More On Investment: “Real” and Real
My note on the weak investment spending of Canadian businesses earlier this week sparked several comments, including one from me on the methodological problems encountered in trying to measure â€œrealâ€ investment effort.Â Hereâ€™s some more grist for the mill of how we understand â€œnominalâ€ versus â€œrealâ€ business investment.Â Point 1 is empirical, and Point 2 is more theoretical.
1. Capital spending price indices.Â Check out the 3Q 2006 national income accounts bulletin.Â Tables 22 (nominal investment spending), 23 (â€œrealâ€ investment spending), and 30 (implicit GDP price indices) are of interest here.
By the nominal GDP table, business non-residential investment equals 11.7% of GDP, and investment in machinery & equipment equals 6.6%.Â By the real table, the numbers are 13.9% and 9.2%, respectively â€“ much stronger.Â Stephen Gordon thinks the latter is a more accurate reflection of true investment, while I favour the former.
Table 30 (price indices) shows that the â€œpriceâ€ of non-residential investment has declined just a bit (by 1 percent) since 1999.Â (The indices are chained $97, but the tables in this edition of the NIEA start in 1999 â€“ so weâ€™ll use 1999 as our starting point.Â This is convenient since 1999 was also the cyclical peak for Canadian business spending).Â This 1 percent decline reflects a rough balance between a 19 percent increase in the price of non-residential structures, and a 13 percent drop in the price of M&E.Â (Since M&E accounts for more than half of all non-residential spending, its price decrease slightly outweighs the larger price increase in structures â€“ most of which, I suspect, is due to whatâ€™s happening in
Northern Alberta).Â So â€œinvestmentâ€ is becoming cheaper â€“ but not by much.
But letâ€™s decompose these numbers a bit.Â Table 30 doesnâ€™t do this.Â But we can do it ourselves, by comparing the nominal and real investment series in Tables 22 and 23.Â The numbers are surprising.
As expected, the apparent â€œpriceâ€ of computers has fallen dramatically â€“ by 57 percent between 1999 and 2005 (and by over 70 percent since 1997, when the chain index starts).Â The â€œpriceâ€ of software has also fallen, but less dramatically so: by 5% from 1999 through 2005, and by 8% since 1997.Â The â€œpriceâ€ of all other M&E has increased over this time (consistent with the hunch I expressed in my comment on my own post).
In fact, the 1997-chained implicit price index for non-computer, non-software M&E is 123.7 in 2005.Â That means that prices for this category (that weâ€™ll call â€œother M&Eâ€) have been growing considerably faster than consumer prices.
In other words, the apparent decline in the â€œpriceâ€ of investment goods is solely due to the dramatic decline in the (quality-adjusted) â€œpriceâ€ of computers. Â Without that, the average â€œpriceâ€ of M&E would be up by almost one-quarter since 1997.
Now, I said in my earlier comment that quality-adjusted price indices for computer products had improved from the days when they were calculated on the basis of a fixed â€œbundleâ€ of goods.Â (Recall, these series used to imply that the real price of computers had fallen almost to zero â€“ because they were based on the relative computing power of a computer, using an ancient 64-KB RAM computer as the â€œbenchmark.â€)Â On further reflection, however, it doesnâ€™t seem that these indices have improved by much.Â Even using a chain index, the index implies that the price of computers has fallen by 70 percent in less than a decade.Â Is there any meaningful sense in which this is true?Â (Remember, purchases of personal computers for business use constitute a major component of what counts as business investment in computers.)Â Like most people, I suspect, I spend about the same amount of money every time I upgrade to a new generation of PC.Â Yes, the computing power of that new computer is vastly improved.Â But does that mean its â€œpriceâ€ has fallen by many tens of percent?Â Not at all â€“ especially when you consider that my old generation product wonâ€™t even work on todayâ€™s software.
Businesses face the same challenge in responding to rapid technological change (more on this below).
These wild results in the M&E deflator have some equally wild consequences for estimating how much businesses are spending.Â For example, in â€œnominalâ€ dollars businesses spent $8.5 billion on computers in 2005.Â In imaginary chain-linked 1997 â€œrealâ€ dollars, they spent $30 billion â€“ almost 4 times as much.Â Which is more meaningful as a measure of spending?Â The $30 billion might as well be printed on Monopoly Money, for all the real economic impact that that inflated figure has.
