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Foreword
Foreword
This volume contains the papers presented
presented at a conference
conference on
"Financing
“Financing Economic Growth:
The Problem of Capital Formation,”
Formation,"
held at the Center for the Study of American Business, Washington
University on November 30, 1976.
1976.
Cosponsored by the Center and
the Federal Reserve Bank of St. Louis, the conference considered
considered
the problems of generating sufficient flows of saving and
investment to finance economic growth and development in the
future.
Included here are the luncheon address by Lawrence Roos
of the Federal Reserve Bank of St. Louis and the major papers
presented by Robert Eisner of Northwestern University, Allen
Data Resources, Inc. and Massachusetts Institute of
Sinai of Data
Technology, and Jai-Hoon Yang of the Federal Reserve Bank of
St. Louis.
iv
CAPITAL FORMATION AND THE FEDERAL RESERVE
Lawrence K. Roos
It is a real pleasure to be here as aa co-sponsor, along with
Murray Weidenbaum and the Center for the Study of American Business,
Business, of
this important meeting on capital formation.
II must admit to a certain
feeling of apprehension in attempting to deal with a subject of this
complexity in the company of so many distinguished
distinguished members of the acaacademic community.
As president of aa Federal Reserve Bank, II think it appropriate that
I direct my remarks to the role of the Federal Reserve System in the
process of capital accumulation.
Although the Fed is usually viewed as
playing aa relatively minimal part in that process, some of our actions
in monetary policymaking do have significant long-term effects on capital
accumulation.
First, some background.
As we know, additions to the stock of human
stanand physical capital have in the past produced aa steadily rising stan-
dard of living for our people.
In fact, our ability to accumulate and
expand capital has brought us a standard of living rarely matched by
others.
As we look ahead to the future, however, there are serious
surgrounds for concern as to whether our economy can match, much less sur-
pass, the record of past accomplishment.
What has been the accomplishment
accomplishment of the recent past?
From the late—
late-
194O's
1940’s to the early-197O's,
early-197O’s, our economy's
economy’s stock of human capital grew
Mr. Roos is president of the Federal Reserve Bank of St. Louis.
sented these remarks as the luncheon address at the conference.
-1—1—
He prepre-
rapidly as a result of advances in education and training, improvements
in health care, enhancement of knowledge, and development of new techtechnological know-how.
During the same period, resources were allocated to
the production of business
business plant and equipment (i.e., physical capital)
to such an extent that growth of business physical capital far outstripoutstrip-
production of goods
ped growth of the number of man-hours worked in the production
and services.
As a result of these two developments, overall productivity grew at
an historically high rate.
As a consequence, the average rate of inin-
crease in our standard of living more than doubled during the past.
past three
decades.
Growth in output per capita rose from a 1.5 percent average
annual rate of increase in the late-l940’s
late-1940's to about a 3.5 percent rate
in the early—l97O’s.
early-1970's.
So much for the past.
But what does the future hold in terms of
the ability
ability, of our economy to sustain, or to exceed, the average rate of
increase in output per capita of the early-1970's?
early-l970’s? AA related question
while at the
is whether past rates of growth in output can be sustained while
same time achieving often asserted social objectives.
At this moment the answer to these two questions must be “NO”
"NO" unless
the influence of prospective demographic trends on output per capita are
offset by other developments.
Let me elaborate.
According to Census Bureau projections, growth in the labor force
aged population, that is, the potential number of persons available for
filling jobs,
jobs, is expected to slow markedly over the balance of this
century.
At the same time, growth of the total population is projected
-2—2—
to increase somewhat.
An implication of these two projections is that
growth in output per capita will
wi 11 recede from its recent rate of increase
the
unless there are compensating offsets, such as aa marked rise in ·the
growth of productivity.
In turn, the extent of productivity growth will
depend crucially on the potential rate of capital formation.
As economists, you are familiar with the economic considerations
which influence the rate of capital formation.
are varied.
There are many and they
As president of a Federal Reserve Bank, I shall direct my
remarks to the contribution that the Federal Reserve System can make totoward facilitating growth in the capital stock.
It might be appropriate to start by pointing out what the Federal
Reserve cannot do to affect capital growth.
It can neither directly
increase the amount of resources available for production nor directly
directly
influence the allocation of these resources to capital formation.
The
money and, thereby exert
exert an
Federal Reserve can only control the stock of money
indirect influence on capital formation.
indirect
Fed do this?
How can the Fed
growth rate
One way is to avoid pronounced short-run changes in the growth’
of money.
Many studies indicate that stop-and-go monetary actions in the
post—World
short—term accelpost-Horld War
Har II era produced alternating periods of short-term
acceleration and deceleration of monetary growth, thereby, contributing in
considerable measure to fluctuations in income, output, and employment.
Such instability has the effect of generating uncertainty regarding
returns to be expected from additions to capital and, thus, tends to
discourage capital formation.
The other way the Federal Reserve can facilitate capital formation
is by controlling the average growth rate of money over longer periods
—3—
-3-
inflation or deflation.
deflation,
of time so as to avoid inflation
AA generally accepted
proposition today is that the trend growth rate of money relative to the
trend growth rate of output is the fundamental determinant of inflation.
level~ given our institutional
instituti
As rising price levels,
rigidities, are an imporimportant deterrent to capital fonmation
formation and to the efficiency
ency of the allocaallocation of capital, it is appropriate to consider
consi
just how they impact capcapital markets.
First, inflation tends to shorten the maturity structure of debt.
Lenders, to protect against the erosion of their investments caused by
possible changes in the rate of inflation,
inflation, opt for loans with shorter
maturities.
In such situations, firms engaging
engagi
in longer-run capital
formation, such as public utilities, face the necessity of constantly
rolling over short-term
debt.
short—term debt,
The resulting uncertainty with respect to
borrowing costs again tends to reduce the incentive to invest.
Under the progressive income tax rate structure,
structure, conditions of inin-
flation cause personal income tax li
ilities to rise faster than income.
liabilities
As a result, the expected real return to individuals from adding to their
human capital is reduced.
structure, inflation also
al so has
Given our present corporate income tax structure,
an adverse impact on business capital formation,
formation.
Plant
ant replacement costs
rise, but depreciation deductions from
from corporate income for tax purposes
are based on historical costs.
costs,
As aa result, reported profits are overover-
instated, firms pay higher taxes than otherwise, and the incentive to invest in plant and equipment declines.
Firms in regulated industries find that during periods of inflation
their regulated prices tend to rise more slowly than their market—
market-
determined costs.
As a result, they often are unable to compete for inin-
vestment funds with firms in unregulated industries.
Under such circumcircum-
stances, the allocation of resources to capital formation is less effieffi-
cient than if all firms were able to compete on an equal basis in the
marketplace.
In addition, inflation
inflation often leads to calls
calls for the imposition of
formal or informal controls over all prices and wages.
The possibility
of wage and price controls leads to uncertainty regarding
regarding future expected
returns from capital investment, and consequently, reduces the incentive
to accumulate capital.
capital
AA similar situation prevails when ceilings are imposed on interest
rates that thrift institutions may pay on time and savings deposits.
It
is well documented that rising market interest rates are the handmaidens
of inflation.
It is also well documented that when market rates rise
above legally mandated ceiling rates, investable funds bypass thrift
institutions for unregulated markets.
The frequent result is a less
allocation of current resources available for capital formation
efficient allocation
formation.
All of those factors, I believe, underscore the role of Federal
Reserve monetary policy in facilitating capital formation.
Our mission
is to promote a more stable economy and to prevent a persistent rise in
the average level of prices. This role calls for relatively stable
short-run growth of money, and long-run growth roughly in line with the
trend growth of output.
It is clear that monetary authorities should be
primarily concerned with providing a stable monetary environment in the
long—run,
long-run, rather than engaging in attempts to solve sectoral problems.
This is true particularly where capital formation is concerned.
—5—
-5-
Essential to the capacity of the Federal Reserve to fulfill its
its
proper monetary policy role is its ability to function independently of
short—run
influences which call for the use of monetary policy to solve short-run
problems.
The framers of the Federal Reserve Act wisely provided an
independent status for the Fed whereby it would be able to function in
the national interest independent of political or social pressures.
Any
Any
lessening of this independence might
might indeed produce disastrous long-term
results.
In this respect, independence must be construed in both a legal
and de facto sense.
While it cannot be denied that even a legally inin-
dependent system can make errors, problems are more certain to occur
occur when
a monetary authority tries to respond to public pressures
pressures to counteract
short-term economic problems. We must resist both legal and de facto
independence.
threats to Federal Reserve independence.
society’s goals is to foster
In summary, if we believe that one of society's
continued growth in our standard of living at a rate commensurate with
past experience, II suggest that continued capital formation is aa necesneces-
goal.
sary condition for the achievement of this goal
.
For this objective to
be achieved, it is necessary that the Federal Reserve System remain
legally and practically independent.
While such independence does not
assure that adequate capital formation will take place, it will at least
increase the probability that some of the obstacles facing us will be
minimized.
—6—
-6-
GOVERNMENT POLICY AND INVESTMENT
Robert Eisner
There is nothing that cripples business investment
investment like aa recession.
From the beginning of 1974 to the third quarter of 1975,
1975, while unemployunemploy-
ment rose from 5.2 percent to between 8.5 and 99 percent, real nonnonresidential business fixed investments fell 17.5 percent.
While gross
national product in constant dollars declined 6.6 percent from the fourth
1975, the total of fixed investinvestquarter of 1973 to the first quarter of 1975,
ment, including residential as well as nonresidential structures,
dropped 23.6 percent from the first quarter of 1973 to the second
quarter of 1975.
These facts should be an unforgettable reminder to all concerned
with obtaining both aa substantial and an optimal rate of business
business
investment.
The one major government responsibility in this area
area
should be to provide aa general climate of prosperity.
Beyond that, II
comshall argue, government should leave investment decisions to the competitive processes of the free enterprise system, unless cogent reasons
otherwise,
exist for doing otherwise.
There should be no general presumption that
business investment.
government should encourage -- or discourage -- business
--
--
Dr. Eisner is William R. Kenan Professor of Economics, Northwestern
University, and Senior Research Associate, National Bureau of Economic
Research. Many of the views expressed here,
here, and some of the wording,
Research.
are to be found in other recent and current works of the author;
see L4,
/4~, 5, 6, 7 and §..7.
87.
-7—7-
“Investment Needs"
Needs’ and Presumed Constraints
"Investment
We are frequently to
told
l4e
1d that productivity, prosperity, employment,
and growth depend upon major business investment.
investment,
There have then been
many efforts to project "investment
“investment needs."
needs.”
A New York Stock Exchange study
A
bi 11 ion by 1985.
of some $650 billion
L2~17pointed
L2'ff
to a capital "shortage"
“shortage”
/J,s Treasury Secretary, William
Wi 11 i am E. Simon
P.s
L1lf!
of over $2.5 billion
L7!.7 suggested
suggested aa capital
capital gap
gap of
billion by comparing his
estimates of capital requirements in current dollars over the next
decade with actual expenditures in current dollars over the last
decade, without noting the noncomparability of prices.
There have been many other comparisons of projected needs and
requirements and anticipations of actual investment. Bosworth, Duesenberry
and Carron
L3J ooffered
L’~~_7
ffered
a projection for 1980 of 15.8 percent as the
ratio of gross private domestic investment to gross national product.
figure was in fact just about the mean for that ratio
This particular figure
in the 1950’s
1950's and in the pre—recession
pre-recession year of 1973.
A major study of
A
capital requirements was undertaken
undertaken for the Council of Economic
Economic Advisors
under the direction of Beatrice N,
N. Vaccara of the Bureau of Economic
Economic
Analysis.
It projected aa figure of $986.6 billion, in 1972 prices, for
non-residential
non—residential business fixed investment from 1975 to 1980, or 12.0
percent of cumulative gross national product, “in
"in order to insure a
sufficient to meet the needs of a full employment
1980 capital stock sufficient
pollution abatement and for decreasing
economy, and the requirements for pollution
petroleum." L22,
dependence on foreign sources of petroleum.”
L22, p. JJ
7/
Frequently, financing has been seen as aa major concern for the
supply of business investment.
''To
Benjamin Friedman wrote in 1975, “To
an unusually great extent, financial considerations may act during this
-8W-8-
period LT977-817
[1977-Bfl as effective constraints on the amount of fixed Investinvestment which the economy in aggregate is able to do.”
do." Lit
[Tl, p.
sy
5,g7’
ln
In
May
1976, however, Allen
A11 en Sinai reported, “There
"There are no financial
financi a1 shortages
of any consequence.”
consequence. " L!O,
{[o, p.
y
if
Concern has also been expressed with regard to the rate of return
on capital. AA study by William Nordhaus LT2T
LI'ff suggests a drop in the
"genuine"
“genuine” rate of return on non-financial corporate capital.
It
appeared to fall fairly steadily from
from a high of 10.0 percent in 1965
1970's, before the current
to a plateau of around 5.5 percent in the 1970’s,
recession.
adjust(This genuine rate of return involves a depreciation adjust-
ment, akin to that now incorporated in the national income accounts, and
the inclusion of net interest in the numerator and the total value of
denominnon-financial corporate capital, rather than net worth, in the denomin-
ator.)
Presenting a variety of measures, Holland and Meyers found that
mid-1960's and lower
real rates of return were generally higher in the mid-1960’s
"are better off now
since, but they note that non-financial corporations “are
mi d-1950' s." They observed further, “operating
"operating profitability
profitabi 1i ty
than in the mid-1950’s.”
(ROC)
(R0C) is about the same now as then but the cost of capital is lower.
'shortage,' it has as yet had no observable effect
If there is a capital ‘shortage,’
on the cost of capital.”
capital." LT3,
[13, p. 3!7
3§]
I have elsewhere offered critical reviews of some
lome of these studies
and reported findings.
~!hat Ishould
I should like to do here, however, is to
What
consider what the role of government has been in achieving the rate of
investment that we have had and offer some thought as to what government
-9-
policy should be.
be,
I shall consider, in particular, the argument that
government, with business and individual income taxation and with our
social insurance system, discourages saving and investment.
Hence, it
is claimed, government should take special measures to encourage
investment to compensate for this discouragement.
Policy
The Government Record on Tax j~gjj~y~
With regard to the tax system a widespread argument by business
spokesmen, politicians and some economists is that after—tax
after-tax returns on
capital and business investment are generally depressed by government
policy.
In its more sophisticated form the claim is that there is aa
"wedge,"
“wedge,” consisting of the rate of income taxation, between the marginal
social return on saving and investment and the after-tax return perceived
by investors.
One presumes, by this reasoning, that there is no social
cost to capital or to its accumulation which should be met by taxation.
To the extent that national defense and police forces are used to protect
capital or the cost of the future income, this is not true.
Further, business income taxation should not be viewed as taxes on
capital, except in the Marxian sense of all capital, “constant”
"constant" and
"variable."
“variable.”
For if business or corporate income taxation discourages
business production, it does not general
generally distort the choice of input
to achieve
achi eve any given output.
Taxation on one sector, of course, wil
will1
discourage production
production in that sector.
discourage
With less production in that
sector there would be less employment of labor
labor as well as less utilization
of capital.
unaffected, however,
however,
If aggregate demand and output are unaffected,
there would then be more production in other sectors, with the relative
-1 ~
utilization
utilization of labor and capital again unaffected.
We may view business taxation as so pervasive
pervasive aa tax on productive
activity that it offers no alternative in the way of reallocation of
resources to production outside of the business (taxed) sector to some
other productive activity.
would have to assume that
In that case, we wculd
business taxation discourages productive activity generally,
generally, increasing
the demand for leisure and reducing not only investment but the employemployment of labor and the production of market output.
AA more sophisticated
sophisticated view of a possible role of business income
taxation in discouraging investment begins with the acknowledgement
that such taxation is aa tax on profits and not on capital or any one
factor of production
production except to the extent that the costs of non-capital
services,
factor services are more fully tax deductible than are capital services.
Thus, in the so-called
"nee-classical" formulation of the investment
so~caiied“neo~classical”formulation
investuient
function, what becomes criti
critical
ca 1 is whether tax depreciation equals
equa 1s
economic depreciation, whether capital costs such as interest
interest and
dividends are deductible, and whether capital gains and losses are fully
included in taxable income (See {If/,
example).
LT4J, for example),
!fall
If all this were
true, business income or profits taxation would be neutral with respect
would not
to the proportions of factors used in production and hence would
directly affect
affec·:: irwestment,
investment.
It is hardly clear, when these elements
are considered, that business income taxation has on balance discrimindiscriminated against capital and investment.
First, despite the long hue and cry about the inadequacy of tax
depreciation charges, there is considerable evidence that, except
for some of the last few years of extraordinarily rapid inflation, tax
depreciation has in fact exceeded
exceeded economic depreciation.
This is largely
"capital consumption
confirmed by the new Bureau of Economic Analysis “capital
adjustment"
adjustment” for corporate enterprise.
This adjustment is essent~ally
essentially
the difference between depreciation charges calculated on aa consistent
straight-line
basis but adjusted for inflation and the estimates of
straight—line basis
actual depreciation charges based largely on tax depreciation.
It
turns out that for each of the years from 1962 through 1973 the BEA
capital consumption adjustment to corporate profits was positive,
indicating that consistent straight-line depreciation (at 85 percent
of Bulletin “F”
"F" lives) with adjustment for rising replacement costs
was less than actually reported corporate depreciation charges.
The
similar adjustment for non-farm proprietors’
proprietors' income was positive for
L2'§J and L'Zff,
Table
every single year from 1946 through 1975 (See L~..7
L2i~7~
T
able 1.13).
1,13).
find,
The reasons are not hard to find.
The Congress, the Treasury and
the Internal Revenue Services have been
beer. increasingly “liberal”
"liberal" on tax
depreciation and amortization allowances over the years.
