The Great Divergence: Private Investment and Government Power

Monday September 20th, 2010   •   Posted by Robert Higgs at 6:49am PDT   •  

Private saving and investment are the heart and soul of the dynamic market process. Together they provide and allocate the resources used to augment the economy�s productive capacity, generate sustained long-run economic growth, and thereby make possible a rising level of living. Economic crises interrupt this process by discouraging investors and causing them to consume their resources or to employ them in relatively safe, low-yielding ways. Absent entrepreneurs willing to take the great risks that characterize investments in great technological and organizational innovations, the growth process fades into economic stagnation or even decline.

The present recession starkly displays this characteristic crisis-related abatement of the economy�s investment process. Indeed, the decline of private investment during recent years has been much greater than most observers realize. Consider the following data, taken or derived from the most recently revised National Economic Accounts prepared by the Commerce Department�s Bureau of Economic Analysis (Tables 1.1.5, 1.1.6, and 5.2.6).

In 2006, gross private domestic investment reached its most recent peak, at $2.33 trillion (in constant 2005 dollars), or 17.4 percent of GDP. After remaining almost at this level in 2007, this measure of investment fell substantially during each of the next two years, reaching $1.59 trillion, or 11.3 percent of GDP, in 2009. This decline is severe enough, but it does not give us all the information we need to gauge the extent of the investment bust.

The greater part of gross investment consists of what the statisticians call the capital consumption allowance, an estimate of the amount of money that must be spent simply to offset wear and tear and obsolescence of the existing capital stock. In a country such as the United States, with an enormous fixed capital stock built up over the centuries, a great amount of funds must be allocated simply to maintain that stock. In recent years, the private capital consumption allowance has ranged from $1.29 trillion in 2005 to $1.46 trillion (in constant 2005 dollars) in 2009. Thus, even in the boom year 2006, about 60 percent of gross private domestic investment was required merely to maintain the economy�s productive capacity, leaving just 40 percent, or $889 billion in net private domestic investment, to augment that capacity.

From that level, net private domestic investment plunged during each of the following three years, taking the greatest dive between 2008 and 2009, when it fell to only $54 billion (in constant 2005 dollars), having declined altogether by 94 percent from its 2006 peak! Last year only 3.5 percent of all private investment spending went toward building up the capital stock. Thus, net private investment did not simply fall during the recession; it virtually disappeared.

Unless this drastic decline is reversed soon, the future will be bleak for the U.S. economy. Without substantial net private investment, brisk economic growth is unthinkable beyond the very short run. Although private investment spending has recovered somewhat since it reached its trough in the third quarter of 2009, gross private domestic investment in the most recent quarter (April to June) of 2010 remained 21 percent below its peak in the first quarter of 2006, and net private domestic investment remained about 64 percent below its previous peak.

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September 2010