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US private capex, inventories indicate American businesses lack confidence on economy

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If investment is always an act of faith – because it's a leap into an unknowable future – than the numbers on U.S. capital spending in the first half of this year show worrying signs of declining business confidence.

America's investment outlays over that period fell at an annual rate of 2.1 percent, marking a substantial decline from an already lackluster 3.2 percent pace of advance in the second half of last year.

And there is worse. Taking a longer view of this bellwether segment of aggregate demand, which represents one-fifth of American GDP, one can see that the spending by U.S. companies on plant and equipment slowed to a growth rate of 0.6 percent in the year to June, compared with a 5.5 percent growth a year earlier.

This tells us that American companies don't see any compelling reason to expand their factory floors, or to add new capital goods, because they believe they have enough spare capacity to meet current and expected sales from existing production facilities.

No incentive to invest

That is how much they lack confidence in prospects of a steady and sustainable growth of domestic and foreign demand for their products and services.

A longer view of slowing business investments is necessary to dispose of an apparently widely held belief, circulated last week, that the decline of the GDP growth to 1.4 percent in the first six months of this year was just a matter of short-term inventory adjustments.

The idea here is simple: Destocking is generally taken as a good sign for growth outlook, because the aggregate demand is expected to snap back up as industrial production accelerates to restore inventories (-to-sales ratios) to their desired levels.

Well, that has not happened over the past five quarters, when inventory draw-downs have been a constant drag on economic growth.

Inventory fluctuations have no influence on the volume of productive capital stock businesses wish to have on hand to meet the anticipated sales demand. But, by contrast, utilization rates of production capacities are crucial to business investment decisions.

And that's the problem we have been struggling with for some time. Last June, for example, the capacity utilization rate in manufacturing, mining and utilities was nearly 5 percentage points below its long-term average of 80 percent, and an entire percentage point below its year-earlier level.

Clearly, there is no incentive here to invest in new production facilities.

The numbers are showing that, over the four quarters to June, investments in structures (factory space) declined at an average annual rate of 6.4 percent, while additions to equipment marked an increase of only 0.7 percent.

This is a serious problem for American economic policy. And it should be center-stage in an election year when presidential contenders have to tell the nation about their plans for jobs, incomes, social welfare services and the country's security.

All these policy objectives depend on how much we can invest to raise our dismal 1.6 percent potential growth rate. Indeed, physical limits to the economy's noninflationary growth condition our ability to generate jobs and incomes to pay for infrastructure, healthcare, education and defense in an increasingly hostile and polarized world.

Policies to restore confidence

So far, we heard very little about that, except for intriguing sound bites about repatriating the manufacturing outsourced to foreign low-cost producers, and revisions of trade policies to stem our soaring deficits and our runaway net foreign liabilities.

We need to hear more about economic policies, because the long period of cheap money is about to end. The only unknown is whether the adjustment to the new world of economic realities will be a gradual and orderly process, or whether it will lead to a chaotic downturn and rising unemployment.

To avoid unnecessary pain and disruptions to economic activity, the coming measures of monetary restraint should be part of a broader and more balanced policy mix. Fiscal, structural and trade policies should operate in concert with the Fed's monetary management to keep the economy on a steady growth path.

Technically, that is tough. Politically, that may be even tougher – or downright impossible - because the proper conduct and coordination of these policies will crucially depend on the new balance of power between the Congress and the White House. All these policies also have small margins to maneuver.

The fiscal policy is a prime example of that. Wars and policy mistakes leading up to the financial crisis and the Great Recession have narrowed the scope for active fiscal policies. However, assuming a cooperative relationship between legislative and executive branches, national priorities can be rearranged to support economic growth without compromising public sector accounts.

Structural policies can also contribute to growth by removing obstacles to competition and market efficiency. Labor markets, in particular, need measures to increase the supply and professional qualifications for a more productive manpower. Only specific policy actions could bring back into the labor force nearly 4 million long-term unemployed people and those who have become virtually unemployable.

Foreign trade is another area that needs a closer look. In an open U.S. economy, where the external sector represents about one-third of GDP, trade issues are of paramount importance for growth, employment and price stability. Our foreign trade deficits are big numbers. In the year to May, the deficit on goods trade was a whopping $751 billion, and the deficit on goods and services over the twelve months to the first quarter came in at $473 billion, nearly 3 percent of GDP. That will be adding to our $7.5 trillion of net foreign liabilities clocked up at the end of the first quarter.

These deficits are a drag on America's economic growth. I wonder how many people know – or care – that during the twelve months to June, trade deficits took half a percentage point from the growth of our domestic demand.

Some of these trade problems are created by growth differentials and by export-driven freeloaders. Outsourcing and hollowing out of our manufacturing industries is also part of the problem. Other difficulties are caused by discriminatory trade rules and practices. All these problems can be addressed – without causing trade wars – by (a) reviewing our business policies (b) strengthening the G20 consultations and (c) enforcing the rules of the World Trade Organization.

Investment thoughts

Declining business investments are a serious obstacle to a sustained and balanced growth of the U.S. economy.

Events will force America's new legislative and executive authorities to understand that monetary steroids have run their course. Restoring growth to investments in human and physical capital, and raising the economy's noninflationary potential to produce goods and services, requires a different combination of policy instruments.

The Fed's efforts to support the economy have to operate in concert with active fiscal, structural and trade policies.

Failing that - and continuing to rely on printing presses - is a way to a blind alley.

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