Beginning
"Certificates of Necessity”
Necessity" for five
with World War II, we had various “Certificates
amorti2e.tion, renewed again during the Korean War.
year amortization,
In 1954,
sum-of-the-digits and double-rate
sum—of—the—digits
double—rate declining balance depreciation were
initiated for tax purposes.
These entailed aa major acceleration of
consequent increase in annual depreciation charges.
depreciation and consequent
accelerContrary to some confused or confusing interpretations, such acceleration does represent, in an economy growing as is ours in the annual
money value of capital expenditures, a permanent
permanent increase in annual
-12—12—
depreciation charges.
In 1962, “guideline”
''guideline'' depreciation was instituted, offering more
acceleration of depreciation and increases in annual charges.
In 1971
we acquired the "Asset
Range" system which permitted still
sti 11
“Asset Depreciation Range”
further acceleration of depreciation by allowing shortening of tax
lives by 20 percent beyond the already shortened guideline lives.
Finally,
over several decades, it turns out, the Internal Revenue Service has been
acquiescing in a very considerable shortening of lives for tax deprecidepreciation purposes (so that by 1971 for much property there was indeed little
to gain from the Asset Depreciation Range system).
With regard to the costs
costs of raising capital for investment, interest
expenses are fully deductible for tax purposes.
What is more, as
pointed out by George von Furstenberg, with continuing inflation,
busiinflation,busi-
ness borrowers may charge against taxes "not
“not only 'real'
‘real’ interest but
also the inflation premium in their interest payment."
payment,” L21,
-/21, p. 225.7
Vet, with inflation, the real value of bonded indebtedness declines
Yet,
and businesses pay no tax on the implicit capital gain
gain in their net
worth.
Perhaps most important in recognizing overall tax effects on investinvestgains,
ment is our lack of effective taxation of capital gains.
These are of
course only taxed upon ''realization,''
“realization,” and then essentially at half of
normal income tax rates.
Taking into account the extent and timing of
"realization,"
“realization,” which still need not occur even at death, the effective
rate of taxation of capital gains, frequently zero, is almost certainly
-13—
-13-
under 10 percent.
percent. 11
Inflation can lead to nominal capital gains which are not real.
Even inclusion of only half of such nominal capital gains in taxable
income could result in taxation of
of capital rather than true income,
defined as the value of what can be consumed while maintaining real
capital intact. The combination of tax deductibility of interest paypayments and limited
1imited taxability
taxabil ity or non—taxability
non-taxabil ity of capital gains, nominal
or real, may lead, however, to quite different results.
One can
finance a great deal of investment in tangible assets by borrowing,
finance
with the interest costs contributing to a reduction of taxes on other
income. Then, as the return on the investment accrues in the form
form
of increased value of th!
the assets, no taxes are paid. The net after—
aftertax return on investment is thus raised.
Additional government encouragement of some forms of business
investment stems, of course, from the so-called investment tax credit,
which is in fact a reduction of taxes related
re 1ated to purchase of eligible
e 1i gi bl e
equipment. That credit, introduced initially in 1962 and variously
revised, suspended, reinstituted, abolished, reenacted, and extended
and increased, now stands at 10 percent for business generally,
with an extra 1.5 percent related to corporate contributions to
employee stock ownership plans.
Taking into account all of these factors -- accelerated depreciation
——
for tax purposes, full
full deductibility of nominal interest costs,
depreciation of the real value of business debt as a consequence of
1sailey
- - offered an estimate of 8 or 99 percent in 1969.
Bailey /3J
LU
-14-
inflation, the non—taxation
non-taxation of capital gains, and the equipment tax
credit -- I would charge that federal government tax policy has in
——
fact slanted the economy to an overallocation of resources to business
investment in physical capital.
While I suspect that it is too early
to be sure of a secular downturn, particularly with figures heavily
influenced by the stagflation and recession of the last few years, one
may wonder whether the declining rate of return on business capital
suggested by Nordhaus and others perhaps relates to these government
policies.
How Tax Incentives Influence Investment
Government tax incentives for business investment may be expected
to increase investment and the capital intensity of production until
the marginal after-tax
after—tax return has again fallen to whatever is the
in principle, leave
required rate of return on investment. This would, In
the long run after-tax rate of return largely unaffected, while causing
is
capital gains for owners of capital until the new equilibrium Is
reached.
In practice, however, there may well be some over—shooting.
over-shooting.
ual firms perceive higher after-tax profits for themselves.
IndividIndivid-
They may
not anticipate
anticipate all of the ultimate effects for the economy as aa whole
as increases in other taxes counteract their own ininediate
immediate tax gains.
They then react largely to an expansion effect of apparently lower tax
substitucosts without recognizing that in the aggregate it is only a substitu-
tion effect which can apply.
Hence they over-Invest,
over-invest, at least given
the width of markets, as perhaps they did in the late fifties and into
—15-
the sixties only to find excess capacity and excessive capital intensity
in the seventies.
before-tax and
Thus, not only have the marginal before—tax
social returns to business capital been reduced by the introduction and
extension of tax incentives.
The after-tax returns to business and
to the owners of business
business capital may also have been reduced.
The issue of effects upon rates of return is in a fundamental
analytical sense related to the considerable dispute as to the effectiveeffectiveness of various government tax measures in increasing the rate of
aggregate investment.
Aside from influences on aggregate demand, which
we may wish to rule out on the assumption that alternate taxes or
business
reductions in government expenditures would replace any given business
tax reductions, special tax measures for investment such as the equipment
tax credit and accelerated depreciation must operate by lowering the
relative price of capital.
Consequences for investment then depend
upon the elasticity of substitution between capital and other factors,
or more generally among all factors of different durabilities, and
upon costs of adjustment which dictate the time paths of capital and
associated investment,
investment.
"neo-classical" framework simply assumed perfect
Early work within a “neo-classical”
competition and aa Cobb-Douglas production function, where
where the elasticity
elasticity
of substitution between capital and labor is, of course, unity. (See LTk7
[Jtff
and LI':if,
Li5/, for example.)
All that was actually estimated was a set of
distributed lag coefficients, and these were actually taken as constant
and independent of the factors inducing investment.
With discussion of
the critical nature to the investment function of these underlying
underlying
-16—16—
assumptions (See /5
L9 and 127),
l_Q/), attention to parameters of production
functions increased, both in themselves and In
in terms of their roles
functions
in investment.
Forms of production functions proliferated, along with
presumed empirical findings.
Estimates of investment functions tended
"capital" and
on balance to find elasticities of substitution between “capital”
"labor"
“labor” less than unity but in many instances one could not pinpoint
estimates sufficiently to reject the possibility of unitary elasticity
and of the Cobb-Douglas form
form (Note
LVJ.
L1J”).
Differences tended to appear
with
as between estimates from time series and from cross sections, wIth
the former generally showing lesser elasticities of substitution (as
observed in
LIV),
LTZJ),
and we have seen various arguments that the one or
the other set of estimates was biased.
The connection of all this to investment Is
is that, if finns
firms minimize
costs or maximize profits, the prime effect of government lowering of the
after-tax
after—tax cost of capital is, by lowering the relative price of capital
in general or in some Instances
instances more durable capital in particular, to
In
increase the capital intensity of production.
The extent of this increase
depends in equilibrium upon that critical elasticity of substitution.
Given non-zero
non—zero elasticity of substitution, lowering the relative
price of capital brings about an increased rate of gross investment.
In an otherwise stationary economy, the capital intensity of production
capital-labor ratio rises to a new equilibrium, at which point
or the capital—labor
greater depreciation and retirements of capital are offsetting the
permanently higher rate of gross investment.
Net investment returns to
zero. Maintaining aa constant ratio of capital to output or capital
-17—17—
to labor, where output or labor are increasing, of course requires
increasing capital, that is positive net investment.
AA higher capital
intensity or a higher capital-labor ratio, in a growing economy, implies
a permanently higher rate of net investment.
Government investment incentives may be perceived by individual
firms as increases in cash flow and decreases in costs, with product
demand unaffected.
Positive investment
investment responses in the short run
may be related to these perceptions.
We may presume, however, that government policy aimed at increasing
increasing
investment is independent of policies directed toward the maintenance
of aggregate demand.
considerations of fiscal policy,
If general considerations
including real or imagined needs to combat inflation or meet balance
of payment or exchange problems, are such
such as to maintain aggregate
demand or its path invariant, the short run considerations
considerations that lead
underto increased business investment are in time overwhelmed by the underlying constraints of the production function.
Thus, if the elasticity
of substitution is low, any substantial short run increases in business
investment may be followed by sharp reductions in experienced rates of
return and evidence of an apparent over-supply
over—supply of capital.
capital,
As firms
experience the inelasticity of the demand for additional capital with
respect to its rate of return, our usual government incentives
incentives bring
little bang for the buck.
subsidies in the
Many billion dollars of tax subsidies
form of equipment credits and accelerated depreciation produce only
modest increases in investment.
We may also wish to consider the differential impact of investment
-18-
tax incentives on large and small firms. AA good argument can be made
that the equipment tax credit and other business investment tax preferpreferences are a disproportionate advantage to large business, with small
business figuratively picking up the crumbs from the table.
AA major
reason for this is simply that it is big business that tends to be
most capital intensive and uses not only
only the largest amounts but the
largest proportions of equipment In
in the productive process.
Hence
tax benefits for the purchase of business equipment are a much more
substantial boon to large business than to small business, both absolute
and relatively.
The consequence is not only that small business gets less relative
benefit.
There may also be a backwash in this instance which leaves
altersmall business altogether worse off. Aside from the fact that an alter-
native to reducing business taxes in a manner that gives peculiarly
large benefits to big business might be a reduction in taxes of another
form which would be of more benefit to small business, there are certain
form
real and monetary effects of a tax credit and other
other investment tax
subsidies which indirectly injure small business.
First, to the extent that
that large business does take advantage of
the tax credit to order more equipment, it puts added pressure on supply,
including small
small
thus raising equipment prices which all business, Including
business, must pay.
Secondly, added business investment by large concerns
may further tighten credit markets, raising interest rates and making
credit more difficult to obtain by small business. The net gain to
small business from these incentives would thus clearly be less than
-19-
the apparent gross gain which seems so attractive, and may even
possibly be negative.
possibly
There is in fact aa third manner in which the equipment tax credit
and accelerated depreciation allowances
allowances are likely to be of less
relative benefit to small than to large business,
business.
This relates to
depreciathe rather obvious fact that the tax credits and increased tax depreciation deductions are essentially benefits to firms that are already
making profits.
With limited provision for loss offset, small firms
and new firms which are showing little or nothing in the way of taxable
profits hardly benefit from tax advantages which would reduce their
profits tax liabilities.
Effects on Saving of Individual Income Taxes and Transfers
Some see the individual income tax as a deterrent to investment.
It is claimed that saving for future consumption is taxed twice, once
as current income is received and a second time as a return has been
saving.22 Thus, the relative price of future consumption
earned on the saving.
and current consumption, or of saving and current consumption, is altered
to the advantage of current consumption.
As aa consequence, individuals
or households attempt to save less and, given a full employment economy,
less saving occurs and hence there is less investment.
With diminishing
before-tax, social
marginal returns to capital, we have aa higher before—tax,
2As suggested
suggested above,
the availability
availability of
interest deductibility
above, the
of interest
deductibility
and largely untaxed capital gains, as well as explicit tax shelters,
may in fact leave many forms of saving less heavily taxed than current
consumption.
-20-
return on capital than there would be without income taxation.
PrePre-
sumably we have sacrificed investment with a social return which, except
for tax considerations, would be warranted.
Given the assumption of full employment, taxes on income may not,
however, reduce the rate of saving.
substitution effects.
We must distinguish income and
If savers are concerned primarily with establishestablish-
ing a future consumption stream, say for their retirement, a tax on
the return to cumulative wealth reduces permanent
permanent income and reduces
current consumption, and thus increases current saving.
A
A lower rate
of return may induce individuals to save more in order to attain
consumption goals in later years:
the old Cassel effect.
In aa growing
economy with a growing population, we then have increased saving of the
relatively more numerous working young.
If there are not compensating
If
income transfers, this is supplemented by decreased dissaving of elderly
retirees who, because of the lower rate of return on their past saving,
must consume less.
It is frequently argued that government redistributional efforts,
efforts,
in the form of the
the whole tax and transfer payment package, encourage
consumption and hence discourage saving.
This argument may be questioned
appropriately in terms of both the Friedman permanent income LI'[/
LT~Jand
Modigliani life-cycle consumption functions Li~.7.
[If[/. Both the Friedman and
Modigliani models suggest that the marginal propensity to consume
the Modigliani
of poor transferees may be no higher than that of rich tax—paying
tax-paying
transferers.
Redistribution from rich to poor will not then necessarily
raise consumption.
-2
It has also been argued recently, particularly by Martin Feldstein,
that our social insurance system and its method of financing reduce
private saving below what it would otherwise be, and substitute no real
public saving.
One might suggest one contrary effect in the dominant
component of taxes on the working young
young to finance transfer payments
to the elderly retired.
The propensity to leave estates may be such
e·lderly to consume all of their pensions,
that, despite the need of many elderly
our social security system adds more to private saving than it subtracts.
subtracts.
Except for this, it might
governmight be conceded that the guarantee by govern-
ment of retirement benefits reduces a major
r11ajor motivation for saving.
Consideration of historical alternatives to governmental guarantees
of old age support, though, still leaves questions.
What we had before
"social"
“social” security at a government level, and what still exists in
much of the world, is private support within the family, essentially
essentially by
one's children.
one’s
Before the advent of social security in the United
States, it would appear that the bulk of the population found themselves
unable or unwilling to save significantly during their working lives,
and relied in large measure on the support of their children for
sustenance in old age.
The final word on empi
ri ca 1 data is certainly
empirical
yet to be said, but there may have been little loss in private saving
as a consequence of the shift of support of the aged by their children
from aa private mechanism to one socialized
socialized by the state.
To the extent that the social commitment appears more reliable it
may enable individuals to insure themselves
themselves more readily against risks
and uncertainties of all kinds regarding retirement needs, includino
includinci
—22-22-
the uncertain length of life itself, and future health and medical
expenses.
Social insurance may thus bring about aa reduction
reduction in saving
intended to meet risk and uncertainty.
Such aa governmentally induced
•
reduction
reduction in saving is not necessarily a welfare loss.
We may well
prefer to save less and have a lower expected lifetime income when
risk and uncertainty are reduced.
We may prefer the lower-income-
lower-risk combination which
which social insurance makes possible, to the
lower—risk
higher income-higher
income-higher risk combination, which we would be forced to
seek through more saving if social insurance were not available.
Monetary Policy
Business investment
investment is seen by many to depend considerably upon
monetary policy.
In general, easier monetary policy is viewed as
bringing lower interest rates, although this is disputed by “monetarists.”
"monetarists."
They argue that increases in the quantity of money will only temporarily
temporarily
lower interest rates but then raise prices, the expected rate of inflainflation and the nominal rate of interest as well,
Clearly, higher expected
rates of inflation bring on higher nominal rates of interest.
It is
hardly clear, however, that these prevent the lower real rates of
interest which are what should be relevant to investment decisions.
Further, one may well properly question whether expansionary monetary
policy alone, that is the Federal Reserve system bringing about the
J
exchange of non-interest bearing debt (money) for interest bearing debt,
will generally cause much inflation.
The main body of economic thinking does perceive a negative relation
between the rate of interest and investment and hence a positive relation
-23-
between easier money and investment.
What that monetary policy will
be is likely to depend considerably upon the political process.
Despite
the short run independence of the Board of Governors of the Federal
Reserve system and of the Open Market Coninittee,
Committee, one may anticipate
that a Democratic administration will have some influence in implementaimplementation of its traditional policy of easier money.
This would appear
particularly likely as long as the rate of unemployment remains high
from the sharp and
and the economy has not completed its recovery from
deep recession that began in 1974.
Measures intended to affect investment are frequently poorly
judged if one concerns oneself exclusively with business investment
which, as we shall notefurther,
note further, is a small proportion of total capital
accumulation.
In fact, there is little evidence that tight money and
higher interest rates have a direct impact on business investment.
They
do have profound effects, in large part because of governmental restricrestrictions and institutional arrangements in mortgage markets, on investment
in residential housing.
Tight money may choke off investment by relatively smaller and less
credit-worthy unincorporated business.
credit—worthy
It may have very drastic effects
on investment by state and local government and school districts.
may also make puchases of some consumer durable~more
durable.s more difficult.
It
In
its impact on security prices it may importantly affect people’s
people's percep—
percep-
tion of their wealth and hence their own consumption and investment in
human capital.
Important indirect impacts on business investment may
stem from the general movement of the economy in response to monetary
policy.
-24—
-24-
Paradoxically, it is possible that tight money intended to discourage
investment may actually increase business investment.
For example,
to the extent that construction resources are freed from residential
housing and government building, they may become more readily available
for the erection of new business plants.
Corporate fund raisers may
lament the higher interest rates that they pay and yet not note that
lower construction costs (or less rapidly rising construction costs)
or shorter delivery times are a consequence of the tax impact of tight
money elsewhere in the economy.
AA Broader View of Investment
These considerations should lead us to aa much broader consideration
of basic determinants and costs of business investment.
One may be
seriously misled by too narrow a view, particularly that of an individindivid-
firm,
ual firm.
Here it may appear that the availability of funds is aa simple,
overwhelming determinant of the rate of capital expenditures.
Even
in this instance, one may readily document the fact that most large
firms make capital expenditures to the extent that they appear sufsufficiently profitable.
For the giants of American industry that do the
bulk of capital spending, funds are available.
The question is whether
the profitability of their use is sufficient.
And the expected profitprofit-
ability of use of funds varies considerably
considerably more than their cost.
cost.
