WHY DO WE IGNORE BUSINESS INVESTMENT?

Gross Domestic Product, or GDP, is commonly thought to reflect accurately the value of all goods and services provided in an economy. In the GDP model, the economy can be viewed simply as the result of adding the dollar value of five components, typically shown in the formula given below.

GDP = Consumption Spending + Investment + Government Spending + Exports - Imports

From this formula it follows that if we want to increase GDP, we only need to maneuver or increase one of its components. This explains why during and immediately after the 2008/09 recession there was a rush to increase government spending, on the misguided assumption that this would increase automatically GDP and get us out of the recession. President Obama, working with Congress, pushed through the so-called stimulus bill (the misleadingly named "American Recovery and Reinvestment Act") that called for spending of more than $800 billion by the Federal government. It was assumed that this boost in government spending would bring the economy rapidly out of the recession. The spending bill actually included several tax provisions too.

As we now know, and a few sage economists knew before, the much anticipated boost in GDP did not happen. Average GDP growth over the last six years, that is since 2009 when the stimulus spending bill was passed, has been a measly 1.4%. In contrast, the average growth of all previous economic recoveries since the end of the Second World War has been over 4.0%.
We have multiple examples, besides the recent U.S. experience, where boosting government spending has not resulted in a much heralded economic boom. Rather, the opposite has been the case, as in Japan where continuous bursts of government spending over the last 25 years have not pulled that country out of its dormant state.

Increased Government and Consumer Spending do not Lead to Growth

Given all this evidence disproving the presumably beneficial effect of government spending, it is mystifying why this approach continues to grab the attention of so many economists and businessmen.  Two plausible reasons appear to be self-interest and the burden of knowledge. Self-interest because of the benefit, direct or indirect, to those propounding government spending (the crony capitalism syndrome). Burden of knowledge because of the intellectual investment they may have in those theories and their reluctance to accept an alternative explanation of how a market economy works, thereby discarding their belief in incorrect theories.

As far as government spending goes, it's easily seen that what the government spends are funds not spent by consumers. When governments engage on additional spending, they are taking funds away from the public; either immediately in the form of taxes or in the long-run because of the new debt incurred to sustain that spending. Similarly, consumer spending does not lead to growth- at best it simply maintains the same level of goods flowing into the economy.

The Key to Growth: Savings and Business Investment

But the one element of the simplistic GDP formula above that is often neglected, investment, is the key to economic growth. It is only through investment, obtained from the savings of individuals and businesses, that real economic growth results. Most of us remember the example of Robinson Crusoe discussed in our first economics course. The purpose of bringing Crusoe to class was to explain how one day Crusoe decides not to consume all the berries he harvests (or whatever it was), and save some for a future day when the saved berries will allow him to spend his time developing a tool; a tool that will make it easier and more efficient for him to harvest berries in the future. This is the act of saving and investing that is so crucial for economic growth. But also this is the act that seems to have been forgotten in the efforts to generate growth without any effort.

There are many examples of the role investment plays in economic growth and development. We need to look no further than the Chinese economy to appreciate fully the value and impact of investment for economic growth. The phenomenal growth in the Chinese economy over the last 30 years did not result from spending by the Chinese government.  Yes, freeing up markets (to some extent) and allowing for investment to take place. This investment in capital good (facilities, machinery, etc.) is what trigger such spectacular growth. The savings came initially mostly from the Chinese diaspora in places such as Hong Kong, Singapore and Taiwan; most recently it's been from savings by Chinese nationals.

And in the U.S. investment has also historically been key in producing high economic growth. However, it also helps explain the slowdown in economic growth we have had since the beginning of the century. Although the chart "Gross Private Investment" shows what appears to be large and rising business investment in the country, except for the large dip around the 2008-09 recession, disaggregating it into its two main components helps explain that slowdown in growth, as shown below.

The two components are shown on the chart "Non-Residential Business Investment." They are investment for Replacement and Maintenance of the existing stock of capital goods, the ever rising line in red, and investment for New capital goods shown by the blue line on the top chart. At the bottom we display the ratio of New to Total investment where we can see that while in the sixties and seventies the proportion dedicated to New investment was roughly around a third of total investment, the ratio has been on a falling trend since the 1980s.

Naturally a question to ask is what is the significance of this declining trend?

Investment and GDP Growth
By plotting this ratio against GDP growth we can get a clear idea of the relationship, and the impact that New investment has on economic growth in general. To simplify the analysis, we have plotted on the chart "New Investment Ratio & GDP Growth" the five-year averages for both of these variables- GDP growth and the New Investment ratio. This averaging was done to smooth the data and get to the essence of the relationship.

We can see that up until the mid-1990s the New investment ratio was relatively flat, and also GDP growth was fairly robust. However, afterwards the investment ratio began to decline sharply, and so did GDP growth.

What does it all mean?
The emphasis on spending, whether it's government or consumer spending, has resulted in a neglect of business investment. Further, recent economic policies have tended to be adverse to investment, or even to discourage investment. At best, we have seen that the government officials give investment lip service, but they typically prefer direct spending since their effects are presumably more visible and immediate.
But one reason that despite these policies the U.S. economy still maintains some modicum of positive growth, is because the main alternative to investors is focus on one of the European countries. And we all know that the majority of those countries operate in an environment that is yet more punitive towards businesses than the U.S., making investments in those countries a not very attractive and more risky proposition.