San José State University
Department of Economics
Thayer Watkins
Silicon Valley
& Tornado Alley

The Catastrophic Collapse of Investment
in Plant and Equipment in 2008-2009:
Now the wolf really is at the door!

Throughout the first eight months of 2008 the media and various politicians without any real justification were declaring the U.S. economy was in recession. Strictly speaking a recession would mean that the output of goods and services was decreasing. That was not happening. The graph below shows the real quarterly GDP (measured in the year 2000 prices).

There was not a significant decrease in real GDP until the fourth quarter of 2008, when it decreased 1.6 percent compared to the third quarter. (The real GDP did decrease slightly in the third quarter of 2008 compared to the second quarter but it was only for an insignificant 1/8 of 1 percent. The statistics are just not accurate enough to say that there really was a decrease in production.) In the first quarter of 2009 the real GDP continued that rate of decrease.

Thus the recession in output began in the third quarter of 2008. This is confirmed by the statistics on the month-to-month rate of change in total nonfarm employment shown below.

Employment was decreasing slightly from month to month up until September 2008 when the rate of decrease quadruped.

What happened in September of course was the final collapse of the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). This left the holders of subprime mortgages without credit default insurance and without a secondary market for subprime mortgages. The values of the subprime mortgages and securities based upon them dropped. This left many lenders with assets far short of their liabilities. This meant they were bankrupt. The collapse was earlier than expected and the unexpectedness of it produced panic in the financial markets.

Foreclosures of real estate purchased with the funds provided from the subprime mortgages resulted in a decline in real estate values. This led to abandonment of some real estate based upon prime mortgages. This resulted in chaos in the financial markets. But the state of financial markets is not the same as the state of the economy.

The financial markets are important to the extent that they make it possible for someone who wants to purchase the products of the economy to do so. If no one wants to borrow the funds to make purchases then the availability of funds in the financial institutions is irrelevant.

What is happening now is the government is focusing on saving the financial institutions while destroying any motivation for businesses to invest in increased productive capacity.

Historically output recession in the U.S. have occurred when, for one reason or another, businesses started reducing their investment in plant and equipment. This may come as a result of businesses losing there confidence in the future growth of the economy and their sales. Such a loss in confidence becomes a self-fulfilling prophecy. The decrease in investment in plant and equipment might also come from a substantial increase in the real interest rate. It could also come as a result of an increase in taxes that reduce the profitability of increases in productive capacities.

Here is a graphical display of the statistics on the real value of the components of Private Investment. The data on investment in plant and equipment is shown as Nonresidential.

Note that the investment in plant and equipment (Nonresidential Investment) was increasing right up to the fourth quarter of 2008. Also note that the level in the first quarter of 2009 is below what it was in the first quarter of 2005. Thus all the gain from the first quarter of 2005 to the third quarter of 2008 was wiped out in the next two quarters. In contrast the real GDP in the first quarter of 2009 was down but it was substantially above what its level had been in the first quarter of 2005. In fact, the real GDP in the first quarter of 2009 was down only 2.6 percent from its level in the first quarter of 2008 and hardly at all below its level in the first quarter of 2007.

The components of nonresidential private investment show the same pattern as the total. Here is the graph of the figures along with a graph of inventory change with an expanded scale.

The graphs below illustrate why investment in plant and equipment is so volatile. Investment in plant and equipment when GDP is or is expected to be greater that the recent GDP. If GDP drops then the investment purchases of plant and equipment drop to near zero. (Because there are some new industries for which there is no existing capacity there will be some investment even in a severe recession.)

When GDP is significantly below capacity small increases in demand have no effect on investment in plant and equipment. In contrast, consumer purchases decrease as a result of decreases in production (GDP) but do not start dropping to zero. And when demand increases there is a corresponding induced increase in consumer purchases.

The statistics for the past few quarters bear out this point concerning the volatility of the investment in plant and equipment. Whereas between 2008III and 2009I real GDP declined by 3.06 % (6.125% annual rate), investment in plant and equipment declined by 16.85 % (33.7 annual rate). The selling off of inventory and not replacing it (negative inventory investment) increased by $61.8 billions between 2008III and 2009I. This $61.8 billion decline in inventory investment along with the $230.1 billion decrease in investment in plant and equipment accounts for 81.4 percent of the $358.7 billion decline in GDP over that period. The decrease in investment in residential housing over the period was $60.3 billion. This amount along with the declines in investment in plant, equipment and inventory account for 98.2 percent of the decrease in real GDP. There were other declines, such as $58.6 billion in consumer purchases, and some positive influences, such as an increase in net exports of $50.5 billion. (An increase from −353.1 billion to −302.6 billion.)

In the past there were decreases in investment in plant and equipment which led to recessions and the recessions were then declared. In 2008 a recession was declared and as a result of the financial chaos of September 2008 businesses accepted this declaration and began to reduce their investment in plant and equipment.

The collapse of investment in plant and equipment in past recessions could give some confirmation of how fast and how deep the collapse will go. Unfortunately this information is available only for the 2001 recession. Here is that information.

Only the downward portion of the curve is relevant. The investment in plant and equipment declined for five quarters before leveling off. In the first two quarters of its decline it dropped about five percent. The first quarter of decline was relatively small. The decline from that first quarter to the third quarter of decline was about six percent. In the two quarters of decline of the current recession the decline has been 16.5 percent, which is an annual rate of 33 percent.

Although the investment in plant and equipment is the crucial variable it is worthwhile to look at the profiles of decline in total private investment in the last three recessions. The statistics on these are shown below.

Once the collapses shown above started, it took six to eight quarters before some policy change was found to stop the decline. They did not stop on their own. The collapse for the current recession only started in the fourth quarter of 2008.

The profile of an accelerating collapse as shown below

can be discerned in the three cases shown.

The Chairman of the Federal Reserve Board, Ben Bernanke, on May 5, 2009 said he sees the economy improving by the end of 2009. San Francisco Federal Reserve Bank president, Janet Yellen, echoed Bernanke's view. There is absolutely not a shred of theory or empirical evidence for this view. This is just baseless wishful thinking. As presented above the crucial element of investment in plant and equipment is in free-fall toward zero. Business is selling off inventory which is not being replaced at a rate of significantly upwards of $100 billion a year. As the venerable Robert M. Solow puts it:

No one can possibly know how long the current recession will last
or how deep it will go.1

It took the collapse of financial markets in September of 2008 to destroy business confidence; it is going take more than unfounded forecasts of tepid recovery by the likes of Bernanke and Yellen to resurrect business confidence. Timothy Geithner asserted that the problems of the banks will be resolved by the end of 2009. The Treasury and the Fed may take steps to make sure that lenders have plenty of funds for business borrowers but that effort is of no consequence if the borrowers are just not there. The ongoing collapse of business investment in plant and equipment indicates that the borrowers will not be there. The accelerated selling off of inventory without its replacement indicates that the upturn in consumer purchases in the first quarter of 2009 may not translate into increases in production. The Wolf is now really at the door and the people who should be dealing with it realistically are behaving like pollyannaish Little-Bo-Peeps.

1 Robert M. Solow, "How to Understand the Disaster," The New York Review of Books, (May 14, 2009), p. 4.

For more on economic conditions see Survey of Current Economic Conditions.

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