•
Where profitable opportunities dwindle it may appear that the high
cost of funds is
t discouraging investment.
But were profitability high,
that same high cost would not discourage investment.
may be an evidence of expected
expected profitability.
-25—
-25-
Even availability
Banks and other investors
will be reluctant to supply funds if investments do not appear sound,
that is, profitable.
Ultimately the total amount of saving and investment
investment in the economy
may be seen to depend upon total income and output and proclivities
to save for future consumption instead of consuming r.ow.
now.
As long as
employment
employment is less than full and output and income are hence less than
total of which the economy is capable, saving and investment can
the total
and would be increased by coming closer to full employment,
employment.
Given
a situation of less than full employment, virtually any increase in
output, whether of consumer goods or goods and services produced by
investor purchased by government, would also generate more saving and investment.
The underlying economic relation, indicating that higher income
implies more saving and investment, is relatively unassailable.
The financial counterparts to this underlying real relation may
be varied.
With aa higher national income, there may be greater personal
saving, more in the way of undistributed corporate profits, elimination
of dissaving by the unemployed and financial flows in one way or
dnother
another from the savers to those requiring real capital, to the extent
those in these categories are not identical.
Once full employment is attained, the story
story is aa different one.
Any attempts now to increase investment, that is output not contributing
to current consumption, must involve aa reallocation of resources rather
than merely
merely the utilization of previously
previously idle people and
and productive
productive
capacity.
In such aa situation, difficulties experienced by corporations
in financing more investment may reflect simply the reluctance of
-26—26—
•
government, or non-business investors, to give up their
business or ~overnment,
shares of output.
While fiscal
fiscal and monetary measures may well bring about some
alteration in the mix of output for current consumption and investment
for the future, much of their effect is rather to alter the composition
of investment
investment itself.
Investment may properly and usefully be viewed
contrimore broadly as all current output or productive activity which contributes to future output.
Alongside of the traditionally included business
business
acquisition of plant, equipment and additional inventories, we should
then place similar acquisitions by government, federal, state and local,
and by non-profit institutions.
We might also note that acquisitions
of automobiles by households are as much investment as similar acquisiacquisitions by taxi companies or firms.
Washing—machines and dishwashers
Washing-machines
acquired by households are as much investment as those acquired by
laundromats or restaurants.
Not only are durable goods of households, government and non-profit
institutions investment, so too are education and training,
trainin9, whether onthe-job, in school, or in the home.
future output.
For these also contribute to
By many measures,
measures, the last dollars spent in education
and training have been more productive
productive than the last dollars spent on
plant and equipment.
In addition, we might include in investment child
rearing expenses and provision for health and mobility, all of which
make possible future output.
And, of course, few deny that expenditures
develpment have contributed mightily to productivity.
for research and develpment
Our stock of knowledge is in many ways more valuable than our stock
-27—
-27-
of brick and mortar.
Much of the brick
brick and mortar, of course, is
investment
conventionally counted as part of gross private domestic investment
relatively little of this
in the form of residential construction, but relatively
residential construction will be included in business investment.
Hence we find business investment aa quite minor proportion
proportion of
total capital accumulation in the economy.
In connection
connection with certain
on-9oing
on-going research on extended concepts of national income and output,
T~.7, we
utilizing in large part recent estimates by John Kendrick L[I§],
take total capital accumulation in the United States economy during
1969, excluding "net
“net revaluations"
revaluations” or capital gains, to be $671 billion.
Against this we may note that all non-residential
non—residential business investment,
corporate and non-corporate, amounted to only $98.5 billion for
structures and equipment
equipment and $7.8 billion more for change in inventories.
Non-residential business investment was thus less than 16 percent
Non—residential
of all investment in the economy.
economy,
For the great bulk of capital accumulation which takes place in
under-investment
tangible or human form, there are basic reasons to expect under—investment
and hence higher marginal returns.
Where aa company constructs
constructs or buys
plant and equipment, it can retain it and its benefits for itself,
itself.
Where it invests in research, development, know-how and training, since
knowledge and skills are generally freely disseminated in a free
society, differences between marginal return to the investor and marginal
social return may be substantial.
social
Most particularly,
particularly, since we
we are
not a slave society, it does not pay individual private enterprise to
invest in human beings for more than the expectation of returns from
-28-
their uncertain and usually short run employment.
Yet the serious imperfection in human capital markets, along
vi dual risk aversion, makes it very difficult
with understandable indi
individual
for people to invest adequately in themselves,
themselves.
transInformation and trans-
action costs curtail drastically the supply of finance for human
human capital.
What youth with aspirations for business leadership or service as an
engineer, political leader or economist can go to the bank and say,
“Invest in me!
"Invest
My expected life—time
life-time earnings are high.
I would be
happy to give you a promissory note or sell you equity rights in my
human capital"?
capital”?
Attention to human capital may lead us to aa large issue which
perhaps underlies much of
Of the heat in discussion of government policy
towards investment.
We are frequently told that we need more capital
or investment for output, productivity, jobs and growth. Measures
are devised presumably to increase the aggregate of business investment,
of investment
investment in housing and of various particular forms of capital
accumulation.
regulation of particular industries
industries are
Protection and regulation
Protection
put in terms of inducing desired investment.
Yet, aside from measures to bring about full employment and full
utilization of existing capital, government policies may influence
the aggregate of investment far less than widely supposed.
Given full
employment, we may find investment
investment heavily dominated by people’s
people's
desires to save.
These latter may well be relatively inelastic with
respect to parameters readily susceptible to control by government in
a reasonably free economy in aa democratic society.
-29—
-29-
What much of the
argument may really relate to, therefore, is not how much investment
but what kind of investment, and who should own the resultant capital.
income and
This comes down to the nitty-gritty of the distribution of Income
particularly of wealth.
Thus, tax concessions to tusiness,
tJsiness, allegedly to encourage investinvestment, offer ownership of additional capital to current equity holders.
General cuts in taxes to stimulate demand, indirectly
indirectly encouraging
investment, give the additional capital to those who save more out of
increased after—tax
after-tax incomes.
Government expenditures or subsidies
to stimulate employment, or to further education and training, increase
wealth primarily of those whose only capital is human.
Why do we hear so frequently that the business coninunity
community is
frightened by government spending which, it is suggested, may discourage
“investment”?
“spending” is.
"investment"? Is it perhaps
perhaps because the government "spending"
is
not perceived as necessarily adding to business capital? Business rarely
objects to government contracts to purchase its output.
But government
literal~y
expenditures which might properly be directed to bringing literally
millions of youths, minorities, women and many men into productive
or more productive employment represent essentially investment in human
capital.
They increase most directly the wealth of those who are now
owners of business capital.
v/hat Government Policy Should Be
What
As I indicated at the outset, business
investment suffers severely
sev~rely
bus.iness investment,
in situations of generally inadequate aggregate demand and unemployment.
By far
far the greatest tonjc.,
tonic for investment is full
full employment.
-30-
To attain this,
this, one may best focus on measures not directly concerned
with business investment.
The government expenditure-transfer—tax—
expenditure-transfer-tax-
package should be such that effective demand is equal to the value of
full employment output, whatever the implications for fiscal and monemonetary policy.
undertaken
In addition, appropriate measures should be undertaken
in the way of employment credits, particularly for youths, blacks,
new workers and generally those hard to employ.
These should be supplesupple-
mented by improved efforts at job training
training and placement.
Well planned
public employment is likely to prove aa necessary and useful tool in
the full employment arsenal.
If there is to be some kind of direct subsidy to plant and equipment
investment in connection with efforts toward full employment, the most
subappropriate tool would be a variable but high, marginal credit or sub-
sidy, which may be negative.
sidy,
negative,
Thus instead of a ten or twelve percent,
permanent tax credit on all business equipment expenditures, we would
be much better served in time of recession by a direct subsidy of say
50 percent for all investment over some reasonably high base figures.
That base might be set equal to depreciation charges or, for example,
years’ investment.
investment,
80 percent of the average of the past three years'
Ideally,
profit—making business but
the subsidy should be available not only to profit-making
to unprofitable business, to non—profit
non-profit enterprises, to government
enterprises and government bodies, and indeed to households.
If the benefits were high at the margin and variable, their impact
could be very great.
substitution, as suggested
Low elasticities of substitution,
earlier, may preclude any major effect on investment, particularly in aa
-31—31—
permanent credit of ten or twelve percent.
recession, from a permanent
A
A marginal
dissubsidy of 50 percent would cost the Treasury less and have less distributional effect and yet bring on more investment.
But most important,
if affected taxpayers and individuals recognize
recognize that the credits were
temporary, they would have major motivation to proceed while it is in
effect.
For all would be forewarned that the 50 percent credit might
turn to zero next year, or even to aa 50 percent tax on marginal investinvestment, if policy needs dictated discouragement of aggregate demand.
Prohibitions, restrictions and ceilings on the payment of interest
by banks and financial institutions should be removed with all speed
and in aa manner consistent with orderly adjustment of portfolios.
Particularly with continuing inflation,
inflation, small savers would then have
some opportunity at least to avoid negative net returns, as nominal
rates of interest on demand and time deposits would rise to reflect
expected rates of inflation. To the extent that substitution effects
do dominate income effects, this would induce more saving.
Under
conditions of full employment one might then expect more investment.
Individual and corporate income taxes should be integrated. This
would mean elimination of the corporate income tax with
~lith stockholders
having to credit their full shares of corporate earnings, whether retained
or paid out in form of dividends, to their own individual taxable incomes.
II do not see this as aa measure likely to offer general stimulus to
business investment.
investment mix by
It v1ould
would rather improve the investment
by
forcing firms to compete in the marketplace for capital.
It would
would
eliminate the current major
major tax advantage of retaining earnings within
the firm, regardless of profitable investment opportunities.
-32-
Without
integration, the accumulation of retained earnings, perhaps invested in
taxed capital
outside acquisitions, yields stockholders untaxed or little taxed
gains instead of taxable dividends.
If no further exemptions
exemptions or exclusions of capital gains were added,
firms would be pressed to pay out earnings so that stockholders, having
to pay tax on the earnings in any event, would not have an additional
gains tax on the value of corporate retentions.
This should not,
however, reduce the supply of funds to business as a whole.
Corporations
could offer reinvestment options with dividend checks, as some firms
do already.
themBut with full integration, corporations would find them-
selves bidding against each other, in a vastly enlarged capital market,
for the opportunity to reinvest their own earnings and those of their
competitors.
major role for government in proproThere is still likely to be aa major
moting investment
investment with genuinely positive external economies, as well
as a role for taxing or otherwise discouraging investment
investment with negative
externalities.
There may be similar needs for intervention, ideally in
the form of taxes or subsidies, where unavoidable imperfections in capital
or other markets call for compensation.
I have already pointed to the
investment in human capital.
likelihood of needs for major investment
These do
clearly relate most to imperfections in capital markets and to exterexternalities.
Society benefits from taking youths off the street, out of
into productive jobs.
lives of dependence of crime, and getting them into
And the relative nonexistence of private markets for investment in youths,
particularly of minority groups, suggests that, even ignoring exterexternalities, considerable investment of human capital may well be subsidized
—33—
-33-
in
ir. the interest of closing the gap between marginal private returns
and cost.
More investment and moves closer to an optimum may be expected
as well from removal of a host of government interferences with free
CAB-imposed high airfares, rather than stimulating Investinvestcompetition. CAB—Imposed
ment by giving the airline industry funds to acquire additional planes,
may be discouraging investment by reducing the rate of utilization of
existing capactty. Protective tariffs or quotas on steel imports may
eventually leave the United States steel industry with less demand for
steel and less need for additional steel mills.
Beyond the achievement and maintenance of full employment,
attention to externalities, and the removal of uneconomic government
interferences in capital markets and elsewhere, our policy should be
directed to the promotion of free competition. With such a thrust,
I am confident that we would have more investment in business plant
and equipment, in research and development, in human capital generally
a 11 forms of investment in all
a 11 sectors of the economy. Whether
and in all
they would gtve
give us the most capital or the greatest amount of investment,
I am not prepared to say.
But In
in closing I will
wi 11 return to some thoughts
and words I have offered previously.
I see no reasons of state or religion why we must always more
rapidly accumulate capital for future production.
Such accumulation is,
serafter all, at the expense of current, private and public goods and ser-
vices.
It is
Is not necessary and desirable that we should always have more
in the future than in the present.
It is not axiomatic that we should
sacrifice more when we are ycung
yNmt1 in order to 1
ive better when we
~1e are
live
-34-
that our
older, or that our generation should sacrifice in the prospect that
great-grandchildren would live better.
great-grandchildren
Our golden rule need not be,
"Jam
today!"
Jam tomorrow and jam the next day, but never jam today!”
-35—
-35-
1.
Taxation," in The
Bailey, Martin J. "Capital
“Capital Gains and Income Taxation,”
Capital
Edited by Arnold C. Harberger
Taxation of Income and Capital.
and Martin 3.
J. Bailey,
Bailey. Washington: The Brookings Institution, 1969,
pp. 11-49.
11—49.
.
2.
“Hypothesis Testing and the Demand for
Bischoff, Charles W. "Hypothesis
Capital Goods,”
Goods," Review of Economics and Statistics, Aug. 1969,
1969,
51(3), pp. 354-68.
354—68.
3.
Bosworth, Barry,
Capital Needs in
1975.
4.
Eisner, Robert. "Issues
Formation," Statement
“Issues Regarding Capital Formation,”
Before the Joint Economic Committee, Congress of the United State~,
State~.
June 9, 1976. Washington: U.S.G.P.O., 1976.
5.
. “The
"The Corporate Role in Financing Future Investment
~N-ee-d~s-,n~J-o~i
n.t
Economic
Committee, U.S. Economic Growth from
Needs,”.. -,~.
in Joint
1975-1985:
Problems. Washington: U.S.G.P.O.,
0.S.G.P.O., 1977.
1975—1985: Prospects and Problems.
6.
-.-.--..-,--...--·
7,
7.
_______________.
8.
______________.
Carron, Andrew
the Seventies.
S., and Duesenberry, James S.
Washington: The Brookings Institution,
_______________.
"Capital Shortage: Myth and Reality,”
Reality," presented
“Capital
at American Economic
Economtc Association Meetings in Atlantic City, September
1976, to be published in American Economic Review, February 1977.
______________.
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L. White,
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“Government Pol
Policy,
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icy, Investment and the Return on
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ital Dans La Fonction De Production, forthforthCapital
coming Conference Volume
Vo ume of International Symposium of C.N.R.S.,
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X - Nanterre, November 18-20,
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..---,----,,--~·
1
—
9.
.,....--~-.-..,,.,-- and Nadiri,
Nadi ri, M.I.
M. I. “Investment
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________________________________.
“Neo—Classical Theory of InvestInvest-~~~~-~~--~~~· "Nee-Classical
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A Comment,”
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216-22.
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Friedman, Benjamin N. "Financing
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Investment,” Sloan Management Review, Spring 1975,
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12.
Friedman, Milton. A
Function.
A Theory of the Consumption Function.
National Bureau of Economic Research, 1957.
______________
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369-8 .
-36—36—
Princeton:
13.
“Trends in Corporate ProfitHolland, Daniel and Meyers, Stewart. "Trends
Profitability and Capital Costs."
Cambridge:
Sloan
School
of
Management,
Costs.”
M.I.T., 1976, xeroxed.
xeroxed,
14.
Jorgenson, Dale W. “Capital
"Capital Theory and Investment Behavior,”
Behavior,"
American Economic Review, 53(2), May 1963,
1963, pp. 247—259.
247-259.
15.
and '.::tephenson,
Stephenson, James A. “The
"The Time Structure
of~I~n-ve-s~t-m-en...,t~B~ehavior
of Investment Behavior in
in United
United States
States Manufacturing,
Manufacturing, 1947-1960,"
1947-1960,”
Revie~,
1967, pp. 16-27.
Review of Economics and Statistics, 49(1), Feb. 1967,
16—27.
_______________
16.
Formation and Stocks Jf
Kendrick, John W. The Formation
of Total Capital.
New York: National Bureau of Economic ReseariTh,
Research, 1976.
1976.
17.
Lucas, Robert E. "Labor-Capital
Manufacturing,"
“Labor—Capital Substitution in U.S. Manufacturing,”
£dited by Arnold C.
Ca~ital. idited
in The Taxation of Income From Capital.
Brookings
Harberger and Martin J.
3. Bailey. (ashington,
Washington, D.C.: The Brookings
Institution, 1969,
1969, pp. 223-274.
18.
Modigliani, Franco and Brumberg, Richard. "Utility
“Utility Analysis and
the Consumption Function: An Interpretation
Interpretation of Cross Section Data,”
Data,"
K,K. Kurihara. New Brunswick:
Economics. Edited by K.K.
in Post—Keynesian
Post-Ke{nesian Economics,
Rutgers UniversityPress,
388—436.
On versity Press, 1954, pp. 388-436.
19.
Nordhaus, William
“The Fa
Falling
Wi 11 i am D. "The
11 i ng Rate of Profit,”
Profit," Brookings
Papers on Economic Activity, 1: 1974,
1974, pp. 169-208.
20.
“The Prospects of a Capital Shortage in the U.S.,"
U.S.,”
Sinai, Allen. "The
Euromoney, May 1976, as reprinted
reprinted by Data Resources, Inc., as
Economic Studies Series Number 24.
21.
“Corporate Taxes and Financing Under
von Furstenberg, George M. "Corporate
Continuing Inflation,”
Inflation," in AEI Studies on Contemporary Economic
Problems. Edited by William Fellner. Washington: American EnterEnter225-254.
prise Institute for Public Policy Research, 1976, pp. 225—254.
22.
Bureau of Economic Analysis. AA Stud~
Study of Fixed Capital Requirements
of the U.S. Business Economy 1971-l~O
1971-1980 (prepared under the direction
BeatriceN.
