US businesses are financially strong. They are making record profits: more than $1,600 billion in 2006, or almost 14% of total national income. Last year aggregate cash flow of non-financial corporations was sufficient to finance all but $47 billion of $1,000 billion in capital expenditures. Companies could easily have raised far more in the capital markets — and at the most favorable lending terms in years. But they decided to spend cautiously on equipment and software, the key ingredients of business fixed investment. And this caution has carried over into 2007. The first estimate of Q1 GDP says real capital expenditures went up just 2.2% per annum and contributed a mere 0.14 percentage point to growth. By comparison, in the past three years, their growth contribution averaged over a half percentage point per year.
Federal Reserve officials have said they are puzzled by the reluctance of profitable companies to spend more on fixed investment. The Fed’s internal models predict much higher spending. Why are businesses acting so much more carefully than in the past?
At least three explanations are worth considering. First, while most corporations are doing well, not all are making substantial profits. And in one key sector — motor vehicles and parts — firms continue to make huge losses. Operating losses of US auto and parts manufacturers came to $17.9 billion both last year and the year before. Almost all of the major parts makers are in bankruptcy. The big three Detroit auto companies have closed numerous plants and slashed employment. Maintaining sophisticated investment programs is necessary if the companies are to survive. But given the financial constraints, capital expenditures have to be constrained. Their struggles account for part of the shortfall of equipment and software purchases from what the models predict.
Second, many companies in profitable industries have decided that prospective rates of return on new fixed investment in the US are not sufficient to justify increasing capital spending programs significantly. Foreign expansion may offer greater profit potential. Or in some industries, like the energy sector, environmental, regulatory, or political opposition to certain projects may make it impossible to invest more in the business.
Instead, managements and boards of directors have chosen to buy back shares of stock, returning money to shareholders through a higher stock price. Net withdrawal of equity by non-financial corporations reached a record $600 billion in 2006, almost doubling the previous peak withdrawal of $363 billion in 2005. By comparison, in 2002-2004, net withdrawals averaged just $70 billion a year. Most companies that buy back their stock finance their purchases from current earnings, but many use borrowed funds. So not only do these firms conclude that stock buy-backs promise a higher rate of return than added investments on equipment and software. But they also have chosen to increase leverage, as well.
Third, one of the most important developments in the US economy recently has been the increased role of private equity firms. They have been acquiring and restructuring a growing number of public companies. In fact, a big portion of net equity withdrawal is directly related to public companies being taken private.
What is one of the first things a private equity firm does when it takes control of a business? Answer: it goes over the acquired firm’s capital spending plans with a fine tooth comb. The new ownership seeks to get more productivity out of the firms’ existing capital stock. So it demands strong justification for adding to capital that it believes is sufficient. In the end, investment plans are often cut back substantially.
This greater scrutiny naturally impacts the entire corporate sector. If you are running a business that might be a target for private equity investors and want to avoid a takeover, you naturally are going to try to head that off by doing many of the things yourself that would otherwise be forced upon you after an acquisition. Greater discipline on procurement and hiring are part of the response. But you are also likely to establish tougher criteria for approval of capital spending proposals of your divisional managers. The result is leaner, more disciplined and more profitable companies.
Therefore, Fed officials and private-sector economists alike ought not to see the slowdown in business investment spending as a problem. Instead, it is an important element in preserving an economy that generates a high rate of growth in productivity, not just labor productivity, but the productivity of the entire capital stock. As the US expansion moves into a mature stage, maintaining productivity growth is essential for supporting higher pay for workers without putting pressure on inflation. Disciplined capital spending programs are essential to achieving that objective.
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