A Return to Lower Levels of Investment Activity

Economic growth continues to be modest compared to previous recoveries. Real GDP rose only at a 2.2 percent annual rate in the first quarter of 2012, according to the advance estimate from the BEA, and over the course of the recovery so far, it has grown just 2.43 percent annually. Going forward, it is forecasted to expand at rates lower than 3 percent for a long time. These rates are lower than is typical during expansionary periods, and they entail a gap between economic activity and trend growth that will persist into the future, rather than rapidly close as in previous recoveries. To shed some light on this puzzling feature of the current recovery, we take a longer-term perspective and examine the pattern of investment activity in the decades leading up to the current cycle.

Average Growth Rates of Real GPD during Expansions

	1971:Q1– 1973:Q3	1975:Q2– 1979:Q4	1980:Q4– 1981:Q2	1983:Q1– 1990:Q2	1991:Q2– 2000:Q4	2002:Q1– 2007:Q3	2009:Q3– 2012:Q1
Average growth rate	5.38	4.49	4.34	4.34	3.72	2.73	2.43

Source: Bureau of Economic Analysis.

After growing 3.46 percent on average during the 1970s and 1980s (more precisely, between the peaks of the 1969–1970 and 1990–1991 cycles), investment accelerated during the 1990s and remained elevated until the 2007 recession. Between 1995 and 2007, investment exceeded the level consistent with a 3.46 percent constant growth rate by about 20 percent to 40 percent. Relative to real GDP, investment measured in real terms rose from 12 percent to record-high levels above 17 percent. Several factors contributed to this period of high investment activity, including the introduction and spread of new information and communication technologies, which raised the productivity and return of investment; the steep decline of the relative cost of investment goods; and the greater supply of funds made available by the larger flow of foreign capital entering the U.S.

The higher level of investment had a positive impact on aggregate demand and economic activity. And by deepening the capital stock, it raised labor productivity and economic growth. After averaging 1.6 percent between 1987 and 1995, productivity growth accelerated to 2.6 percent. Of this productivity acceleration, capital deepening was a major contributor, raising the growth of labor productivity by about 0.6 percentage points during 1995–2010 relative to the previous 1987–1995 period.

When the 2007 recession hit the economy, investment dropped. Since then, it has recovered, but only partially, and it is still well below its pre-recession peaks. What level of investment activity should we expect going forward?

One reason investment activity is weak is that there is a large overhang of unused and underutilized structures, resulting from past high investment levels, which is depressing investment in residential and nonresidential structures. As the overhang will be absorbed over time, this effect will fade away, and investment will pick up.

However, investment activity is not likely to return to the high levels that it reached during the 1995–2007 period. The current level of investment activity, both relative to its trend and relative to real GDP, is broadly in line with the levels that were typical before the investment acceleration of the 1990s. This suggests that some of the factors that raised investment activity during that period have attenuated, and investment activity has stably returned to lower, more typical levels.

This pattern of investment activity has implications for economic activity and growth. Since a lower investment level weighs on aggregate demand and economic activity, it can partly explain why the forecasted path of real GDP has shifted downward and remains well below any measure of trend that is based on pre-recession levels. It also suggests that the strong contribution of capital deepening to labor productivity growth may weaken over time, leading to a slowdown of labor productivity and economic growth.