector declines and layoffs follow. Depending on how high expectations had risen, panic can result and firms, consumers, and banks cut back and the recession starts. The biggest difference between this story and that in part 3 is that investment turns out to be the critical factor, not durables.

As important as physical investment is, you don’t really hear much talk about it. It’s portfolio investment (stocks and bonds) that grab all the headlines. It’s not unimportant, but it’s really a reflection of what’s going on elsewhere rather than a causal factor by itself. Sort of. You’ll see when I get to part 5: THE STOCK MARKET!

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Written by rommeldak

January 10, 2009 at 3:54 am

Posted in Uncategorized

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5 Responses

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  1. Excellent examples! I really found this installment useful and easy to understand.

    Thanks!

    oktyabr

    January 20, 2009 at 3:48 am

  2. Any data for how many people become entrepreneurs and start their own businesses only because they got laid off? I’ve known a number of them who then prospered…

    Charles Flemming

    January 27, 2009 at 11:35 pm

    • That’s very interesting (i.e., that they went into business for themselves because they got laid off), but I’ll wager such stats don’t exist. It’s easier/less expensive to keep tabs on the big boys!

      What I am arguing here is that, ultimately, the limiting factor is the demand for goods and services. Given that the average recession since World War Two has lasted ten months, and further given that it would probably take someone 3 to 6 months to get set up as an entrepreneur, it wouldn’t be terribly surprising to find that they succeeded since by the time they really got started the economy had recovered. They probably could have had their old jobs back, too!

      rommeldak

      January 27, 2009 at 11:52 pm

  3. I guess that’s the upside element of the “creative destruction” apology for recessions. Some people won’t move from the safety of employment till forced to and miss the potential for greater success.

    And, of course, every recession produces a bunch of “consultants” who are actually networking for safe job somewhere.

    My boss (owns the small printing company where I work) is very careful about debt and creative about re-purposing old technology. Because he’s not burdened with debt, he can adjust during slow times, cutting back hours, delaying new hires, laying off unproductive or troublesome employees. Then, he watches other small printing firms fail and buys their equipment or—more importantly—their customer lists and digital assets. In other words, he grows his business, even during a recession. At the very least, he finds new customers to take up the slack of existing customers who have fallen off or cut back. I suspect printing firms, by the way, to be leading indicators of recessions and recoveries.

    Right now, we’re booming. What’s that about?

    Charles Flemming

    January 28, 2009 at 12:16 am


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