Corporate profits and cash flow are strong, American firms have record levels of cash on the books, and prospects for future growth in the economy appear bright. Yet capital investment in the United States, which now includes research, development and investment in intellectual property, is historically weak and has been since the fall of the dot-com bubble in 2000. Because capital investment is one of the main pillars of economic and productivity growth and, hence, growth in the standard of living, this weakness is a real problem for the United States. This is especially the case since other nations, most notably those in emerging Asia, Eastern Europe, as well as India and Mexico are gradually narrowing the investment, technology and productivity gaps which have allowed the United States to prosper for the last 150 years. Understanding the factors behind this weakness is crucial to reversing the course.
While our assertion of investment weakness may be a surprise to some, a few numbers help solidify the case. In 2014, real GDP was 8.7 percent above the level it reached just prior to the onset of the Great Recession in late 2007, yet gross private investment was just 3.9 percent higher. What’s more revealing, however, is private investment net of depreciation, since this is a better measure of keeping up production and innovation capacity. Net private domestic investment was just $524 billion in 2013 (the last year for which we have good data), compared to $860 billion in 2006, the high level prior to the Great Recession. Figure 1 above gives graphic illustration of the trends since 1967, showing that the downturn started after the dot-com bubble, and accelerated with the Great Recession. The impact of this weakness can be measured in the much slower-than-average recoveries to the last two recessions and especially to a slowdown in productivity growth. Labor productivity, for instance, grew at only 1.5 percent between 2006 and 2014, and just 0.7 percent after 2011. These numbers compare poorly to the 7.3 percent average growth between 1967 and 1973 and 3.2 percent between 1996 and 2004.
One increasingly popular explanation of this slowdown is the notion of “secular stagnation” advanced most forcefully by Robert Gordon and Tyler Cowen and supported in part by Lawrence Summers. The idea rests on the twin pillars of long-term change in demand due to slowing demographics and improvement of labor skills, and of an end to dynamic boosts to the economy from major technology breakthroughs, such as occurred with the advent of steam and electric power and the computer/internet revolution. A similar argument was advanced by American economists and theorists in the wake of the Great Depression, but was obviously proven wrong by the generation-long boom and technical progress following World War II. We are not convinced that technological innovation is at a standstill, either for so-called “major breakthroughs” or even for the increasingly important category of “incremental improvements.” The Internet of Things, emerging bio-chemical advances, robotics and 3-D manufacturing may offer the kinds of disruptive change that reignite growth. And weakness for demand domestically can be offset by the growth of demand around the world, provided that U.S. firms recapture lost export market share.
There is no single reason for the slowdown in domestic capital investment, but rather a combination of factors which together help explain this phenomenon. In our longer paper, we explore several important longer-term developments which are behind the slow erosion of the United States as the ideal place to invest. While it would be a mistake to argue that the United States has lost competitiveness, it is growing more clear that other nations have taken steps to strengthen the competitiveness of their economies, while a slow process of incremental changes in the United States has undermined the clear lead it enjoyed in the four decades after 1945.
Many economic and policy analysts, including the President’s Council of Economic Advisers, have noted that U.S. corporate tax rates, including effective tax rates, are near the highest for developed countries, and that this discourages close investment decisions about where to locate production or research facilities. We would only add that the erosion of competitiveness is due largely to reductions in tax rates outside the United States. This problem is not easy to resolve, but bipartisan groups are working diligently to do so.
Many have also noted that government investment in infrastructure and R&D have declined, especially in the last 10 years. Gross government investment is down 130 percent since last 2007, and, if you figure for depreciation, is near levels last seen in the 1990s. In 1968, 9.1 percent of the federal budget went for R&D, but by 2015 this number fell to 3.6 percent. Clearly, this is an area ripe for improvement and subject only to political will.
A more complex problem is the growth of the regulatory apparatus in the United States, especially relative to change in competing countries. Numerous studies catalog the accelerating pace of regulation in the United States. Evidence that it is beginning to have a negative impact on investment comes from a number of comparative international indexes of the extent of regulation and its impact on relative competitiveness. For example, in the World Economic Forum’s annual “Global Competitiveness Report,” the United States typically is in the top five for the overall index, but its latest survey ranks it 82nd of 144 nations in the sub-index for “burden of government regulation.” The Organization for Economic Cooperation and Development (OECD) constructs an index of regulatory restrictions for foreign direct investment. While 20 years ago the United States registered less than the average amount of regulatory restriction in this index, by 2013 the regulatory burden was well above the average with nations as diverse as Britain, Poland, Japan, Sweden, Latvia, Germany, and Costa Rica considered less burdensome. The Fraser Institute’s ranking of economic freedom finds the United States to have fallen from 3rd to 14th in its index since 1980, but 21st (of 156 nations) in terms of regulation and 40th in terms of free trade.
Global trade competiveness can also be cited to explain slowing domestic capital investment, since the United States has steadily lost global market share in this category in recent decades. Figure 2 above charts the decline since 2000. Such a decline surely has affected investment, as both domestic and global markets have been ceded to rising competitors. But the United States has also fallen behind in openness to trade and in free trade agreements (FTA). Over 400 regional FTAs have come into effect since 1995, but the United States is party to just two of these and to 10 bilateral agreements. Europe has 38 separate FTAs, and Mexico has added Europe and all of Latin America to its free trade agreement arsenal. That’s one reason cited by Audi recently in locating its newest plant there instead of the United States. The U.S. enjoys a trade surplus in manufactured goods with its FTA partners, suggesting that finishing the two major FTA negotiations now under way with the Pacific Rim nations and the EU could help reverse the negative trade trend of the last 20 years.
The other major trend that likely affects investment is a more diffuse and perhaps derivative one, that of “uncertainty.” Research at Stanford, the University of Chicago, and elsewhere employs sophisticated models to chart what is seen as a secular trend in growth of uncertainty that is tied to political polarization as well as growth in government regulation, spending, and taxes. Global security trends and major shifts in monetary policy probably also contributes to uncertainty, and by extension to the phenomenon of weak “animal spirits” in the term used by Keynes. Measures of new business formation and venture capital are also linked to uncertainty and have weakened along with capital investment. More stability in public regulatory, monetary, fiscal, and legal policy could help combat the effects of uncertainty.
Given the complexity of these factors and the state of political polarization, constructive attention to treatable problems like tax policy, infrastructure spending, trade, regulation, and stabilizing fiscal and monetary policy will not be easy. But given the powerful link to capital investment, productivity, and economic growth, it would be well worth the efforts of political and economic leaders to find a path to constructive change.