Beatrice N. Vaccara), Washington, December 1975 (Processed).
23.
New York Stock Exchange. The Capital Needs and Savings Potential
Potential
1974.
of the U.S. Economy, Projections Through 1985, New York, Sept. 1974.
24.
Tax Reform. Public Hearings Before the Committee on Ways and Means,
House of Representatives, Ninety—Fourth
Ninety-Fourth Congress, First Session,
On the Subject of Tax Reform, Part 5, Statement of Hon. William E.
Simon, Secretary of the Treasury, July 31, 1975,
1975, Washington 1975.
25.
Survey of Current Business. January 1976,
1976, Part II.
26.
__________________________. July 1976.
1976.
-37-37—
CAPITAL FORMATION
CAPITAL
FORMATION
AND U.S. ECONOMIC PERFORMANCE
Allen
Sinai
Allen Sinai
Three years ago the physical capacity, supply of labor, and
financial resources of the U.S. economy were insufficient to satisfy
demands.
Symptoms of these capital shortages included sharply rising
prices, peaks in factory operating rates, increased unfilled orders,
long delivery delays, higher wages, low unemployment rates, rapidly
accelerating interest rates, widening yield differentials between risky
and “safe”
"safe" financial assets, surging loan demands, decumulation
decumulation of
of
financial assets, and credit rationing. 11 Indeed, the unprecedented
inflation of prices, wages and interest rates was the principal cause
cause
of the deep recession that followed.
A by-product of the 1973-75
1973—75 slump has been a shift from capital
A
"shortages"
1ack in productive capacity, 1labor,
abor,
“shortages” to surplus with great sslack
and financial markets.22 However, the recession also induced a low rate
1As used here, the term "capital"
“capital” refers to physical capital,
human capital and financial capital.
2Utilization rates, whether measured by the Bureau of Economic
Analysis or as newly revised by the Federal Reserve Board, are far
below peak 1973-74 levels and in a majority of cases are less than
the average over 1960 to 1975. Excess supply in the labor market is
indicated by a national unemployment rate of 7.5%,
7.5%, compared to the
less than 5% of three years ago. Also, the current rate of unemployment,
in an expansion that is two years old, exceeds the previous peaks of
7.4% in 1958:2 and 7% in 1962:1. Currently, there is also a large
(17),
financial surplus; see Sinai (17).
Dr. Sinai is Director of Financial Economics, Data Resources, Inc. and
Visiting Associate Professor, Sloan School, Massachusetts Institute
Institute
of Technology.
—39—
-39-
of capital formation, especially by business.
The failure of business
fixed investment to rebound significantly, even in the ensuing recovery,
has raised numerous questions about the relationship of capital formation
to future economic performance.
1)
Among them are:
will capital formation be adequate to support aa full employment
level of output in the years ahead, without a resurgence
subsequent bust?
of inflation and subsequent
2)
what mix of policies would significantly raise capital
formation? Should selective business tax incentives
incentives be
used?
Personal tax cuts?
Easy money policy? Or, some
combination of general monetary and fiscal measures?
3)
will heavy doses of capital formation provide a large enough
increase in productive capacity to ease inflationary pressures
on prices and wages?
This study examines the role of capital
formation in U.S. economic
performance and, in particular,
particulai?~, the effects of some alternative sets
of policies that could stimulate the formation of capital.
The Data
Resources, Inc. (ORI)
(DRI) model of the U.S. economy provided the framework
for analysis, with computer simulations of economic activity in response
to policy changes through 1980.
In brief:
-
the present rate of capital formation, broadly defined,
is insufficient to achieve full employment.
The primary
causes are the deep recession of 1973-75,
1973—75, a sluggish economic
economy's instability
expansion, caution engendered by the economy’s
over the past decade, and the desire of business
business to reduce
financial risk by restructuring balance sheets.
-40-
So far,
nonproductive
spending for
nonproductive investment,
investment, such
such as
as spending
for pollution
pollution
abatement equipment, has not been sizeable enough to bear
a major responsibility for the weakness in physical capital
formation;
—
given the current surpluses in productive capacity, labor
and finance, aggregate macroeconomic policies can be more
effective in raising capital formation than specific business
tax incentives.
incentives.33 Of the policies considered here, a combination
of permanent reductions
reductions in personal income taxes, minimal
growth in Federal government outlays, and easier money
would provide the greatest stimulus to capital formation.
money'' approach, in the sense of
This "tight
“tight fiscal-easy
fiscal—easy money”
keeping a tight rein on growth in government spending,
would have little cost in terms of additional inflation,
even with monetary growth between 8 and 9% per annum in
1977 to 1979;
1979;
3Brimmer and Sinai (2) studied the effects of several business
tax incentives on capital formation and found significant, but only
small impacts. The real case for changes in business taxation rests
on grounds other
other than capital formation; it is to reduce the impact
of higher prices on corporate taxes. Inflation reduces the real purchasing
power of corporations much as in the case of households. Profits are
depending on the method of inventory accounting and historical
overstated depending
cost depreciation does not keep pace with replacement costs. Thus,
periodic reductions in business taxation may be necessary to prevent
an “inflation
"inflation drag”
drag" on corporate spending. This might take the form
of indexing depreciation expenses to capital goods prices, aa policy
suggested by Brimmer and Sinai, or even as reductions in corporate
income taxes. Integration of the corporate and personal income tax
Fellneris also desirable, but on grounds of allocative efficiency. See Fellner—
Clarkson-Moore (8) for a good discussion of tax indexation issues;
Clarkson—Moore
also Tideman and Tucker (20).
-41-
-
as the economy nears full employment, monetary and fiscal
policies must become less stimulative so that
that growth in
aggregate demand slows to balance that of potential supply.
Business tax incentives would then provide aa more appropriate
means for increasing productive capacity further, since
improvements in the financial position of business
business would
accompany the additional capital spending.
Also, the tax
incentives would shift the mix of spending toward business
fixed investment and away from other sectors.
The share
of total L3NP
GNP in business fixed investment, vis—a—vis
vis-a-vis other
sectors, is really an issue only at full employment;
—
the capacity added through aggressive policies
policies to stimulate
capital formation can only bring small reductions in the
inflation of wages and prices, given the relatively small
small
impact of physical capital formation on potential output.
The best insurance against aa resurgence of inflation is
aa gradual approach to full employment with real GNP rising
by 55 to 6% for the next few years, rather than any massive
program of stimulus designed to increase capital formation.
The paper is organized as follows.
The next section reviews
the importance of capital formation and presents a simple framework
for analyzing the effects of measures to enhance the formation of capital.
policies
The analytical model presented helps explain how different policies
affect capital outlays, with resulting increases of business, housing,
and labor capital.
Subsequently, the outlook for capital formation
ORI forecasts of the U.S.
to 1985 is briefly presented, using recent DRI
-42-
economy as a basis.
The following section provides the results of
computer simulations with the DRI model which show the effects of various
policies that could stimulate capital formation.
The policies considered
are 1) sustained reductions in personal income taxes during 1977, 1978,
1978,
and 1979;
1979; 2) these personal income tax reductions accompanied by accommodative
accormiodative
monetary policy; 3) easier money in terms of accelerated Ml growth;
4) personal tax reductions and easier money; 5}
5) personal tax reductions,
slowed growth in Federal government spending, and easier money; 6)
selective business tax incentives such as the investment tax credit
or reductions in corporate profits taxes.
selected
The policy sets selected
for study, while certainly not exhaustive, are those most likely to
benefit capital formation.
The variables studied include real 01W;
GNP;
inflation; the unemployment rate; interest rates; real business fixed
investment; the tangible physical assets of households including housing,
autos, and durables; the tangible physical assets of nonfinancial corporations
including plant, equipment, and inventories; the employed labor stock
and labor force; capacity utilization, productivity;
productivity; and potential
output.
The final section then offers some concluding observations
on the relation between capital formation, productive capacity, and
inflation.
The Importance of Capital Formation
The recent concern with the pace of capital formation has primarily
been focused on the business sector. 44 One line of reasoning has the
capital needs of the U.S. economy so great that adequate
adequate financing
4See
{10), (11), (14), (21), (23}
see (2), (7), (9), (10),
(23) and (25).
-43-
will not be forthcoming in the next decade.
As a corollary, business
fixed investment would be insufficient to create the necessary productive
capacity for preventing a recurrence of the shortages that characterized
5 Labor productivity and growth in potential
the economy in 1973 and 1974.
1974.~
output also would be limited.
Another serious round of accelerating
inflation would result, then a deep recession as policymakers once
again applied restrictive measures in order to contain the inflation.
Indeed, as Table 11 and Charts 11 to 4 show,
show, the rate of business
capital formation has been quite weak since the recession trough in
March 1975.
1975.
investment to GNP was 9.3%
The ratio of business fixed investment
in 1975 and only 9.0% last year.66 These figures compare with averages
of 9.4% during 1955 to 1964 and 10.1% in 1965 to 1974. The only other
investment to GNP has been
years when the proportion of business fixed investment
as low or lower were 1930
1930 to 46, 1952 to 54, and 1958 to 64.
Furthermore,
the upswing in real business fixed investment since the trough of the
recession in 1975:1 is the weakest in the postwar period.
Real residential
construction, on the other hand, has been near average in its expansion.
5vaccara (23) presents the most extreme view. On the basis of
a BEA study, she argues that fixed investment must average at least
12% of GNP in the next four years "to
stock sufficient
“to assure a 1980 capital stock
to provide for increasing productivity, full employment levels of output,
pollution abatement and decreasing dependence on foreign sources of
petroleum".
petroleum”. Most studies project a necessary ratio of 11.5% for fixed
investment to GNP for 1977 to 1980.
1980. Sinai and Brinner (19, p. 44)
are an exception, finding that ratios within historical ranges can
be consistent with a full employment economy by 1981.
6These ratios are net of spending
spending for pollution abatement
abatement equipment,
1975 and 1976.
1976.
estimated at 0.4% of nominal GNP in 1975
—44-44-
TABLE 1. Gross Private Domestic Investment:
Investment:
Historical Profile and DRI Projections*
(GP{11—PASL)/UN1’
{i,FDI-PAtJl)/l,i~i'
l14.3
1,. 3
111.9
' . ,1
11955
'} ') ::,
14)56
)'..,(,
I·;
'Jr
1957
l 'f ';i8
1956
4959
t ·J '\ 9
I<,.
‘4.8fl
1'.i.'.>
15.5
lII.?
5. r
14.3
I 4•e
l 1,. 2
14.2
13.4
13.fti,.&
1’..6
I14.9
4•9
115,0
5. (.
l(,.l
16.1
H,.4
16.4
145.!
5. I
45,3
l'.J.11
115.0
~,. -'.)
i·H,J
4150
l14.1
1,. l
l-; r, 1
1954
1962
t '.162
1l,,u
', .u
t ri. l
15.1
l'>,I
15.1
15.2
lh.?
1)51
1-1
b 5
14964
9 E:, 1,
19,5
1'1·1'3
I1)56
l 6 f,
1-16{
4,61
19/if\
t1966
1949
t(,.1,
46,’.
1 :, • ,)
13.0
l 4•9
14.9
l'i.1,
15.4
16.)
ti,.•::
11,.,,
16.’.
115.6
'i .6
ir,.4
14.6
116.7
I+ • 7
11.5
lt.6
13.6
I 3. &
116.:)
4. ')
11,
.6
16.6
l15.0
5 .')
I 'i. r
15.7
115.9
5. 9
ltl.5
16.3
l15.1
r,. r
I 6. 6
16.6
lf,.J
14,5
,,r, ,-,
(.)1
U’i
1110 1}7')
HTl
1)11
Hf
1)122
1'.,13
1973
1)14
HI 4
1,,
rs
1975
I9’6
l9I 6
1)77
1 -J l l
l '1 T Fl
1918
1919
1'179
1930
1,dO
1991
I 'J 'l l
lii?
l'J'!2
1933
l'H3
19
d4
1936
1')135
49335
'
GNP
GrIP
05372
GNP72
ICR
ICR
1CR72
ICR72
IFIXNR
IF'IXNR
IFSXNR72
IFIXNR72
Jrnv
3159
J01.5972
INV72
PARE
PABE
Sources;
Sources:
l ~ •r
45.1
43.5
1:\.5
115.4
'.',. C
l) . 3
13.3
\ l, • 2
16,2
112.3’
? • (1
\!,.')
45,5
lh3
V53
1954
1i51,
_.,I
CCIII 7213,537?
Gf'Dl
72/t,NP/Z
=
115.1
5. 1
l15.5
'",. 5
1II.!
,, • ~
I5 •G
15.0
lo.,.,
II.)
I;.,
•7
36.7
l 1,.·;
6.)
11.55
11.
13.44
13.
13.8
LL~
I 1, • 3
I’..)
l 4•S
14.5
15.0
I 5. IJ
46.?
t 5. Z
1 '>. '.3
15.0
1
15.8
t':i.f<
15.1
15.
15.6\l
s. e
If
139/3)53
IF IX~EUf;l\/!'
'I.I,
9.4
'l‘.3
• 3
>,6
>."
1J• 4
11,4
l15.5
( •5
9.5
9. '
9.~
?. I
9, r,
9,6
')•I)
9.0
'.<1,ry
9.9
9.5\
9•4
9.4
110.4
iJ, 1,
I11,8
3. Fl
10d
10.3
1 0. 1
10.3
( If
!f II XNR.Pt.RF)/GNP
XNH"'P A.Rf )/GNP
9. 4
9.4
?9.3
• 3
9. 6
9.6
O. 4
l10.4
11.
10.55
9. J
0,3
99.3
•3
9.4
9 • '
9.0
,.o
9. l
9.1
9.0
9.C
q. ,.
9.4
1:).
10.64
l O. ~
10.8
10.2
50.2
l•L?
1-:.,,1
10.9
10.2
1 J. (,
10.4
10.0
10 • 0
9.
9,55
'). 6
‘1.6
1').t,
I0~
l40.0
O .C
l49.4
·". h
10.2
10.2
9. J
9.3
1}.f,
11.6
10.2
1 ').?
9.'
9.”
9.
9,77
(). 5
‘1.5
161
XNRT2/6N312
lflXNR72/GNP72
'l.',
9.5
9. (')
9.0
9.1I
9.
'9.1
.7
lll, l
10.1
11,.
113.5'j
10.6
10-6
111.1
10.9
l11.1
l. l
111.2
I.?
l t.?
11.2
9. J
9.3
'}.
7.66
I/). •J
10.’)
l10.2
'). ;>
t40.’.
110.1
0. l
IO."
10.8
l O. 8
10.8
fl.,.
ICR/GrIP
I CR/GNP
1C977/GNPZ2
I CR72 /GNP72
9.0
9,0
5.0
5.0
4. 4
4.4
9.00
9,
5. 4
4.9
4•9
5.
5.3J
0.4I.
-o.
5.3
~.1
' •7
4. 7
4.?
4.3
' • 3
4. 1,
4.4
5.2
5. 2
4.1
4.6
4,1
4•7
4.7
5.1\
5.
'. '
9.4
9.8
9.8
9.1
'. 7
'8.1
.7
8.1
'. 7
9.(,)
9.0
8.17
e.
8.9
8.9
'. 9
9. J
‘1.3
IC.)
l C. 3
110.8
n. fl
l C. 3
40.3
t O. 3
10.3
10.6
10.6
10.2
10.2
9. 7
9.1
l10.0
O. 0
1\.).6
10.6
IO. 6
10.6
9.3
'. J
9.2
9.2
,.2
9.2
,.,
,.,
9.4
9. '
9.6
9.9
10.1
1 C. l
IC.
10.33
110.6
D. 6
1 I). 7
10.1
1 0. 7
10.1
5.4
,.,
5.9
5.J
,.,
4.8
,.,
,.,
5.4
4. fl
4,8
4,1
4.8
4.B
5.0
'LO
4.6
4.8
'4.4
.4
J.7
3.1
LS
3.5
l. 9
3.9
4.0
4.0
3,6
5.&
4.6
4.6
5.2
5.2
5.0
5.0
3.8
l.l
3.3
l.9
3.9
4. l
4.3
4. (,
4.4
4.4
4.4
4.6
'4.7
.7
4.8
4,8
4.8
4.8
6.1
'. 7
4.6
4.6
,.,
,
..
,.,
4•9
4.9
4. (,
4.6
3,8
3.'
3.6
3.6
4. 0
4.0
J.9
3.9
3.1
J. 7
4.6
' • 6
s.2
5.2
4.1
' •7
J.6
3.6
J.I
3.1
J. 6
3.6
4-0
4.0
4.0
4.0
4.1
4.1
4.1\
4.;;,
4.2
4.2
4.2
4.1\
J
.'
3,9
,.o
,.o
'.
'.
INVClIfG~4l’
l NVC!I/GNP
I3IV7?CH/GNPI?
!iJV7?CH/GNP72
-—0,6
0. i,
C. J
0.)
0,t)
0.0
1.55
1.
1.2
1.2
G.O
0.0
1. 1
1.1
0. 3
0.3
0.41,
I1.1
•1
0.7
0,4
I.!
I. I
1.0
l.O
0.9
1.4
I. 4
I. 9
1.9
1.
1.3J
0.99
\.
1.00
0.4
0,6
0.8
1.4
1.4
0.8
—1.0
-1.0
o.7
0.1
0.6
0.6
0.9
1.
1.00
1.
1.11
1.
1.00
LI
1.1
1.
1.11
I.
1.00
0.9
0.9
0.9
0.2
0.2
‘0.3
0.9
0.6
0,6
0.4
1.0
l.O
0.9
o.,
•). J
0.)
0.J
0.0
J.0
5,0
)1.3)
·J.
3.) )
ij. ·)
0.0
o.,
o.,
0.8
().')
0.0
9.00
'J.
◊. ·)
0.0
1.?
