If hopes were dupes, fears may be liars.

Andrew Smithers
Financial News, a Dow Jones Company., 19th November 2012

Without a rise in corporate investment it will be difficult to take a buoyant view of the US economy.

Talks on the shape of the US budget have begun. It is now clear that compromise is vital to stop the country sliding over a fiscal cliff.

President Barack Obama started the discussions last week by requesting additional tax revenue of $1.6 trillion over the next decade. This figure is unlikely to appeal to Republican members of Congress.

The outcome is guesswork and the sensible approach is to consider a range of possibilities. But the trend is concerning, as US corporate investment data is disturbing, though given little attention.

As of now, the current US budget deficit is 8% of gross domestic product. With a weak US and world economy, the best available solution would be a similar result for 2013, improving steadily thereafter.

This would give the rest of the world, and China in particular, a year’s grace to boost demand. Looking to 2014, and beyond, that recovery would make a reduction in the deficit possible without throwing the US back into recession.

Avoiding even a mild recession is unusually important because of the eurozone’s troubles. There is a clear risk the Eurozone
will break up, as voters in the Mediterranean countries become increasingly fed up with austerity and unemployment. And it is possible that the cost of bailing out the zone’s troubled members will cease to appeal to the Germans.

The weaker the US economy, the more likely it is that such problems will test the patience of electorates to destruction. The shock of a eurozone break-up would probably be sufficient to turn a mild recession into a severe one, in the US as well as Europe.

Although it is desirable that fiscal tightening should be postponed, a more likely outcome to the US budget debate would be an immediate reduction in the deficit. This would be dangerous because any significant tightening of, say, 1.5% of GDP would probably be much worse for the economy than consensus forecasts, such as those made by the International Monetary Fund.

A reduction in the budget deficit has to be matched exactly by a fall in the cash surpluses of other sectors of the economy and it is the business sector that is most likely to be hit.

Fall in cash flow

Since the budget deficit was at its recent peak, corporate cash flow has fallen by just over 2% of GDP and been the main offset to the improvement in the fiscal balance.

This is due to some rise in levels of investment. But if this does not continue, and it seems to be stalling, any further decline in corporate cash flow must hit profits. Because the budget deficit needs to come down, it is a near certainty, falling profits in the US will match at least part of this decline, but it is important it should be gentle.

This is because sharp declines in profits are likely to produce sharp falls in the stock market. This adds to the weakness of the economy and is seldom given enough weight in economic forecasts, which either ignore the stock market or assume that it will not fall.

Long-term changes in the economy also give cause for concern because there have been two discouraging trends in the shape of slowing labour and capital productivity since World War Two.

The two are related because falling capital efficiency means that, without a steady rise in the proportion of GDP invested, the growth of the economy must slow. Unless the numbers of those looking for jobs falls at least as fast, the slower growth of the economy will need to be matched by a rise in unemployment or a slowdown in labour productivity.

The efficiency of capital can be measured by the degree to which additional investment is accompanied by higher output. The incremental capital/output ratio, or ICOR, divides the proportion of GDP which is being invested by the rate of real GDP growth.

The ratio has been on a long-term rising trend and recently shot up. Its rise is partly, but by no means exclusively, the result of the recession. US GDP would have to be 10% higher than it is for the ICOR to fall back to its trend level. But current estimates suggest GDP is less than 4% below its full potential.

Even if GDP adjusts, the ICOR is in worse shape than it has ever been. The last time it shot up was in the early 1980s, and investment went on to fall for six years by around three percentage points of GDP.

Less scope for growth

The risk of a similar fall seems less today because levels of investment are much lower, but this means that the scope for future growth is also less.

The current combination of low investment and a poor ICOR outcome poses a severe problem for the US economy that is seldom discussed.

Unless there is a sizeable improvement, the trend growth rate of the US is likely to be below most expectations. It is too early to be overly worried, as there is a sizeable output gap and, if this is filled by rising investment, the longer term outlook will improve.

But the issue is a concern. Without a rise in investment it will be difficult to take a buoyant view of the US economy when looking at either the shorter or the longer term outlook. Still, the future is not only unknown but unknowable. In the words of English poet Arthur Hugh Clough “If hopes were dupes, fears may be liars”.

His concluding words to the same poem were “But westward, look, the land is bright!”

It’s too bad that, today, this outlook is far from clear.

This article first appeared in Financial News.