William McChesney Martin, Jr., head of the Federal Reserve from 1951 to 1970, famously said that the role of the Federal Reserve is to “take away the punch bowl just as the party gets going.” Today, we might say that a teetotaling economy can't get a hangover.
Here's a chart of what I'm calling “net fixed investment as a percentage of GDP.” What it is – total fixed investment -- public and private -- minus the consumption of fixed capital, all as a percentage of GDP. Think of it like a firewood pile at a ski cabin. It's the amount of new firewood you've bought minus the amount you're burning.
Between 1950 and 2008, this mostly hovered in a range of 6-10% of GDP. An economy must always be investing in new capacity to handle population and economic growth. And then see how it plummeted all the way to 2% of GDP, from which it has yet to even bounce to 3%. We're barely buying enough firewood to keep our house warm – this keeps our bank accounts full (low interest rates) and unfortunately, keeps wood choppers out of work (high unemployment).
This matters because if you look at the chart again, you see that major recessions always coincide with large drops in this metric. If fixed investment doesn't plummet, you don't get the drops in profits, employment, and asset prices that are so devastating to the economy. With it so low, there's nowhere for it to fall. The last recession we had where it didn't fall much was the oft-recalled Panic of 1953-54. It lasted 10 months and the Dow Industrials
(DIA) fell around 5% before rallying over 30% over the next year.
Simply hovering here or even dropping a bit would mean no change or even small gains in fixed investment, and hence GDP growth. The reason? As the economy grows, the amount of old, worn out equipment needing replacement grows. And unlike fixed investment, which waxes and wanes as corporations get more or less optimistic, the path of the consumption of fixed capital is remarkably consistent. Even in the depths of 2008 we saw just a small dip.
The same reason why it's nearly impossible to engineer a bad recession from here is the same reason why it hasn't felt like a recovery. We haven't increased fixed investment. As demand has returned we've just depended on existing capacity. Here's proof – net investment as a percentage of GDP (blue line, left axis) overlaid with capacity utilization (red line, right axis). Capacity utilization has experienced a V-shaped recovery, and has gotten back to normal levels so quickly because we haven't added to our capacity at all.
The good news? Our investment-less, jobless recovery is likely over. We've seen it in the housing and autos data over the past two to three quarters, which are beginning to recover nicely. We just can't produce any more than we already are with the capacity we have. We need to invest more. And with China softening and Europe being Europe, it couldn't come soon enough.
Summertime is notoriously quiet, and those screaming about recession get all the attention, but the prospects for fixed investment growth over the next year have rarely looked brighter, and for that reason you should ignore any talk of recession.
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