L2
1,7
\.7
\.2
1.2
0. ,)
6.0
2. ,)
0.0
'). I
0.!
0. 1
0.1
-o •
o.r
o.,
o.,
v.
o.,
o.&
,.o
o.,
o.,
o.,
Gross National
Gross
National Product
Product
Gross National
Dollars
Gross
National Product
Product In
In Constant
Constant Dollars
Residential Construction
Residential
Construction
Residential
in Constant
Residential Construction
Construction in
Constant Dollars
Dollars
Fixed Private
Fixed
Private Nonresidential
Nonresidential Investment
Investment
Fixed Private
Fixed
Private Nonresidential
Nonresidential Investment
Investment in
in Constant
Constant Dollars
Dollars
Change in
Business Inventories
in Business
Inventories
Change in
Business Inventories
Inventories in
Constant Dollars
Change
in Business
in Constant
Dollars
Pollution
Abatement Expenditures
3.5. Business
on Capital
Capital Account
Account
Pollution Abatement
Expenditures by u.s.
Business on
Bureau of Economic
Data Resources,
Inc.
Department of
of Commerce,
commerce, Bureau
Economic Analysis,
Analysis, Data
Resources, Inc.
*
*
t'Ail[ /1;NP
t’A0[/6NP
1977—80 forecasts from OR! Control 2/23/77; 1981-85 figures from long-run projections of March 1977.
1977-80
forecasts from ORI Control 2/23/77; 1981-85 figures from long-run projections of March 1977.
0.2
0.2
~o.J
o.,
O.B
0.8
I. 0
1.0
0.4
0.6
0.8
I•l
1.3
0.1
—1.0
- l .0
0.6
0.5
0.9
0.9
1.0
1.0
1. 0
1.0
I. 0
1.0
1.
1.1I
1.0
1.0
0.9
0.9
o.,
o.,
o.o
o.r
o.,
o.s
o.,
o.,
.
;) • l
0.1
J. 2
0.2
·.). 2
0.2
J. 3
1.3
:,.1
0.3
J. 4
0.4
u.,,
5.6
5.4
,.,
,.,
1.4
t,;. 4
0.4
J.S
0.5
V • 'j
u.S
J.5
3.5
J.5
0.5
0. ,,
0.4
0,4
0.4
v.4
0.4
J.4
0.4
CHART 1. Real Business Fixed
Investment in Recovery
CHART 2. Real Producers'
Producers’ Durable
Equipment in Recovery
I 1.20
t.20
I 1.:r,s
11.25
N
0
"£D
l
,.....__
i
/
£I t . 2 0 f - - - - - - - - - - - ~ . . . , __ _ _ _-I
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• •i9s~!I9~~’
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9601961.7
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•••
1---------~""·:...·...,...
1954.1955
~v1...;.i._:.,.....,,..:/~~
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U
'953-1959
.,,..
/
--
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. o , t - - - - - - -......-'---,.--'--\------1
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)954-~ .·_ .......... ·;-·-~-
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8~ 1.10(-------\1..<:.._.
--,---;;<--..---4
1,10
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—
1954.1955
1954-!955
. . . ..
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(
:91o;.1971
1970-1971
//
.•
1.o,1-----=-.,....--,,----------1
1.05
j’’
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1.oof--~=,...:,.._----7.f-------l
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,,,,
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;,)
-
I
-44
5S
6
Quarters free
Q\larten
f ~ Tro.nh
Tro~h
l '
B
I
..
.. ,r,,
I~ 1.20
t.20
6
""
' ' ·1
:
1I l.S
1.~
/,
M
N
'
Investment
GHART
CHART 4. Real Residential
Residential Investmeht
in Recovery
CHART 3. Real
Real· Plant-Expenditures
Plant Expenditures
in Recovery
D
0
5·
, Q*tterstr~estrough~
Qu,vter • - fl:GI 'ttou;h ·,
-.
N
1975—l976
D
••
£E
A 1.1'
15
I
-
I0
u
8 1.10
G
0
•
/
9541955
1954.-1955
/
H
H
l.05
I .05
,1~
-
1960-1961
1960.1961
/
!958-1959
l958—1959
\iI .
i
3l.3
~J.
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958.1959
/
1.2
1 12
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.,. .
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-
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:
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I
2
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1960-196!
1960z1961
----·----
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—
/7’
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H
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•.~ .,
.
—
"'I/
A 1.4
~1.4
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\.
-
1970—1971
1970-1971
•
4
I
-
I
5
'
Quarters from.
tr0111 Trough
Quarters
-
6
'
I
-
7
I
1.1
-
•
6
-46-
1.0
..
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I- 4,
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I
QuarterS free Trough
Quart.en tro. TrOUCJh
•
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'
;
-
•
Several factors account for the recent poor record of capital
capital
formation by business.
First, the 1973-75 recession was the most severe
of the postwar period.
Aggregate demand dropped sharply late in 1974,
1974,
providing a sudden shock to business
business' sanguine expectations of future
final sales.
In addition, this episode, in contrast to others, was
characterized by extraordinarily high interest rates, greatly
cash flow, and badly
badly deteriorated balance sheets,
sheets. 77 Corporate
diminished
diminished
leverage
moved dangerously high, debt burdens became overwhelming, the average
maturity of outstanding debt shortened considerably, and the ratio
of financial assets to short-term liabilities reached a record low.
Serious threats of bankruptcy and default arose for many corporations.
Debt or equity finance became near impossible to obtain at any cost.
Under these conditions, business
business spending had to be severely cut back.
back.
Second, the expansion
expansion has been extremely weak since the 9.2%
rise of real GNP in 1976:1.
1976:1,
There is considerable slack in the labor
market and capacity utilization rates have only slowly recovered,
recovered, so
that much excess capacity remains to be eliminated in relation to the
same stage in other expansions.
Without the pressure of increased
final sales relative to utilization, probably the most important determinant
of capital spending, business has had little incentive to invest.
Furthermore, fears of continued instability in the economy, similar
7
For a discussion, see (2), (11), (19), (25). Brimmer and Sinai
288-94) describe how deteriorated financial positions affect
(2, pp. 288—94)
business fixed investment in the DR!
DRI model of the U.S. economy. AA
similar view appears in Minsky (13, chs.
ch's. 4 to 7).
-.47-47-
to the ups and downs of 1965 to 1975, have kept businessmen cautious
commitments to heavy doses of capital outlays.
about conritments
Finally, an unprecedented restructuring of balance sheets and
strengthening of liquidity has prevented
prevented business capital outlays from
sharply rebounding.
rebounding. 8 With a resurgence of cash flow relative to capital
outlays, business has increased financial assets relative to liabilities,
short—term debt, restructured debt maturities
retired a record amount of short-term
to aa- longer term,term, sharply reduced the burden of debt service, and lowered
debt-equity ratios for-the
for the first time in many years.
Much lower inflation
and relatively easy monetary policy has helped by reducing interest
rates and easing the external risk to balance sheets.
The return to
this process of corporate “reliquification”
"reliquification" in terms of reduced risk,
risk,
higher credit ratings, reduction of prior claims on income, returns
on financial assets, and accumulation of the liquidity to finance future
outlays, has far exceeded the expected rate of return on the acquisition
of physical assets.
The current weakness in business fixed investment
investment is not without
precedent.
As noted, similar patterns appeared during the 1930's,
1930’s,
early 50’s,
50's, and in 1958 to 1964.
1964.
early
In particular, the 1958 to 1964 experience
was characterized by an approach to full employment without any decided
rise in the ratio of business fixed investment to GNP.
Thus, full
employment has not necessarily been precluded in the past because of
weakness in business plant and equipment spending.
8See
see Sinai (17).
-48-
In each case,
case, however,
in this
the process of getting to full employment
employment took many years, and in
sense it can be argued that capital formation was inadequate.
Despite the focus of most researchers on capital formation by
business, the problem is not limited to that sector.
Tangible capital
also is found in the household, financial, and government
government sectors.
sectors. 99
The stocks of housing, autos, and durables provide direct utility to
households and make household production
production easier.
Even household inventories
productivity of
probably matter for social welfare, if not for the productivity
The equipment and buildings of financial institutions certainly
labor.
provide an input to the production process.
Social overhead capital
or infrastructure such as railroads, urban mass transit, and highways
is important to maximize economic productivity in the private and public
sectors.
And lately, the capital necessary for clean air and water,
energy independence, and urban repair has attracted attention.
Human
capital, too, is now generally considered a part of the total capital
stock, with spending for maintenance and improvement of labor perhaps
as important for productivity as increases of physical capital.
But
the growth in these forms of capital also has slowed in recent years.
The preoccupation with business capital formation is understandable,
since measurement has been concentrated on this category and traditional
production theory includes only business capital.
But it should be
clear that the physical assets of households, labor capital, and social
overhead capital are also critical to society’s
society's welfare and the productivity
of labor.
Accordingly, in this paper, concern with capital formation
is not limited to the business sector, but includes the stocks of
9See Kendrick
9see Kendrick
for different
different types
(12) who presents
(12) who presents
of capital in the
—49—
-49-
an exhaustive set of estimates
an exhaustive set of estimates
U.S. economy.
housing, automobiles.
automobiles~and
and other
other durables
durables in the household sector.
The
induced changes in the labor force and employed stock of labor also
are considered.
The resulting coverage of capital formation is still
still
conceptual point of view, but this is only because of
limited from a conceptual
the scope of the DRI model.
The case for capital formation can be illustrated with a simplified
analytical framework of the U.S. economy.
Consider a model of aa closed
economy that focuses upon the short-run
short—run dynamic behavior of households,
authority,
firms, bank and nonbank financial institutions, the monetary authority,
and government.
Uses and sources of funds behavior of the various
recognized.10 Markets for output; money;
sectors are explicitly recognized.
non—monetary
non-monetary financial assets; the earning assets of banks; household,
business, and government debt; and labor are included.
Price inflation
depends on wage costs, external elements such as OPEC oil price increases,
and demand-pull pressures.
Wage inflation depends on inflation
inflation expecexpec-
tations, the unemployment rate, and the existing framework of institutions.
Employment depends on the demand for labor and real wages.
Disequilibrium
110
°Funds
Funds can be used for acquisitions of physical or financial assets.
For example, households purchase houses, autos, and consumer durable
goods; but also increase holdings of money, deposits, bonds, or equity.
Firms may accumulate inventories, plant, equipment, or labor; but
also place funds in various financial assets. Debt repayment and retireretirements are a use of funds. Financial institutions use funds to acquire
loans and investments. The government sector purchases
purchases considerable
capital and labor. Sources of funds are current new money flows,
borrowing, or the sale of assets (a negative use};
use)-; where new money flows
refer to current exogenous
exogenous sources of funds such as disposable income
(households}; cash flow (corporations); deposit inflows, adjusted for
(households);
reserve requirements, and loan repayments (financial institutions);
contributions to retirement programs (pension funds);
funds}; and tax receipts
(Federal, state and local governments). Viewing the activity of the
various sectors in aa uses and sources of funds framework generalizes
analysis that is based on physical asset
the more standard macroeconomic analysis
purchases and current income flow financing. For some discussion of
these notions, see Sinai (16) and (18).
-50-
is the usual state, with interrelated adjustments of spending and
financial behavior as the various sectors move from existing to
desired positions in assets and liabilities. Expectations are critical
because certainty and perfect foresight are not assumed. Also, the
recognized for households, business,
risks of default and bankruptcy are recognized
and government.
Taxes, too, are permitted.
AA large number of financial
markets are assumed to exist for both short- and long-term
long—term securities.
The demand and supplies of financial assets and liabilities interact
to determine the structure of interest rates.
(underThe equations describing this system can be summarized as (under11
lined variables are exogenous):11
Real Sector
rse·
hfaet-11 (cl/yd)
(ds/yd)e·' cst '· kc~
kc t-11]]
Ct =
= f
[yd~rs~rl~ret;
(cl/yd)~
~
11.• Ct
t' rle.
t' ree·
t' hfa
t-1'·1(ds/yd)e;
11 (ydte.,
2.
ifixedt
=
3.
irest
=
f3
4.
invt
= f
5.
it
ifixedt
6.
t.~ = f6(y~)
4
f2 [(py/r)e; (db/cf)e; Uek
~
[remort; Amortt ~ vac~~
kti]
krest_i]
[ye; delaye ~,ue;
(db/cf)e; kinvtij
+
irest
+
.
-
-
invt
-
11
1tThese
lhese equations reflect the structure of the DRI model of the U.S.
economy, although not exactly the model generating the simulations presented
below. The conceptual framework that determines national income is reprerepresented, but some detail is omitted. For example, not all of the variables
specified and many of the exogenous variables
appear in the equations as specified
are actually endogenous in the DRI model. See Data Resources,
Resources, Inc. (5)
and Eckstein-Green-Sinai
Eckstein-Green-Sinai (6) for aa more complete discussion.
-51—51-
7.
yd.~
Ey~—t~
yd
t =
y t - tt
8.
g=~
9 = .!!.
8a) deft
9. - tt
8a)
deft =_g_
= f
8b) A~debt~
llgdebt t =
f88 (deft;
( def ; gdebt~..
gdebt 1))
t
t-1
-
9.
y~= ct
i~+ g
+
Capital Stock Identities
10.
10,
kc~ c.~ +
11.
11.
kt
12.
kres
krestt
13.
kinv~
~
ifixed~+ 62 kti
ires
= irest
t
+
+ 6.,
o~.o3
kres t-1
inv~+ kinv~1
Financial Sector
14.
md~=
f
[yr; rs~rd~ret; rl~A9debt~td~,,1 usbondst_1 md~1]
15.
mst
=
f15 (mb; rsf4; rloan4; resreq; curratio)
16.
mst
=
mdt
14
=
m~
Potential Output
17,
yP
= f
17
(nft; kt; T)
Employment, Prices and Wages
18.
n~= f18[y~kti; (w1p)~ (r/p4; (db/cf4]
19.
4
=
~
PQEt;
jjp~(w/p)~]
-52—52—
20.
20.
= n5 =
nndt =n
t =nnt
21.
p
.
[(y~- yP); Pstruc.
~struc. ; wtJ
~i
21[(yt
t == ff21
-
yP>O, then Pt>Pstruc.
if yt - y~>O,
~t>~struc.
if
-
22.
~t
23.
~t
=
+
.
yP<O, then
then ~t<~~struc
Yt - y~.cO,
Pt<Pstruc.
if
if
—
nt-i
f23[(l/ru)t; ‘~w~~]
24.
24.
w~!~
wt =Wt+~wwt-l
25.
25.
rut == ~25
rut
f25 [[zi: (yP/y)~.]
(yP/y) t-il
i=o
-3
Definitions (superscript ee refers to expectations or expected value):
.
C
c
yd
yd
rs
rl
re
hfa
cl
ds
=
=
=
=
=
=
=
=
=
=
=
=
=
cs
kc
ifixed
=
p
=
y
y
=
rr
db
db
=
=
=
=
=
=
real consumer expenditures
real disposable income
real disposable income
short-term interest rate
long—term
long-term corporate
corporate bond
bond rate
return on corporate stock
real household financial assets
consumer installment credit liquidations
debt service, defined as a weighted average of outstanding
mortgages and consumer credit. The weights are arithmetic
averages of the current and past interest rates for each
debt instrument
consumer sentiment
stock of consumer goods
real business expenditures on plant and equipment
price level of physical output
physical output of goods and services
rental price of capital
debt burden, defined as a weighted average of outstanding
bank loans, commercial paper, and corporate bonds. The
-
.53-53-
cf
=
u
kk
=
=
ires
rmort
rmort
mart
mort
vac
=
=
£2.e.
kres
inv
mv
delay
=
=
=
=
=
=
=
=
=
=
=
=
kinv
=
=
ii
=
=
tt
9.
.9.
def
gdebt
md
rd
td
us bonds
usbonds
=
ms
mb
rsff
rloans
res reg
resreq
curratio
m
m
yP
nf
T
T
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
weights are arithmetic averages of the current and
past interest rates for each debt instrument.
cash flow, after inventory valuation adjustment
capacity utilization rate
stock of plant and equipment
real residential construction
mortgage rate
outstanding mortgages
vacancy rate
population
stock of housing
real inventory investment
delivery delay, precent of companies reporting slower
deliveries
del iveries
stock of inventories
real gross private domestic investment
tax receipts
real government spending
Federal budget deficit (NIA basis)
outstanding issues of Treasury debt
demand for money
effective yield on passbook deposits
time deposits
holdings of U.S. Treasury securities
securities by households,
firms, and state and local governments
supply of money
monetary base
Federal funds rate
prime rate on bank loans
reserve requirements on deposits
currency ratio
MI, narrowly defined stock of money
MI,
potential real output
full employment
technology
-
—54—
-54-
nd
n’~
=
ns
=
=
=
lf
=
li
=
=
Q2£.
lfpr
=
=
lier.
=
ww
=
.p
=
Pstruc
~struc =
=
W
w
=
ru
=
=
=
•
=
=
demand for labor
supply of labor
labor force
population
population
labor force participation rate
level of wages
rate of price inflation
structural
inflation
structural inflation
rate of wage inflation
unemployment rate.
The uhexplamned
unexplained endogenous variables in equations
equations (1) to (25)
fall into three categories: interest
interest rates (rs; rl; re; rmort; rd;
rsff; rloans), the rental price of capital r, uses and sources of
funds (hfa; 6mort;
Amort; td; usbonds), and balance sheet indicators of
financial instability (cl/yd; ds/yd; db/cf).
In the ORI
DRI model, the
interest rates are determined in aa segmented market framework where
where
the demands and supplies for a particular instrument, across sectors,
stochastic equations.
interact in stochastic
flowsFull explanations of sectoral flows—
liabilities
of-funds,
of—funds, the holdings of financial assets, physical assets and liabilities
for households, nonfinancial corporations, commercial banks, savings and
loan associations, mutual savings banks, and life insurance
insurance companies are
provided.
