TCS Daily

2002, A Boom Odyssey

By Kevin Hassett - March 19, 2002 12:00 AM

Just about everyone is on the record saying that the recession looks like it is over now. In his testimony before the Senate Banking Committee on March 7th, for example, Federal Reserve Chairman Greenspan said "we have seen encouraging signs in recent days that underlying trends in final demand are strengthening." The debate is no longer about how long the recession will last, but rather, has now turned to how powerful the recovery will be.

As mentioned in the previous Greenbook, the best argument for a weak recovery is that there continues to be a large capital overhang. A capital overhang occurs when firms overestimate the future demand for their products and purchase excess capacity. The firm stops investing in new machines until demand catches up with the capacity on hand, and the economy remains in the doldrums.

It is also true that investment depends on profitability. If firms are not making money with what they have, they typically don't bother increasing their capacity. In other words, a capital overhang will be present when the firm is achieving disappointing profits. So, we would expect to see a capital overhang if those industries that purchased the most capital in the years up to last year were the ones that saw the sharpest declines in profits in 2001.

An alternative story is that some other forces (monetary policy, oil shock, the tragedy of September 11th) hurled us into recession, but that the new economy story is correct. According to this view, investments made in 2000 may have improved firms' ability to compete enough to help them stay afloat in the recession.

Last time, we explored some broad-brush anecdotes that suggested the overhang story may be weak. In this installment, we pull out our trusty magnifying class and look to see if the story is in the more detailed industry-level data.

Figure 1 has two lines. The top line (color) shows the percentage change in business investment by industry for 2000. (The names of the industries written across the bottom of the chart.) The bottom line (color) shows the percentage change in profits by industry for 2001.

Now if there were a large capital overhang, then we might expect to see a negative relationship between these two lines. The industries that invested the most in 2000 -- perhaps because of the tech bubble -- were the ones that saw their profits tank the most in 2001. If, on the other hand, there is a new economy, then we might expect to see the opposite pattern. Investments paid dividends even in bad times.

Which is it? Take a look at the chart. If the two lines were negatively correlated then we would expect them to look like a mirror image of each other with the bottom line going to the biggest negative numbers when the top line goes to the largest positive numbers. Instead, we see the opposite pattern. Both lines tend to move together. The visual pattern is confirmed by a simple statistical analysis we performed with these data that revealed that the two lines are positively, not negatively, correlated. This implies that the evidence in favor of the capital overhang view is weak, and may suggest there is something to the new economy story. The industries that loaded up on new machines in 2000, on average, were the ones that weathered the storms of 2001 the best!

A number of cautions are, of course, in order. (I am an economist after all.) First, it might be that this crude measure of previous investment activity is not the best. Playing with the available data, however, I was unable to find an alternative explanation that revived the overhang view. Second, it might be that industry patterns obscure the truth, which would be more apparent if we looked at firm data. For example, suppose that firms in high investment industries who did not invest did well. In that case, the industry pattern might look good, but the truth would be that investments turned sour. We will turn to that question when we pull out the microscope in the next installment and look at the firm-level data.

But if the pattern apparent in these data holds, and further inspection bolsters the conclusions, then it is very good news for the outlook for 2002. If the firms that purchased the most capital in 2000 are the ones now doing the best, then we can expect an investment boom in 2002. If that happens, 2002 is going to be a great year.

Kevin Hassett is author of the forthcoming book, "Bubbleology: the New Science of Stock Market Winners and Losers."

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