EconoBytes - Friday, August 17, 2012
EconoBytes is a quick daily economic roundup for journalists, sponsored by the Roosevelt Institute and compiled by Fenton Communications. We bring together blogs, analyses, and studies by progressive economists, policy experts, and think tanks on the most pressing issues in the current public economic debate. To subscribe to EconoBytes, email econobytes@fenton.com.
Friday, August 17, 2012
Today, an EconoBytes exclusive: economist Dean Baker (Center for Economic and Policy Research) shows that business investment has recovered, and lower tax rates will not speed recovery.
Weakness in Housing—not Insufficient Business Investment—Delays Recovery
In a Washington Post column yesterday, Kevin Hassett, director of economic policy studies at the American Enterprise Institute and Glenn Hubbard, dean of Columbia University’s Business School (both of whom advise the Romney campaign), rightly take President Obama to task for blaming the ongoing weakness of the economy on the financial crisis, but prescribe a false solution—lower marginal tax rates to boost investment—at a time when investment in equipment and software has never been much higher than it is now (with the exception of the dot.com bubble years of the late ‘90s).
1) Extraordinary weakness in housing could explain much of the weakness of the recovery.
Hassett and Hubbard cite a recent study from the Federal Reserve Bank of Cleveland showing that recoveries following financial crises tend to be stronger, not weaker, than other recoveries[1], and rightly take President Obama to task for blaming the ongoing weakness of the economy on the financial crisis. While there are some questions that can be raised about this study (e.g., was the financial crisis in the 1990 recession really comparable to what we saw in the fall of 2008?), the basic point seems right.
However, the Cleveland Fed study doesn’t quite say that this recovery should be like any other recovery, as the Hassett and Hubbard column implies, but instead notes the extraordinary weakness in housing in this recovery and points out that this weakness could explain much of the sluggishness of the recovery.
2) If residential construction returned to its pre-recession levels, as has been the case in all prior post-WWII recoveries, the data suggests that the economy would be back near full employment.
The Commerce Department’s quantity index for residential construction since World War II shows that, almost 5 years after the start of this recession, the real level of construction is still less than half of its pre-recession peak:
It is not hard to understand why housing has not recovered. The massive over-building of housing during the bubble years led to an enormous over-supply of housing, which resulted in a record vacancy rate in the years 2006-10[2]. In the last couple of years, the vacancy rate has begun to decline, which can explain the recent uptick in housing over the last few quarters.
This housing story explains why we should have expected a long and drawn out recovery. There is no easy way to replace the massive loss in demand associated with the collapse of the housing sector. The wealth created by bubble-inflated house prices was also an important factor boosting consumption. The consumption boom driven by this wealth pushed the saving rate to near zero at the peak of the bubble, 2004-2007. The saving rate has since risen above 4.0 % (still low by historic standards), which corresponds to more than $400 billion in lost annual consumption demand.
3) Investment in equipment and software has largely recovered to its pre-recession level measured as a share of GDP. It has never been much higher than it is now.
For the most recent quarter investment in equipment and software was 7.4 percent of GDP. This compares to a pre-recession peak of 8.0 percent reached in the first three quarters of 2006. Rather than presenting evidence of fearful investors, the investment figures are actually quite healthy, especially given that many sectors of the economy still face large amounts of excess capacity.[3]By contrast, the equipment and software investment share of GDP peaked at 8.4 percent of GDP in 1979, a level never matched during the ‘80s recovery.
Equipment and software investment has never been much higher than it is now, apart from the dot-com bubble years of the late 90s. Its current level is almost identical to 7.6 percent average GDP share during the 80s recovery. In order to close the demand gap created by the collapse of the housing bubble investment would have to rise to shares of GDP far higher than we have ever seen. While that is not theoretically impossible, it does not seem likely and certainly not likely to happen over any short-term time horizon.
4) It hardly seems plausible, as Hassett and Hubbard imply, that lower marginal tax rates would provide a sufficient boost to investment to make up for the demand lost from the collapse of the bubble.
The prescription for increased investment proposed by Hassett and Hubbard, lower marginal tax rates, seems unlikely to have much impact. Determinants of investment is a well-researched topic. The vast majority of this research, including work done by Hubbard, finds that tax rates and the cost of capital have relatively little impact on investment.[4] This work indicates that sales growth and cash flow are by far the most important influences on investment especially for small firms. That would suggest the importance of demand growth for boosting investment. In other words, macroeconomic stimulus is likely to have more impact on investment decisions than changes in marginal tax rates.
In short, it is difficult to see how the tax policy being promoted by Governor Romney will have much of a positive impact on investment and growth, especially if it is accompanied by further cutbacks in government spending. While the Obama administration’s stimulus policy was clearly inadequate to make up for the shortfall in demand created by the collapse of the housing bubble, Governor Romney’s plan is not likely to do any better.
In the near term, there is little alternative to relying on government spending to fill the demand gap. Over the long-term, a lower trade deficit can replace government spending, but this will require a substantial decline in the value of the dollar and a lengthy period of adjustment for the United States and its trading partners.
[1] Bordo, Michael D. and Joseph G. Haubrich, 2012. “Deep Recessions, Fast Recoveries and Financial Crises: Evidence from the American Record,” Federal Reserve Bank of Cleveland, Working Paper 12-14.
[2] The Commerce Department produces quarterly data on vacancy rates which is available at http://www.census.gov/hhes/www/housing/hvs/hvs.html. It is important to combine the vacancy rates for rental and ownership units, since housing can easily change status. Almost one third of rental units are single family homes.
[3] The latest data from the Federal Reserve Board shows capacity utilization in manufacturing to be a full percentage point below its average for the last four decades and more than 7.0 percentage points below its peaks in the 80s and 90s.
[4] The best summary of this research is Chirinko, R.S., 1993. “Business Fixed Investment: Modeling Strategies, Empirical Results and Policy Implications,” Journal of Economic Literature, (Dec.) V. XXXI,1875-1911. See also Fazzari, Steve, R. Glenn Hubbard and Bruce Peterson, 1988. “Investment, Financing and tax Policy,” American Economic Review, (May) V. 78., 200-205.
Special thanks to Dean Baker and the Center for Economic Policy Research for today’s EconoBytes.
For questions or interviews, please contact Ira Arlook (202.258.5437) or Sharon Rose Goldtzvik (202.789.7753).
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