The economy could grow faster than it has recently, despite the low unemployment rate, as I explained in a recent post, ‘Slower Economic Growth and Low Unemployment.’ What sectors could drive further growth? Business capital spending offers the greatest possibility, but its acceleration is far from certain.
Consumer spending has made the greatest contribution to overall economic growth in the past four quarters, with residential construction and federal non-defense expenditures helping. Pulling down GDP expansion have been non-residential construction, business capital spending, inventories, exports and defense spending. Weakly positive has been state and local government expenditures.
Business capital spending is the area ripest for rebound. It peaked a year ago and has declined since then. Orders for new capital equipment, a precursor of much actual business spending, peaked nearly two years ago and has declined 12 percent since then. The subsequent declines occurred despite continued economic growth, albeit slow growth.
The classic model of business capital spending begins with capital needed for production, based on expectations of future sales. The cost of capital impacts how intensively the company uses capital, because a given amount of production can be accomplished with lots of capital and very little labor, or just a little capital and lots of labor. So the two key elements are expected future sales and the current cost of capital.
Expectations for future sales have been weak. The surveys of business attitudes conducted by the Business Roundtable and the National Federation of Independent Business show a drop from 2014 or 2015, though the most recent numbers indicate a small rebound. The business executives I’ve spoken with this year expect roughly flat sales in the next two years. Uncertainty about the political future weighs on some minds, but if all the non-political factors pointed upward, then businesses would ignore politics.
The second capital spending element, the cost of capital, should be stimulating a great deal of activity. Interest rates are low and the stock market is up. Companies can borrow or issue equity on good terms. On the converse side, businesses with cash balances have poor financial investment opportunities for their money.
As the economy creeps forward, more executives may find that they are straining their capacity. Costs rise with older equipment, efficiencies decline, and the urge for new capacity grows. This is how the economy could expand in the coming years. I’m not convinced that our slow growth will overcome the attitudinal inertia, but it’s the best story out there for optimists.
Alternatives for strong growth include an export rebound, That would take stronger economic growth around the world, a falling dollar on foreign exchange markets, or both. It’s possible but not likely.
Consumers are unlikely to suddenly reach beyond their means. Housing will expand, but a large acceleration is unlikely because of our slow population growth, as I explained in April’s Housing Construction Forecast. Defense spending will probably rise after the new president is in place, assuming that we elect either Hillary Clinton or Donald Trump and not Gary Johnson. It wouldn’t be until the new budget is approved, late in 2017, though, before defense spending could increase. None of these growth sources are as likely as a resurgence of business capital spending.
A rebound of business capital spending is our best hope for accelerating economic growth, but it seems to me a less than 50-50 probability.
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