•
This includes hfa, 6mort,
tmort, td, usbonds, cl/yd, and db/cf.
A
A
total of 103 behavioral equations and 99 identities describe the financial
12
system. 12
t2There is no need to present such detail here.
12
There is no need to present such detail here.
full description.
—55—
-55-
See (5)
for aa
See
(5) for
The above system generalizes standard macroeconomic analysis
to aa more realistic framework in several ways.
dynamic.
First, the model is
There are own stock adjustment processes
processes in each of the major
expenditure equations; but also interrelated dynamic adjustments in
sector. 13
the other assets and liabilities of each sector.
disaggregation.
Second, there is considerable disaggregation.
has 718 equations; 379 behavioral and 339 identities.
variables also are included.
ORI model
The DRI
Some 170
17D exogenous
The breakdown is final GNP demands (176);
incomes (31); financial (202); supply, capacity, and operating rates
(10); employment, unemployment, and the labor force (10); prices, wages
and productivity (81); industry production, investment, capital stock,
and employment (208).
(208}.
Third, expectations play a major role in the economic behavior
as modeled.
In a world of uncertainty, almost all the right-hand
right—hand side
variables in the equations should be expected values.
true for prices and other signal mechanisms.
This is especially
The formation of expectations
is generally adaptive or extrapolative, and current
period actual values
current-period
4 Explicit survey measures of sentiment (cs)
(~) and delivery
are eschewedJ
eschewed. 14
delays (delay) are used.
Thus, distributed lag specifications are
pervasive.
•
13See
see (2) for an example.
14 There
rhere have been no attempts yet to incorporate rational expectations
into the structure of large—scale
large-scale econometric models. While the inadequacies
of extrapolative methods for projecting expectations are well-known,
well—known,
it is not clear at this time whether implementation of rational expectations,
even if possible, will improve upon the current formulations.
-56—56—
Fourth, disequilibrium is the normal state with equilibrium
of the system aa special case that is never attained.
The flows of
spending and financial activity describe quarterly behavior, a period
•
that is too short for full equilibrium to be reached.
The interrelated
adjustments of real and financial activity within each sector, as actual
states approach those desired, make disequilibrium dynamics
dynamics the focus
of the analysis.
Steady state growth dynamics do not appear until
many periods after a shock, but then show numerous familiar characteristics.
Fifth, there are many nonlinearities in the system.
These range
from ratio variables on the right-hand side of an equation to nonlinear
specifications
specifications for the effects of capacity utilization, delivery delays,
and financial constraints.
on—and-off mechanisms exist
Numerous on-and-off
exist and
ceilings on variables such as interest rates are specified.
Sixth, there is a very detailed financial system, with explicit
modeling of the balance sheets for households, firms, and financial
institutions.
Government financing is an endogenous result of spending
and tax receipts, with effects on interest rates for municipal and
U.S. Treasury securities.
U.S.
Interrelations between the spending and
financial activities of each sector generate the balance sheet items
items
and measures of bankruptcy or default risk that appear in the main
spending equations.
Financial
Financial markets are imperfect and almost all
of the instruments in the portfolios of the various sectors are included
in the analysis.
Traditional interest rate linkages from finance to
real final demands appear, but in addition, there are variables that
reflect the supply of funds for markets in disequilibrium (mortgages
(mortgages
and housing); recognize the interrelated adjustments of financial assets,
-57—57—
physical assets, and financial liabilities (consumption
(consumption, investment);investment);
and capture the inhibiting costs of balance sheet instability, potential
(consumption, investment
bankruptcy, or debt default on real final demands (consumption,--investment
and state and local government spending).
is endogenous, with changing stocks
Seventh, potential output
output
is
of labor and capital the major inputs.
Given utilization rates and
the state of technology, potential output affects the unemployment
rate (equation 25); wages through the unemployment rate (equation 23);
and price inflation directly via the relation between aggregate demand
and supply (equation 21).
Thus, business capital formation tends to
Thus,
--
ease inflation by increasing the capital input to production.
production
wage-price interactions heavily reflect inflation
inflation expectations
expectations.
, Finally, wage—price
,Inflation
policy,,
Inflation itself arises from external sources such as OPEC pricing policy,
',•·'
the existing institutional framework, the price-setting
price setting practices of
business, and commodity shortages.
Thus, aa base rate of inflation,
Thus,
is assumed to exist at full employment, with deviations
Pstruc.,
deviations,
struc.
about p
due to changes
ch
in unit labor costs and the relation
p
struc.
of aggregate
aggregate
output.
of
demand to
to potential
potential output.
Capital formation affects
-
-
inflation to the extent
extent
productive
is increased.
productive capacity
capacity is
increased'.
- -
-
Equations (1) to (25) can
can be collapsed to an IS-LM
IS—LM model by
removing the dynamic elements; assuming certainty in
in order to eliminate
expectations; treating the financial
financial markets
markets as
as perfect
perfect so
so there is
only aa single rate of interest; and eliminating the sectoral portfolio
approach to finance.
Thus, in a sense the macroeconomic model utilized
here is an extension of IS-LM analysis,
analysis,
but its necessary realism makes
difficult so simple aa categorization.
categorization.
-58-
-
-
-
By tracing through the effects of autonomous shocks to the macroeconomic
system that is depicted, the case for capital formation can easily
be seen.
Consider an autonomous increase of business fixed investment,
perhaps because of improved confidence in the stability of policies
to emanate from the Administration.
Aggregate demand rises, but so
does potential output as business capital is formed (equations 11 and
17).
17).
Any resulting rise of inflation depends on the relation between
actual and potential output (equation 21), and is less than if the
rise in aggregate demand were due to another source.
With no change
in the monetary base, interest rates rise to provide a negative feedback
5 The constraining impact
effect on both consumption and investment.’
investment. 15
of the rates operates directly on consumption, raises the rental price
of capital, and increases the debt service charges of households and
firms.
Higher interest rates also cause a decline in stock prices,
a reduction in the market value of household financial assets, and
reduced consumption.
The higher rental price of capital and debt service
burden facing corporations keep business fixed investment lower than
under aa regime of constant interest rates.
Deposit flows to banks
and nonbank financial intermediaries diminish with the increase of
interest rates, reducing the supply of mortgage money and constraining
constraining
residential construction.
However, the net effect is still higher
output; greater rates of investment and consumption; more employment;
upward pressures on prices and wages; and increased stocks of consumer
durable goods, business capital, and housing.
Whether the housing
15 Also state and local government spending.
—59-59-
stock rises or falls depends on the relation between the increased
demand for housing and previously existing stock, as manifested in
6 A
a measure of vacancies.’
vacancies. 16
A lower vacancy rate stimulates housing
starts, as evidence that the backlog of housing demand is rising.
But diminished funds flows lessen the availability of mortgage money
as an offset.
The increased capital stock of business raises the productivity
of labor
labor (equation 18), so there is a rise in the demand for labor.
Thus, the case for capital formation includes 1) increased productive
Thus,
capacity for the economy; 2) an easing of the inflationary pressures
from aggregate demand against potential supply; 3)
3) greater productivity
labor and increased employment; 4) and the enlarged purchasing power
of labor
that goes with slower increases of prices.
Now, by equation (2), business capital formation will occur
increas,ed output.
regardless of the cause of increas.ed
Thus, any measures to
stimulate the economy would promote this type of capital formation.
17
So would changes in tax incentives that affect r, the rental price.
price.
policies is
However, the relative size of the effects from different policies
uncertain.
And, the tangible physical assets of households as well
as labor capital also would be affected, but not always in the same
direction.
Consider further the effects of several policies on capital
formation -- a sustained
sustained reduction in personal income taxes; increased
increased
——
16See
see Eckstein, Green, and Sinai
Sinai (6, pp. 598—602).
598-602).
17 See
see Brimmer and Sinai (2).
—60-60-
government spending; easier monetary policy; changes in tax incentives;
and a mix of restrained government spending and easier monetary policy.
In assessing
assessing the effects of these policies, impacts on business, human
and housing capital will be examined.
Reductions in personal income taxes raise expected disposable
and increase consumption.
income (yd~)
(yd~)and
increases the deficit (deft)
At the same time the tax reduction
Agdebt).
and Treasury issues of debt (( 119debt).
The increased issues result in aa higher demand for money (equation
14) and, in the absence of accommodating monetary policy, raise interest
short—term)188 The resulting rise in national income
rates, especially
especially short-term.
also increases
the demand for money, hence interest rates.
The higher output and higher prices as demand closes on potential
output cause an increase of business fixed investment.
This
This enhances
productivity,
capital formation by business, raises capacity, increases productivity,
and exerts downward pressure
pressure on prices.
But the increases in debt
service for households and firms as interest rates rise, a higher rental
price, and the possible negative feedback effects on the market value
of financial assets because of falling stock prices, all act as restraints
on the increased spending.
In particular, higher money market rates
of interest draw funds out of financial institutions, lower the supply
of mortgages, and cause a cutback in residential construction.
Thus,
housing capital would grow more slowly, or even drop,
drop, relative to business
capital formation.
Of course, an accommodating monetary
monetary policy could
could
18Accommodating monetary policy is defined as maintaining constant
18
Accommodating monetary policy is defined as maintaining constant
nominal interest rates in the face of a change in fiscal policy.
-61—61—
alleviate this problem.
The only question is how severe the inflation
reaction from an extra monetary stimulus.
This is primarily an empirical
~ 0,19
question, depending on dp/dt when J5’ - 5’JPp al,,
o. 19
—
In summary, sustained
sustained reductions
reductions in personal income tax rates
increase real output, raise inflation, lower the unemployment rate,
and cause aa rise of interest rates.
Consumption is higher, business
fixed investment
investment rises in response to the greater real output, and
the rate of capacity utilization moves up.
The tangible physical assets
of households, including autos and durables, rise from the higher
consumer spending.
Business capital stock rises higher, too, though
not so strongly as in a case where
where monetary policy is accommodating.
The outcome for housing capital is less clear, however, with the positive
effects on housing of demand-induced
demand—induced declines in the vacancy rate perhaps
more than offsetting aa reduced supply of mortgages.
Finally, employment
employment
is increased because of a rising demand for labor.
A second policy for stimulating capital formation is increased
A
Federal government spending.
A higher rate of government expenditures
A
directly affects output, employment, and income.
An increase of disposable
income stimulates spending on autos, other consumer durables and housing.
Business fixed investment and inventory spending rise in response to
the stronger utilization of existing capacity causing a rise
rise in replacement
spending for plant and equipment (equation 2).
Thus, the capital formation
enhanced.
of households and business is enhanced,
19 No link of mm and pp through expectations is assumed.
-62—
-62-
However, the benefits of increased government spending are accompanied
accompanied
by
some negative feedback effects.
and higher interest rates.
Most important are more rapid inflation
The extent to which prices rise depends
on the position of the economy relative to full employment output.
The increased inflation restrains spending by reducing purchasing power.
The rise in interest rates stems from the financing of a greater Federal
government budget deficit and the effects of a worsened inflation.
Higher interest rates directly restrain consumption and investment
{equations
(equations 11 - 4)
4) but also do so indirectly through a worsening of
—
the debt burdens of households and business (equations 11 - 2).
2).
—
Further,
higher interest rates tend to reduce stock prices and diminish the
real value of household financial assets.
weaker (equation 1).
Consumer spending is then
AA higher financial cost of capital also causes
a reduction in fixed investment through the rental price
price of capital
goods (equation 2).
Finally, higher market rates of interest draw
funds out of financial institutions and reduce the supply of mortgages.
of funds causes housing outlays
The mortgage rate rises and a lack of·
to weaken (equation 3).
-
The net impact effect from all of these factors, however, would
be increased GNP, a higher rate of investment, lower unemployment,
and greater capital formation throughout the economy.
But the negative
feedback effects restrain the beneficial impact -of
of the government sector’s
sector's
expenditures, especially in housing.
The closer to full employment
of labor and physical capacity, the more substantial the negative impact
of rising interest rates and accelerated inflation.
-63—
-63-
In an extreme
situation, the increased expenditures by the government can
can totally “crowd—
"crowdout” the gains to the private sector, with no real benefits for overall
out"
capital formation,
formation.
self—defeating element in using
Thus, there is aa self-defeating
Federal government spending to enhance the capital formation of the
private sector.
A third
A
policy to increase capital formation is easier money.
An increase in nonborrowed reserves raises the monetary base and the
supply of money. The federal funds rate declines and other short—term
short-term
rates follow a similar pattern, caused by commercial bank arbitrage
of assets and nondeposit liabilities to minimize the costs of funding
loans.
The lower interest rates stimulate consumption and investment.
Further, given a slow response of deposit rates at bank and nonbank
financial institutions to the easier monetary policy, the returns on
these deposits become relatively more attractive to households and
businesses than the yields on money market instruments.
Funds flow
into financial institutions, substantially increasing the supply of
mortgage money and raising expenditures on housing.
Another effect
is aa reduction of debt burdens for households and business because
of the lower interest rates, higher disposable income, and greater
cash flows,
flows.
associated
The reductions of interest rates are initially associated
with higher stock prices and an increased market value of household
financial assets.
In turn, consumer spending rises
rises even further.
The easier monetary policy will have the net effect of increasing
capital formation throughout
throughout the economy, in contrast to the policies
of reducing personal income taxes or increasing government spending.
-64-
The housing stock, stocks of durable consumer goods and cars, and business
business
plant and equipment all rise under the easier monetary policy.
policy.
does the employment of labor.
So
The increased capital formation in
the business
business sector leads to a higher potential output.
There is an
There
easing of pressure on prices from the increased
increased supply, although to
some extent offset by a lower unemployment rate, increased wage inflation,
and subsequent cost-push
cost—push effects.
There are several negative feedback effects associated with
the stimulative monetary policy, however.
The growing economy will
raise inflation as actual output moves closer to potential.
This greater
tend-to
inflation will tend
to push interest rates higher and also reduce the
purchasing power of households and business.
The borrowing that is
associated with the increased expenditures raises outstanding debt,
debt,
hence the debt burdens of the various sectors.
Of course, these negative
feedback effects take time to develop, so that the economy could benefit
considerably from the easier monetary policy for a number of quarters.
The main danger of the easier monetary policy approach is the
possible resurgence of inflation and high interest rates if economic
growth accelerates too rapidly.
Another potential problem has to do
with the formation of inflation expectations in response to the easier
monetary policy, and whether in fact, a temporary speedup in monetary
monetary
growth will cause aa sharp enough rise in inflation expectations to
defeat the thrust of the policy.
empirical.
These issues, like many others, are
The results of the policy simulations in the section entitled
"Simulation Results"
“Simulation
Results” give some quantitative responses.
—65—
-65-
A
A
fourth policy to stimulate capital formation is through reductions
of business taxes.
Corporate profits taxes could be reduced, depreciation
allowances increased, or the investment tax credit raised.
have been analyzed in Brimmer and Sinai (2).
These policies
Only small impacts on
incentives unless
business capital formation were found for these tax incentives
monetary policy was accommodating.
Modest increases in potential output
and productivity occurred, but there was no real improvement in inflation.
inflation.
The tax incentives primarily shifted capital formation into the business
sector from housing and improved the financial position of business.
Thus, it is not clear
clear that business
business tax incentives would
would be beneficial
beneficial
overall,
overall.
A
"tight fiscal—easy
fiscal-easy money”
money" approach.
A final possibility is a “tight
By tight fiscal policy is not meant decreased expenditures by the Federal
government.
More realistically, it refers to slower growth in Federal
government spending than has been
been the case in previous years. The
component of
of the-tight
fiscal—easy money
“easy
money” component
"easy money"
the.tight fiscal-easy
money policy
policy also
also does
does
not refer to a radically extreme measure.
Federal Reserve policy that
By easy money is meant a
permits money growth between 8 and 9%
per annum, in recognition of the difficulty of reducing the core 55
2°
economy.20
to 6% inflation in the U.S. economy.
20The Federal Reserve's
long-run targets for monetary growth reflect
Reserve’s long—run
a set of goals, explicit or implicit, for real economic growth, inflation,
and unemployment. However, a target of 5-1/2%
5—1/2% growth in Ml (the midpoint
of the current long—run
long-run target range of the Federal Reserve) implies
structural
an inflation rate goal that is unrealistic, given the basic structural
inflation that exists in the U.S. economy. This price inflation
inflation results
from an institutionally determined wage inflation;
(Continued
... )
(Continued...)
-66—66—
fiscal-easy money”
money"
In order to highlight the effects of a "tight
“tight fiscal—easy
policy on capital formation, consider an extreme case of reductions
in Federal spending and aa simultaneous easing of monetary policy.
The decline of government expenditures will cause a drop in real output
and employment.
Consumption, investment, and inventory accwnulation
accumulation
would decline via multiplier effects.
Potential output would drop
but there would be less inflationary pressure with the larger declines
in spending relative to supply.
The remaining effects would be the
opposite of those described for the case of increased government expenditures.
Along with the reduction in Federal government spending would
come a smaller budget deficit.
The flow of new Treasury issues to
the financial markets would drop, with a resulting easing of pressure
on short-term
short—term interest rates. The lower output and easing of inflationary
pressure reduce transactions demands for money, further lowering interest
rates.
flows-of-funds to financial institutions would
In response, flows—of—funds
rise, mitigating the negative effects on residential construction from
the weaker economy by increasing the availability of mortgage money.
20 (Continued)imported
(Continued)imported inflation,
inflation, e.g.,
e.g., from
from OPEC;
OPEC; and
and the
the price—
pricesetting practices of business, which include rapid markups over shortrun rises in costs. The OR!
