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. September 16, 1977
InvestmentandSupplyConstraints
Businessfixed investment amounted to a rather modest 9.7 percent of
GNP in the first half of 1977,and the
latest Commerce Department investment survey suggestsa 6-to-7
percent growth in this sector over
the year ahead. This relatively small
investment growth, in the context
of a projected moderate expansion
of business activity, implies that
capacity utilization in industry will
rise from its second-quarter level of
83 percent to the neighborhood of
88 percent by mid-1978-a level
which in the past has indicated
fairly severe supply constraints on
expansion. What are the implications for the current recovery of
this impending approach to full
capacity utilization?
In the past, supply constraints generally have led to substantial increasesin the share of GNP devoted
to business investment, and some
time thereafter to increasesin interest rates. Neither of these effects is
bad for the economy in and of
itself. Neither supply constraints
nor rising interest rates necessarily
imply either recession or serious
inflation. In fact, on two occasions
in the past, supply constraints have
helped cure developing imbalances
between capital and labor markets.
Capital shortage?
The question of the appropriate
level of capital investment is a separate issue from the widelydiscussed question of ({capital
shortage." In our context, businessmen can face no true capital short-
age, for if they find an investment
to be profitable, they will make it. It
has been argued, most forcefu lIy by
Burton Malkiel, that the United
States is likely to have undesirably
low capital formation over a long
period of time. But this is not a
strictly economic argument, for
business has found no difficulty in
the past in moving to very high
rates of capital formation on short
notice.
Malkiel argues, in effect, that the
amount of capital businessesdesire
to hold (and which, except for brief
transition periods, they will hold) is
lessthan we should wish them to
hold in some social sense.The
quantity of desired capital is based
on the expected demand for the
output of that capital and its profitability, but people in business may
differ from (say)people in Congress
regarding what levels of investment
are desirable.
Yet, apparently, a dollar of investment now has slightly less effect on
the growth of total output than it
once did. The 9.7-percent fixedinvestment share of GNP in the first
half of 1977, and especially the 10.5percent average of 1964-76,were
somewhat higher than the average
recorded during the 1952-64 period. However, output growth in the
past dozen years was comparable to
that of the 1952-64period, so that a
given ratio of investment to output
seems compatible with slightly less
real growth now than in the late
1950's and early 1960's. But this fact
(continued on page 2)
IF
§@1
lliIF
Opinions expressed in this newsletter do not
necessarily reflect the views of the management of the
Federa! Reserve Bank of San Francisco, nor of the Board
of Governors of the Federal Reserve System.
in no way contradicts the ability of
businessto achieve its desired capital/expected output ratio given existing laws and other institutions.
Investmentvs. capacity
In the past, periods of high business
investment have been closely associated with periods of high capacity
utilization. This timing might seem
strange, for it implies that businessmen have a positive preference for
investing in periods of high and
rising interest rates, and also that
they are systematically very shortsighted about their need for additional capital. The timing might
indeed suggest that businessmen
have a very low time preference, so
that events in the future matter
little to them.
A more plausible explanation, however, may be that businessmen are
able to divorce investment from the
long-term financing of such investment, and that they have a strong
aversion to investing unless the
demand for the resultant output is
clearly apparent. The former (financing) requirement need only
mean that businessmen have a reasonably strong cash flow and lines
of credit at their disposal. The second (demand) requirement implies
the ability during periods of constraint to create extra output fairly
cheaply (with extra labor, say) along
with the existence of some kinds of
capital equipment with poor resale
value. The demand requirement
suggeststhat businesseswill prefer
2
to "ride out" short periods of high
capacity usage by hiring labor rather than by buying capital goodsand also that businessespossess
some capital goods (such as factory
structures) which have no real rental market, and which thus must be
assessedover their entire lifetimes.
In contrast, capacity constraints are
unlikely to be caused by (say) a
shortage of trucks, because the businesssector has available a large
buffer stock of trucks owned by
truck-rental firms.
Two periods of past capacity constraint provide examples of the way
that added investment can relieve
capacity pressure and lengthen expansions. From 1955 to 1957, and
from 1966 to 1969,supply constraints were relieved by increased
investment, permitting substantial
further reductions in unemployment.
Investmentvs. interest rates
In earlier business cycles, interest
rates began to rise substantially
about a year or more after the time
when the businesssector reached
full capacity and began investing
more in new capacity. As one explanation for this lag in rates, the
increased spending generally began from a low level of investment,
and thus put little pressure initially
on financial markets.
Nonetheless, any prolonged period
of high investment normally will
occur in an environment of high
and rising interest rates. Despite the
initial lags in rates, past periods of
high investment-such as 1955-57,
1965-70,and 1973-74-generally
continued even in the face of sharply rising interest rates.
generally led to large increases in
businessfixed investment and, subsequently, to large increases in interest rates. Many analystsexpect to
see this pattern repeated in the
period after mid-1978.
Looking ahead
On present indications, however,
the period of supply constraint may
not turn out to be prerecessionary,
because of the modest increase
experienced to date in the growth
of business investment spending.
There is still room for considerable
growth in this sector without too
much effect on other areas of the
economy.
larry Butler
Most analysts agree that the nearterm outlook involves continued
GNP growth and a relatively moderate increase in business fixed investment. Consequently, we could
reach a point around mid-1978
where capacity constraints limit further growth of the economy. In the
past, this kind of development has
Percent
11
-c: High Capacity
Utilization
9
7
5
3
1953
1955
960
1975
1977
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BANKINGDATA-TWELFTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assets and liabilities
large Commercial Banks
Amount
Outstanding
8/31/77
Loans (gross, adjusted) and investments*
Loans (gross, adjusted)-total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.S. Treasury securities
Other securities
Deposits (less cash items)-total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits-total*
States and political subdivisions
Savings deposits
Other time deposits:j:
Large negotiable CD's
99,910
77,337
1,710
23,685
25,212
13,633
8,418
14,155
98,204
28,231
213
67,972
5,301
31,704
28,959
11,290
Weekly Averages
of Daily Figures
Week ended
Member Bank Reserve Position
ExcessReserves (+)lDeficiency (-)
Borrowings
Net free(+)/Net borrowed (-)
Federal Funds-Seven Large Banl(s
Interbank Federal fund transactions
Net purchases (+)/Net sales (-)
Transactions with U.S. security dealers
Net loans (+)/Net borrowings (-)
*Includesitems
Change
from
8/31/77
+
+
8124177
-
+
+
+
-
+
+
+
+
+
+
+
+
330
156
602
179
108
129
215
41
1,036
942
1
155
53
114
232
175
Change from
year ago
Dollar
Percent
Week ended
8/24/77
57
124
67
+
+
+
+
+
+
+ 11,135
+ 10,112
+. 195
+ 2,139
+ 4,577
+ 2,083
757
+ 1,780
+ 9,772
+ 2,999
29
+ 6,685
174
+ 4,720
+ 2,456
+
634
+
755
576
+
465
+
+
+
-
+
+
+
+
Comparable
year-ago period
7
223
230
146
-
12.54
15.04
12.87
9.93
22.18
18.03
8.25
14.38
11.05
11.89
11.98
10.91
3.18
17.49
9.27
5.95
+
+
53
0
53
920
+
122
not shown separately. :j:lndividuals, partnerships and corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author ••. ,
Information on this and other publications can be obtained by calling or writing the Public
Information Section, Federal Reserve Bank of San francisco, P.O. Box 7702, San Francisco 94120.
Phon.e (415) 544-21184.
@FedFRASER