Similarly, in nominal dollars, computers and software jointly accounted for 13% of all business M&E spending.Â (That strikes me as a reasonable estimate based on what I know of real businesses.)Â In imaginary chain-linked 1997 â€œrealâ€ dollars, however, computers and software accounted for 40% of all M&E spending.Â Thatâ€™s nonsensical.
Including computers and software, â€œrealâ€ business M&E spending has grown by over $25 billion (or almost a third) between 1999 and 2005.Â Excluding computers and software, it grew by $7 billion (or 12 percent).Â In fact, excluding computers and software, the growth in â€œrealâ€ business investment has been much weaker than the growth in measured nominal investment spending: up 17% from 1999 through 2005, versus a growth of 31% in the nominal series.Â (This would be an ideal time for me to use Stephen Gordonâ€™s argument in reverse, to claim that real investment â€œeffortâ€ is even weaker than the nominal data indicate.Â But I wonâ€™t.Â I still think it is investment spending in dollars that matters, for most macroeconomic purposes.)Â Remember that corporate after-tax profits roughly doubled during this same period.
One other interesting empirical note:Â The decline in the overall implicit price index for M&E was about twice as steep as the decline in the parallel implicit price deflator which StatsCan calculates for all goods imports.Â Moreover, the M&E index has continued to decline through 2006 even though the dollar has started to come (somewhat) back to earth â€“ whereas the imported goods price index has been increasing with the dollarâ€™s softness.Â From what (little) I know, I think the methodology of calculating import and export price indices is questionable.Â (Iâ€™d appreciate hearing from anyone with insight on this point.)Â But at any rate, it is clear that the decline in implicit M&E prices is not mostly due to currency fluctuations; it is mostly due, rather, to the bizarre impacts of quality-adjusted price indices for computer products.
It seems very clear to me from this review of current capital goods price data that the claim that â€œrealâ€ business investment effort is much stronger than apparent nominal spending is based completely on the strange effects of rapidly improving computer technology on deflated macroeconomic aggregates.Â It is not robust or economically meaningful.
2. â€œVintageâ€ effects for business investment.Â Thereâ€™s a separate, conceptual point in addition to the forgoing empirical concerns.Â Walrasian GE theory treats investment as the outcome of optimizing choices by individual consumers to save.Â These decisions are affected by preferences (â€œthriftâ€) and by the real benefits that come with investing (â€œproductivityâ€).Â In this world, a decline in the prices of investment goods could indeed set off the sort of optimizing recalculation envisioned by Stephen Gordon (in his â€œapples versus orangesâ€ analogy).Â And with the assumption of diminishing marginal returns, it is quite reasonable to expect that a big decline in the price of investment goods would indeed only partially be reflected in more real investment, with the rest of the savings used to fund higher consumption spending (since the trade-off between current and future consumption, on which that whole loanable funds model of investment rests, has been favourably altered â€“ the decline in real investment good prices allows the consumer to have more of both).
In reality, however, business investment decisions reflect other, more autonomous factors â€“ in particular, strategic competition between firms (something that is assumed not to exist in Walrasâ€™ world) and ongoing technological change (something that is not captured well in Walrasâ€™ world).Â Companies are forced by competition to invest continually in improved products and processes.Â In this sense, they HAVE to step up their â€œrealâ€ investment effort (as measured by the flawed methods discussed above) or they will be driven out of business by companies which refuse to keep using 64-KB RAM computers.
In the real world, investment is not a passive consumer-led process of adding to a capital stock, in return for some confidently anticipated return (rooted in the â€œreal productivityâ€ of that new capital).Â It is a turbulent, business-led process as companies position themselves to earn profits (or, more accurately, rents) on differentiated products or processes, anticipating the reactions of their equally-ambitious competitors.Â That process of constant change is embodied in the varying vintages of concrete capital assets.
The fact that Canadaâ€™s corporations, in general (there are some exceptions, but not many), are failing to take advantage of their unique profitability to increase investment and enhance their relative competitive positions, seems to me to go a long ways toward explaining their parallel failure to succeed in differentiated global markets.Â Instead, they are content to reap huge profits by digging stuff out of the ground (resources) and churn paper assets (banking).
Ironically, business investment spending is much more important to economic success in a heterodox understanding of economics, than in a neoclassical model (where investment per se carries no unique importance as a source of demand or growth).Â So maybe itâ€™s not surprising that heterodox economists should indeed be far more concerned about the weakness in Canadian business investment, than neoclassical analysts.