ORI model suqqests
suggests this “core”
"core" rate of inflation
run
to be near 55 or 6%, with no perceptible near-term response to cyclical
cyc1 ical
demand forces. Thus, current monetary growth targets can only result in a
ions
weakness of real output and high unemployment rather than sharp reductions
in prices. On the other hand, too rapid monetary growth of 10% or
more is potentially destabilizing, resembling the Federal Reserve’s
Reserve's
"easy money”
money" of the
"stop-go" approach of previous years. Thus, the “easy
“stop—go”
"tight ffiscal—easy
i sea 1-easy money”
money" policy
po 1icy com
bi nation will
wil 1 be taken to mean
“tight
combination
Ml growth of 8 or 9% per anntsn.
annum.
-67—
-67-
Most importantly, however, restraint on fiscal policy would
would enable
the Federal Reserve to ease monetary policy,
policy.
Sustained periods of heavy
deficit spending by the Federal Government eventually constrain the
monetary policy posture of the Federal Reserve by stimulating the economy
too strongly.
As a result, monetary policy is often tightened when
fiscal policy is stimulative.
AA stimulative fiscal policy increases
pressure on the financial markets directly, but also because of an induced
expansion in the private sector.
At the same time, a tighter monetary
policy intensifies the rise in interest rates.
The result has almost
always been aa credit crunch and recession because of the powerful effects
of money and finance on the economy.
"tight fiscal—easy
fiscal-easy money”
money" approach
AA “tight
could lead to an opposite situation.
In the face of restrained growth in Federal Government spending,
an easier monetary policy, defined in terms of higher targeted money
growth rates, would lower interest rates, reduce debt burden impacts,
increase flow—of—funds
flow-of-funds in markets where rationing occurs, improve the
stock market and stimulate housing, consumption, and fixed investment.
If
If
sustained, aa greater rate of capital formation would occur than under
any other policy.
Further, with aa lower
lower rate of growth in Federal Government
spending, Treasury debt issues would comprise aa smaller proportion of
"crowding
the total financing in the economy, lessening the chances of “crowding
out".
out”.
-68-
Prospects for Capital Formation
Tables 2
2 and 3 provide the profile of the current outlook for capital
2’ The economy shows steady growth through
formation over the next decade.
decade. 21
1980, the result of aa moderately paced but well balanced expansion
of real final demands.
TABLE 2.
GNP grows at rates above the economy’s
economy's
Real GNP
Profile of the Economy to 1985*
History
Forecast
1955-65 1966-75 1976
1977 1978
1978 1979 1980
1980 1976-80
1976—80 1976-85
1976—85
Rates
Rates of Change (~)
(%)
----- -- ------
10.9
10,3 10.4 10.9
10.9 11.3 10.3
4.8 5.2 4.4 4.5 5.0
3.3 3.4
3.3 34
3.4
J.J
J.4 J.J
J .•
J.4
GNP -- Current Dollars
- Constant Dollars
Do 11 ars
Potent la I 81W
GNP
Potential
5.9
3.8
J.8
LB
J.8
8.2
2.6
3.9
J.9
11.6
11.6
GNP
61W Oeflator
Deflator
Wholesale Price
Price Index
Average Hourly
Earniogs
Average
Hourly Earnings
2.0
2-0
0.9
3.6
J.6
5.5
6.2
6.5
5.1
LI
4.6
72
7 .2
Personal Savings
Business Savings
7.5
7 .5
5.7
12.3
8.8
-8.9
-8.9
16.6
3.9 9.9
126
11.4 J.9
9.9 12.6
11.8 13.0 11.6 11.4
11.4
63.5
9.6
9.6
0.0
5.0
o.8
0.8
20.
20.1l
62.4
624
10.3
10.0
0.2
4.1
0.8
21.9
63.8
63.8
9.5
9.0
0.4
3.9
J.9
0.7
21.6
21.5
64.0
9.5
9.1
0.4
43
4.3
0.6
21.3
63.4
9.7
9.3
9.J
0.5
U.S
4.4
0.9
21.l
21.1
5.J
5.3
5.8
5.8
-0.
-0.1l
-0.
-0.1l
4. 25
4.25
4.24
5.0
7.0
-1.2
-1.2
0.4
77.10
.10
7
.40
7.40
7.
7.77
6.5
—3.5
-3. 5
0.8
6.84
8.
33
833
7 .4
7,4
6.5
—4.0
-4.0
1.3
1.3
6.56
8.25
8.25
6.4
6.1
—2.6
-2.6
1.1
1.1
7.01
7 .01
8.
27
8.27
6.1
3.4
J.4
5.8
6.3
L3
77.1
.1
5.9 5.
Li7 5.7
6.J 6.3 6.4
6.3
7.1
7. 1 7.0 7.2.
7.2,
9.
9.77
4.2
J.2
3.2
5.6
6.0
7.1
7 .1
5.2
5.2
7 .o
7.0
5.8
5.8
12.9
6.5
10.3
103
63.1
10.l
10.1
9.6
0.5
4A
4.4
1.0
21.0
21.0
62.5
62.5 63.4
10.5
9.8
9,8
10.0 9.4
0.5 0.5
4.6 4.4
1.1 0.8
Li
20.9 21.2
20.9
62.4
10.4
.10.0
10.0
0.4
4.5
0.9
21.2
21.2
6.0
6. 1
63
—1.7
-1.7
0.9
6.55
7 .95
7.95
5.6
6.6
6.
6.3J 6.3
63
.2.5
—0.8 -2. 5
-0.8
o. 5 8.9
0.5
0.9
690
6.90 6.77
8.36
8.23
8.36
5.9
6.3
-1.4
—1.4
0.7
6.55
a. z5
8.25
Shares of Real
Reel Demand (%)
(t)
------ -- ---- -----Consumption/GNP
Consumpt
ion/GIIP
Business Fixed Investment/GNP
Investment/CliP
{ Exe 1. Pollution
Po 1 Jut ion Control
Contro 1 Expenditures}
(led.
Expenditures)
Pollution
Expenditures/GtlP
Pol
lution Control Expenditures/CliP
Residential
Construction/CliP
Resident
la l Construct
ion/GNP
Inventories/GNP
Inventories/Clip
Government Purchases/CliP
Purchases/GNP
Key Indicators of Activity
Activity (%)
--- ---------- -- -------Unemployment Rate
tinea~loyment
Personal Savings Rate
Personal
Federal Government Oeficit,GNP
Deficit,CNP
State & Local
Deficit/Clip
State
Local Government
Government Deficit/GNP
Prime Rate
Hew
High—Grude Corp. Bond
New Hlgh-Grude
Bond Rate
~ased
DR! Control of February
Februory 1977
and Month
Morch 1977
proiec:tions.
‘Boned on DRI
977 and
977 !~un
ong.ron proiecflons.
21
21Projections
1980 are based on DRI
DR! analyses of short-run
to 1q80
short—run
Projections prior to
conditions. The assigned
assigned probability to this baseline forecast
business conditions,
is 60%. Beyond 1980, the forecasts are based on a balanced, near full
employment path for the economy. Such a projection is primarily designed
for planning exercises that require stable economic growth as an input,
rather than as a "forecast"
“forecast” of expected actual conditions.
-69--69-
potential, although slowing somewhat in 1979-80.
Relatively stable
fiscal and monetary policies, the absence of any destabilizing external
shocks, cautious spending attitudes in the private
private sector,
sector, and constant,
although high, inflation rates are the principal determinants of the
economy’s
economy's performance.
The greater than average inflation during the
period restrains purchasing power, limiting economic growth and reductions
in the unemployment rate.
In 1980, the various price indices are still
still
rising
rising near 5—1/2
5-1/2 or 6% and the unemployment rate averages 5.6%.
Private sector savings flows are ample to finance the moderate
pace of economic activity, especially in the business sector.
The
primarily
share of GNP going to business rises later in the decade, primarily
TABLE
TABLE 3.
3.
Capital and Productivity Items
Average
Average Percent Changes
----------------History
History
Forecast
57-66
67-76 57-76
57-66 67—76
57—76
77-85
77—86
----------------Labor Force
(Mils.
(Pills. of Person!)
Persons)
1.3
Laboi- Force Calculated at
at Full
Labor
-
2.
2.33
1.8
1.6
1.6
£mployment
(Mih. of
teployeent (Pills,
of Persons)
Parsons)
1.4
1.4
2.
2.33
1.9
1.9
1.6
1.6
Real Full
Level of
of CliP
GNP
Real
Full tmployment
Employment Level
(Billi,
(81
15. of 1912
1972 $'s)
i’s)
3.6
3.9
3. 7
3.7
3,2
3.2
4.1
4,1
4.9
'· 9
4.5
4.5
2.6
2.6
2.1
2.7
2.
2.77
4.
4.77
,. 2
2.2
4.1
4.1
4.7
4.7
2.'
2,6
2.6
2.6
4.4
4 ·'
2.6
2.6
4.6
4.6
2.1
2.1
3 .a
3.8
l. 7
3.7
4.9
4.9
3.1
3.1
4.3
4.3
3.4
3,4
4.9
4.9
2.2
2.2
Capital Stock
Stock of Housing
Housing
(Mils.
Unlt!l)
(liils. of Units)
NA
NA
1.6
1.6
NA
NA
LB
1.8
Capital Stock of Households
HousehOlds
(Bils. of S's)
(Oils.
l’s)
NA
hA
77.9
.9
NA
NA
8.9
.J, 3
.3,3
LB
1,8
2.6
2.6
2.
2.99
of
Gross
Stocks (Bils.
(Oils, of 1972
1972 S's)
l’s)
Gross Capital
Capital Stocks
Nonres. Producers
Producers Durable Equipment
Plonres.
EquIpment
Nonresidential Structures
flonrasiderntlal
Structures
Eff1:1ct1ve
Effective
Nonr@s.
Nonres.
Capital Stocks
Stocks (Bils.
$'s)
(Oils, of 1912
1972 i’s)
Producers Durable
Durable Equipment
Producers
Equipment
Nonresidential Structures
Nonresidential
Structures
Capital Stocks (Oils,
i’s)
Net Capita!
(Bils. of
of 1972 S's)
Nonres. Produr;.ers Durable Equ1pme,1t
Nonres. Producers Durable Equipmeit
tfonresidenft1:1l StructurH
Nonresidential
Structures
Labor Productivity
*1971
to 1980
frl:!m DR!
For-reast of
of February
February 1977;
1971; 198\
*f977 vo
900 from
DPI ContM!
Control Fortcn,o
1901 to 1985
905 figures
frort'I Mateh
1911 LOtlg
ttm Trend Fotecoto.
F'oteetnt,
floes
March 1977
Long T
tenon
-70-
,.,
-
9
at the expense of government.
Both the ratios of government purchases
to GNP and the Federal budget deficit to GNP decline steadily
steadily over
the next four years as the Carter administration seeks to balance the
budget by 1981.
The proportion of residential construction to GNP
increases as interest rates do not rise enough to cause the severe
disintermediation of deposit inflows to financial institutions
institutions that
could disrupt housing.
Capital formation is not sufficient to achieve full
full employment
of labor by 1980.
The gross effective capital stock of producers’
producers'
durable equipment (excluding the stock of pollution control equipment)
shows aa 3.9% average rate of growth to 1980, significantly
significantly below the
high
high
performance 4.7% rate of 1967 to 1976.
even more slowly, at 1.8%
1,8% per annum.
rate of increase from 1967 to 1976.
The stock of plant grows
This compares with a 2.6% average
The moderate growth in aggregate
utilization, aa high rental
demand, slowly rising rates of capacity utilization,
price of capital, and near 6% inflation prevent the kind of investment
boom that has typified most business expansions since World War II,
II.
A
A further deterrent is a
a still
still high debt service burden as 1980 is
approached.
Diminished cash flow from eased profits growth, 88 to 9%
long-term bond yields, and aa rising volume of outstanding debt are
responsible.
The net capital stocks of plant and equipment behave
similarly to the gross concepts, although the high business fixed investment
to GNP ratio between 1981 and 1985 raises the average rate of increase
to 4.9% for 1977-85, the same as in 1967-76.
1967—76.
The effects of the slow growth in business capital formation
to 1980 are threefold.
First, potential output grows slowly, at 3.4%
-71—71—
per annum
annt.zn for the next few years rather than the earlier 3.7%, adding
to the pressures for more inflation.
inflation.
Greater inflation lessens real
purchasing power, aggregate demand, and hinders the reduction of unemployment.
Table 2 shows that the GNP price deflater
deflator rises 5.6% per annum from
1976
1976 to 1980.
Second, the demand for labor increases less rapidly
with a more slowly growing capital stock, so that slack in labor markets
remains for aa longer period of time.
Finally, labor productivity
productivity rises
less, causing higher unit labor costs and more inflation.
inflation.
All of these
economy’s progress toward full employment.
effects slow the economy's
The rate of capital formation by households is above the average
of 1967 to 1976, given steady rises in durable consumer spending and
housing.
From 1977 to 1980, household physical assets rise by 9.5%
a year with concentration in autos and houses.
1976,
was 7.5% for 1967 to 1976.
The corresponding figure
Thus, the projections indicate the only
real shortfall of capital, at least by historical standards, to be
in the business sector.
Nevertheless, there exists some more rapid
stock of households that would cause full
growth rate for the capital stock
employment to be achieved.
especially
What accounts for the insufficient capital formation, especially
in the business sector?
First, the recession of 1973-75
businessmens'
1973—75 shook businessmens’
expectations of future sales as real GNP dropped more sharply than
in any other slowdown since World War II.
Further, growth in real
final sales since the March 1975 recession trough has been quite moderate
relative to similar stages of previous expansions.
Chart 55 shows that
the rebound in real final sales during the recent expansion has been
the weakest of the postwar period.
—72—
-72-
Without the strong "accelerator"
“accelerator”
~0..~
CHART 5. Final Sales Growth (1972 $‘s)
$'s)
During Postwar Recoveries
Recoveries
~N
D
aE
x
R
A
A
‘IT
s
B ~---------------~
- .. .
4t-------..,.,..----------;
1958-1959
\, ,_,..
.
," ",
, ,.......
... ..
1961-1962
\ .......
21--,,.--'-----:',......;:-.._."-;:,cc_._,.,.--'--...._,.,.._---;
T
R
0
D
U
u
ot-+:------==..a..!..IC.--~....,,._'----1
,. -...
HH
/
-2t--4-,-,,-,--'--------"----=----'=---t
a0
.. , : - . : . : ; . : : , ; . . . . . . . .
- - -
....
~ Q
1954-1955.)'
-- -
•
a
1.1
.....
..
..
/ ~ . -.
• .•
':f
1971-1972
-41---.\-----------------1
-tot--+--+--+---1---1---+---+---1
2
3
44
5
66
7
88
Quarters
Quarters from
from Trouqh
Trouqto
firms' products,
effect from permanent large increases of demand for firms’
business spending on capital goods has been minimal.
Second, the deep recession left the economy with aa considerable
degree of underutilized physical capacity.
At the trough of the recession
in March 1975, the capacity utilization
utilization rate for All Manufacturing
was 69.6%.
The peak of 88%, reached in July 1973,
1973, was associated
with severe bottlenecks in production.
The moderate expansion since
1975
1975 has produced aa a current rate for All Manufacturing of 80.7%,
indicating the existence of considerable slack.
Thus, replacement
investment, which normally constitutes
constitutes aa large proportion of all new
plant and equipment spending, has remained quite low (equation 2).
Third, the rental price of capital, especially for equipment,
has remained quite high throughout the current expansion.
expansion,
—73—
-73-
Chart 6
shows that rises in rental price during similar stages of previous
expansions have been smaller than in
in this episode.
The principle
principle reasons
CHART 6. Rental Price of Producers'
Durable Equipment During Postwar Recoveries
I
!..05
N
ll
E
X
A
T
LOO
.... - -
0
u
..
.
\
G
,.
.95
•
\
\
1
.
-
\
'
/
''\··
\
·.. ·.. '
T
R
H
/
1
,
'.
'
l975-1976
'
' _.,,
958-1959
.
'
/
J
1954-1955
...
.
1961-1962
·-
-.
-
/' ..- . . . J
/
1971-1972
,115f---t--+--+---+-~-"--I--+----~
22
3
44
55
6
Quarters
TruuQh
Quarters freon
from Trough
7
8
for this high rental price are 1) increases in the supply price of
capital goods that have ranged between 33 and 25.9%; 2) a high average
cost of financial capital due to 88 and 9% nominal long-term
long—term bond yields
and aa relatively
relatively weak stock market; and 3) the failure to implement
22 Changes in
business taxation,
business.22
in business
taxation,
major new tax incentives for business,
including higher tax allowable depreciation rates, shorter lifetimes
for capital goods, the investment tax credit, an.d
and a lower corporate profits
tax rate can have a major effect on rental price.
But the only measure
22
22Significant
was enacted
enacted in
in 1954,
1954, 1962,
1962,
Significant business tax legislation was
1965, and 1971.
1971,
-74-
enacted so far in this episode has been an increase of the investment
tax credit to 10% during 1975.
1975.
Finally, there has been an unprecedented restructuring of corporate
balance sheets since mid-1974, the
the aftermath of the deteriorated financial
23 Given the huge financial
position of business that had evolved.23
risk generated by balance sheets with top-heavy short-term debt relative
to long-term
long—term debt, high leverage, a dearth of financial assets relative
to short-term liabilities
liabilities and exceptionally large debt repayment burdens
to cash flow, the threat of default and bankruptcy within the business
great
sector has been great.
The potential variability
variability in expected earnings
u,nacceptable to business, causing
created by this situation has proved unacceptable
increased demands for financial assets, reductions in the desired
acquisitions of physical assets, and aa decreased rate of debt accumulation.
reliquification, has proceeded for a much longer
This process, known as reliquification,
period and in aa more intensified
intensified manner than during any previous postwar
expansion.
