Why Is Investment So Soft?
Three and a half years after the beginning of the recession, real GDP is still below its pre-recession peak. One reason is that firms’ investment (private nonresidential fixed investment) has not recovered. Currently, it is down 12 percent relative to its level at the start of the recession. While investment in equipment and software has bounced back and is now at pre-crisis levels, investment in nonresidential structures remains depressed. (Click here for more about investment in structures.) This behavior is unusual compared to past business cycles, when investment returned to its pre-recession peak level much more rapidly. Even during the 1973-1975 and 2001 cycles, in which investment remained depressed for years, it was much closer to its pre-recession peak by this point in the recovery.
Whatever is hindering the capital spending of firms, it is not likely to be the financial conditions in which they are operating. After weakening during the financial crisis, corporate balance sheets have since strengthened. Firms are holding relatively high levels of liquid assets. Profits and cash flows have been growing rapidly, driven by high productivity and low labor costs, and are now at record-high levels. External finance conditions continue to be favorable: Firms have been able to issue bonds and raise external funds at attractive, low bond yields.
Why then are firms still reluctant to invest? And why are they shying away from long-lived assets in particular? The most important factor is the large overhang of unused and underutilized structures and the excess capacity present in the economy. During the years before the crisis, high real estate prices encouraged households and firms to overinvest in structures. This generated an overhang of structures, which is now weighing on current real estate prices and investment. Also, with so much capital installed, capacity utilization rates are relatively low, below 80 percent, and there is little incentive to add to capacity. (Click here for more about structural overhang and capacity utilization.)
Another important reason why firms are shying away from investing is that they forecast slow growth and weak aggregate demand, which could make additional investment projects less profitable. Here, there is also a self-reinforcing mechanism at work, as firms’ lowered investment further depresses aggregate demand (since investment is also a component of aggregate demand), which in turn further slows the recovery and lowers growth forecasts.
A third factor behind why firms are tending to avoid long-term investment projects is the uncertainty that surrounds many variables relevant for their decisions, macroeconomic variables in particular. On one hand, economic models based on past business cycles generally forecast somewhat faster near-term economic growth for the current recovery. On the other hand, large downside risks continue to weigh on the outlook. There is uncertainty about the decisions that will be taken to address the U.S. debt problem, there are risks associated with the European government debt crisis, and there are fears that the recovery might stall and might even give way to another downturn. As a result of macroeconomic uncertainty, near-term forecasts of GDP growth have varied quite a bit during the last year. For instance, at the beginning of this year, GDP was forecasted to grow during 2011 at a rate of 3.2 percent. This was faster than long-term trend growth, as is usually the case during economic recoveries. More recently, however, forecasts for 2011 GDP growth have plunged to 1.75 percent, much slower than typical growth rates during recoveries.