In essence, the returns to business from restructuring
balance sheets have exceeded the expected returns from physical asset
acquisitions as reduction of financial risk through reliquification
reliquification
have reduced the potential variability
variability of future earnings.
As of
1976:4,
1976:4, the process was still
still occurring, despite the fact that its
duration had been twice as long as the typical experience.
This desire
by
by business to use funds for purposes other than fixed investment has
been a key distinguishing factor of this expansion compared with other
postwar business recoveries.
23See
see Sinai (17).
—75—
-75-
Another factor affecting business capital formation has been
the laws, regulations, and incentives for dealing with pollution control
and new, less energy intensive production techniques. While no research
how much business capital formation
yet has been able to clearly identify how
is being affected, to some extent productive capacity is being hampered
by
by
the substitution of this “non-productive”
"non-productive" investment for capacity
creating capital spending.
So far, however, the proportion of real
business fixed investment devoted to pollution abatement equipment
has only been near 5%, too small aa figure to bear aa major responsibility
responsibility
for the overall weakness in capital spending.
Potential new programs
for energy independence may increase spending for less energy intensive
capital goods rather than for new capacity, thus hampering the rate
of productive capital formation.
Simulation Results
This section examines the effects on capital formation and U.S.
economic performance of several policies that could be used to accelerate
the rate of capital formation. The simulations were performed with
the Data Resources model of the U.S. economy, beginning in the first
quarter of 1977 and ending In
in the fourth quarter of 1980. The baseline
forecast described in Tables 22 and 33 was subjected to various policy
shocks, with subsequent solutions of the model producing new time series
for the major variables of Interest.
interest.
The amounts of stimulus for the
permit illustration
illustration of the effects, rather
policies were chosen to permit
than as aa matter of realism.
Comparisons between the alternative policy
and baseline solutions provide the differences from which can be determined
—76—
the policy impacts.
Appendix Tables 8 to 14 contain the details of
these simulations,
simulations.
In what follows, the simulations are described, some of the
more interesting results are presented, and supporting evidence for
appropriate for stimulating
some conclusions about the policies most appropriate
presented,
capital formation are presented.
The policy simulations included:
1.
Personal Tax Reductions
Reductions
A
A
billion reduction in personal income taxes
permanent $5 billion
was assumed for 1977:2. There was $20 billion of additional
tax reductions in 1978 and $25 billion in 1979.
In effect,
this simulation assumed that permanent tax reductions are legislegislated each year to eliminate an "inflation
drag" on
on consumers’
consumers'
“inflation drag”
purchasing power because of the "bracket"
“bracket” effect on taxes from
higher inflation.
inflation.
8%
8%
Ml growth was 7.2% in 1977,
1977, 8.2% in 1978,
1978,
1980, The baseline had corresponding
in 1979,
1979, and 6.7% in 1980.
growth rates of 7%, 7%, 6.8%, and 6.8%.
2.
Reductions and Accommodating Money
Personal Tax Reductions
AA permanent $5 billion
billion reduction in personal income taxes
was assumed for 1977:2.
billion of additional
There was $20 billion
tax reductions in 1978 and $25 billion in 1979.
The distinguishing
feature of this simulation from the previous one was the accommoaccommodating money.
Short-term interest rates were kept constant
sufficient bank reserves by the central
through the provision of sufficient
bank.
7,3% in 1977,
1977, 8.5% in 1978, 8.8% in 1979,
1979,
Ml growth was 7.3%
and 7.4%
7 .4% in 1980.
hasel inc had corresponding growth rates
The baseline
of 7%, 7%, 6.8%, and 6.8%.
6.8%,
—77—
-77-
3.
3.
Money
Easier Money
AA 1% higher growth in Ml during 1977 and 1978 than in the
baseline was assumed.
The increased growth was achieved
achieved through
through
central bank provision of nonborrowed reserves until the economy’s
economy's
performance generated the desired money growth.
The result
was Ml growth of 8% in 1977, 8% in 1978,
1978, and 7% in both 1979
and 1980,
1980.
The baseline had corresponding growth rates of 7%,
7%,
7%, 6.8%,
6.8%, and 6.8%.
Although this simuation is entitled easier
money, the higher
higher monetary growth rates were not so great as
to destabilize the
the economy.
4.
Personal Tax Reductions and Easier Money
A
A permanent $5 billion in personal income taxes was assumed
for 1977:2.
billion of additional tax reductions
There was $20 billion
1979.
in 1978 and $25 billion in 1979.
Ml growth was permitted to
rise 1% above the monetary growth in the “Personal
"Personal Tax Reductions”
Reductions"
1978, 0.7% higher in 1979, and remained
simulation during 1977 and 1978,
the same in 1980.
The Ml growth rates were 8.2%,
8,2%, 9.2%, 8.8%,
and 6.7% from 1977 to 1980.
The baseline had corresponding
growth rates of 7%, 7%, 6.8%, and 6.8%.
5.
Tight Fiscal and Easier Money
A
A $5 billion
billion reduction in military spending was assumed
$10 billion from 1978
for 1977, then aa sustained decrease of $10
to 1980.
A
reduction of personal income
A permanent $5 billion reduction
taxes occurred in 1977:2.
There was $20 billion
billion of additional
tax reductions in 1978 and $25 billion
billion in 1979.
Ml growth was
permitted to be 1% above the monetary growth in
in “Personal
"Persona 1 Tax
Reductions" during 1977 and 1978,
0.7% higher in 1979,
Reductions”
1978, 0,7%
1979, but remained
in 1980.
the same in
The resulting Ml growth rates were 8.2%,
-78—
-78-
9.2%, 8.8%, and 6.7% from 1977 to 1980.
The baseline had corresponding
growth rates of 7%, 7%, 6.8%, and 6.8%.
6.
Investment Tax Credit
AA permanent
permanent
increase of 2%, from 10 to 12%, in the tax
credit for producers'
producers’ durable equipment, was assumed to begin
in 1977:1.
Monetary policy was not accorinodating;
accommodating; other tax
and spending parameters remained the same as in the
the baseline,
baseline.
7.
Corporate Profits Tax Reductions
A two-stage
two—stage reduction in the statutory tax rate on corporate
A
profits was assumed.
The rate was lowered from 48 to 45% in
1977 and then to 42% in 1978-80.
Monetary policy was
was not accommodating;
other tax and spending parameters remained the same as in the
base 1i ne.
baseline.
Table 4 summarizes the effects of the various policies on real
24 All changes are expressed
GNP, inflation, and the unemployment rate.
rate.24
relative to the baseline solution.
The policies that most stimulated
the economy involved either more rapid money growth or accommodative
monetary policy.
TABLE 4. Policies to Stimulate Capital Formation:
Inflation, and Unemployment*
Effects on Real GNP, Inflation,
Inflation (% chg.)
Inflation
chy.)
Real GNP (% chg.)
chg.)
No.
Simulation No.
Simulation
1l
22
33
44
55
6
77
77
78
79
80
0.2
0.2
0.5
0.7
0.4
0.1
0.1
1.22
l.
l.3
1.3
0.9
2.1
1.99
l.
0.1
0.1
0.1
1.0
l.O
l.5
1.5
0.5
0.9
1.1
l.l
-0.6
-0. 3
-0.3
0.1
—0.7
-0.7
-0.5
-0.1
-0.11
-0.
—
77
-
0.1
O.l
0.1
0.1
Unemployment Rate(%)
Rate (%)
78
79
80
80
O. l
0.1
0.1
0.2
0.2
0.3
0.3
0.2
0.3
0.4
0.3
0.5
0.6
0.5
0.5
0.5
0.7
0.2
0.8
0.7
77
—
-
-0.1
-0.l
-0.l
-0.1
—
—
*Differences Relative
to Baseline
*Differences
Relative to
Baseline
24The rate of inflation
inflation is for the Implicit
Implicit GNP Deflator.
Deflater.
—79—
-79-
78
79
80
-0.
-0.33
-0.4
-0.4
-0.7
—0.7
-0.8
-0.5
-0.6
—0.9
-0.9
—0.3
-0.3
-1.0
—0.9
-0.9
-0.4
-0.7
—0.5
-0.6
-0.
-0.1l
-0.3
-1.0
—0.9
-0.9
-0. l
—0.1
Money” simulation
The “Personal
"Personal Tax Reductions and Accommodating Money"
(2) was characterized by aa sharp rise in real economic growth and
sizeable declines in the unemployment
unemplo3allent rate.
inflation
However, the inflation
rate was accelerated, especially later, reaching a 1:1.3
1:1,3 tradeoff with
the unemployment rate by 1980.
inflation, its derivative
The higher inflation,
effects on purchasing power and interest rates, and the normal stock
adjustment processes of the economy caused real GNP to drop below the
baseline by 1980.
Money"
The "Personal
“Personal Tax Reductions and Easier Money”
scenario (4) had a powerful stimulative impact on economic growth,
but also was associated with a large rise of the inflation
inflation rate.
The
simulaeffect of the 11 to 2% additions in monetary growth relative to simulation (2)
(2) was a much greater early impact on real economic growth and
unemployment, with little extra inflation cost (0.1%) by 1980.
1980.
The
"Easier
Money" scenario (3) produced
produced steady rises in real economic
“Easier Money”
in unemployment than a worsening
growth to 1980, with more improvement in
inflation.
of inflation.
Maintaining the permanent tax cuts and the same monetary
Money," but restricting
restricting
growth as in "Personal
“Personal Tax Reductions and Easier Money,”
government spending (the "Tight
Money" solution 4)
“Tight Fiscal and Easier Money”
only reduced real growth slightly (from the 2.1% increase of 1978 to
1.9%).
The gain was a more stretched out stimulation of the economy,
lasting well into 1980.
This occurred because the
the tighter fiscal
policy permitted the central bank to provide more reserves to maintain
aa given rate of monetary growth.
The simulations
simulations highlight the important effects of monetary
policy on economic performance.
The provision of bank reserves lowers
interest rates; raises the flows-of—funds
flows-of-funds to housing markets; increases
-80-
stock prices and the real value of household financial assets to stimulate
consumption; reduces the rental price of plant and equipment to stimulate
business fixed investment; lowers the debt burdens of
of households,
business, and state and local government to stimulate sectoral spending;
and reduces the financial risk of greater expenditures.
The resulting spending increases are not accompanied by much
additional borrowing by the private sector until some quarters later,
when inflation and sustained expansion cause a deterioration of
the internal financial position of households and firms.
The “Easier
"Easier
Money” simulation demonstrates that the extra inflation from aa moderate
Money"
relaxation of Fed policy is not great.
The greatest acceleration in
prices occurs when tax reduction is combined with greater monetary
growth than is necessary only for accommodation.
Table 55 summarizes the
the effects of the seven policy simulations
simulations
TABLE
TABLE 5.
5. Policies to Stimulate Capital Formation:
Effects on Capacity Utilization,
Utilization, Federal Budget Deficit,
Monetary Growth, and Interest Rates*
Simulation No.
11
22
33
44
55
65
77
77
77
78
78
79
80
0.1
0.1
o.0.33
0.5
0.1
0.1
1.2
1.3
1.9
3.0
2.3
0.3
0.2
2.1
2.8
0.7
3.2
2.8
0.3
0.2
1.5
2.5
2.6
1.1
2.8
2.
2.77
0.1
-
77
11
22
33
4
55
66
77
78
.04
.52
.01
-.24
—.24
.14
-.57
—.57
.15
.06
.05
-
-1.94
—1.94
-1.80
—2.23
-2.23
.02
-.01
(%)
79
80
1.13
1.13
-.01
-2.10
-1.93
—1.93
-2.22
.29
.23
1.22
.01
-.63
—.63
.76
.75
.05
-.05
25
.26
.30
*Djfference$ Relative to Baseline
*Differences
-81-
78
78
-15.3
—15.3
· —14.1
-14.1
11.8
- 3.3
1.9
—1.9
-1.9 - 1.3
-4,8 -10.1
-IO.I
-4.8
-2.5
—2.4
-2.4
4.2
1.5
4.4
federal Funds
funds Rate
Federal
77
Ml Growth
Federal Deficit, NIA
NM
($Bils.)
($ Bils.)
Capac. Ut
i 1.
capac.
Util.
(%, Mftg.)
-
80
79
79
—
-30.5
-24.1
9.9
-16.1
—16.1
-30.5
-18.8
12.9
12.9
-14.1
—14.1
-10.6 - 8.2
—10.6
- 1.3 - 2.1
-11.0 -12.5
-
-
—
-
(%)
77
77
78
79
80
0.2
0.2
0.2
1.0
1.0
1.2
1.2
1.4
1.0
2.2
2.2
0.1
0.1
0.1
0.1
I.I
1.1
1.9
0.2
2.0
2.0
-0.l
—0.1
0.6
0.5
o. 2
0.2
-0.1
1. 2
1.2
0.1
-
AAA-Corporate Bonds
AAA-corporate
(%)
77
78
79
-.01
—.01
-.01
-.17
—.17
-.17
-.17
—.24
-.24
.01
.01
.01
-.03
.12
.12
.09
—.07
-.07
.01
-.01
-.01
80
.37
.39
.15
.63
.15
.09
—
.10
-.05
—.05
.03
-.03
.40
.04
-.03
.03
-
-
on capacity utilization
utilization (All Manufacturing), the Federal budget deficit,
deficit,
monetary growth, the Federal funds rate, and a AAA—equivalent
AAA-equivalent long—
longterm corporate bond yield.
"Personal Tax Reductions and Easier
The “Personal
Money” and "Tight
“Tight Fiscal-Easier Money”
Money"
Money" solutions speed the economy
most rapidly toward full capacity, with increases of the utilization
rate for All Manufacturing ranging between 2.3 and 3.2% from 1978 to
1980.
1980.
The cost to the Federal Government in lost tax revenues is less
in the “Tight
"Tight Fiscal—Easier
Fiscal-Easier Money”
Money" simulation, with actual declines
of the deficit in 1977 and 1978.
Only the “Easier
"Easier Money”
Money" solution
is associated with continuous reductions in the deficit, as the strong
economy and sharply rising inflation increase tax receipts.
The extra
Ml growth relative to the baseline is the same in both the simulations
(4) and (5).
Interest rates are lower in each of the simulations where easier
monetary policy is implemented.
Rates rise in the solutions where
a fiscal stimulus is applied without offsetting monetary policy.
Both
the shortshort— and long-term
long—term rates are lowest in the "Tight
“Tight Fiscal-Easier
Money"
Money” solution, as Treasury financing is reduced at the same time
the central bank is providing more bank reserves.
The Federal funds
rate is down an~herefrom
anywhere from 55 to 225 basis points as aa result of the
money growth targets selected in this simulation.
The low interest
rates have much to do with the strength of the real economy since the
effects of
of monetary
monetary policy on expenditures are
effects
are so
so wide ranging.
The
Federal funds rate is particularly volatile as the central
central bank maneuvers
to keep money growth constant at a higher rate.
-82-
Table 66 shows the effects of the various policies on capital
formation; in particular, business fixed investment, the gross plant
and equipment of the business sector, household physical assets, and
housing starts.
housing
starts. Of
Of
"Tight Fiscal—
Fiscalthe seven policy simulations, the “Tight
ion:
TABLE 6. Policies to Stimulate Capital Format
Formation:
Capita 1 Stocks
Stocks
Effects on Business Fixed Investment; Capital
of Business
of
Business and Households; Housing*
Gross Pl
ant &
Gross
Plant
&
Equipment (72 5’s;
$'s; Bus.)
Bils.)
Business Fixed
Investment (72
(72 5’s;
$'s; Bils.)
Bils.)
77
77
Simulation
simulation No.
77
78
79
80
80
1I
22
33
4
55
66
77
0.1
0.1
0.6
0.5
0.6
0.5
0.6
0.5
0.6
0.7
0.8
1.0
1.0
2.5
2.6
3.4
1.7
2.8
2.1
2.4
4.6
4.5
5.3
3.0
2.8
0.9
3.1
2.7
4.4
6.0
5.0
3.1
2. 7
2.7
3.5
1.9
J.9
2.1
-
0.3
0.3
0.3
0.3
0.4
79
80
0.6
0.7
2.4
2.8
2.9
1.9
2.1
2.1
2.1
2.9
4.7
7.0
7.5
7.6
4.5
4.7
3.3
6.1
77.0
.0
11.4
11.4
13.4
7.3
7.2
Housing Starts
Housing
(Mils. of Units)
Household Physical
Assets (5
($ Bus.)
Bils.)
11
22
33
44
55
66
77
78
. 77
77
78
79
79
80
80
77
78
79
-0.l
—0.1
-1.0
-34.6
—34.5
-32.5
—32.5
—39.9
-39.9
0.3
-0.6
11.6
1.5
43.2
49.9
37.3
3.6
0.6
40.2
30.6
21.0
49.7
49. 7
48.6
6.1
4.0
70.6
70.5
.007
.023
.023
.004
92.5
74.6
189.4
171.6
3.9
3.9
4.1
.010
.156
15S
.153
153
.191
.053
.063
.151
151
.179
.240
.008
-.008
.040 —.079
-.040
-.079
-
-
80
.034
-.034
.133 .115
.133
.049
.155
.011
.251
.058
.058
.317
-.027
.028
-.027 -.028
.089 -.083
.083
-.089
-
-
-
-
*Dufferences
to Baseline
*Differences Relative
Relative to
Easier Money”
Money" policy has the biggest impact on the capital formation
of business
business
of
and the second greatest effect on household physical assets.
The rise in housing starts relative to the baseline is far above the
other simulations.
The reasons are straightforward.
straightforward.
First,
First, rapid
rapid real economic
economic
growth
"accelerator"
growth and sharp rises in capacity utilization
utilization have aa major “accelerator”
effect on business fixed investment.
-83-
Plant and equipment spending
is $5.3 and $6 billion above the baseline for 1979 and 1980 in the
"Tight Fiscal—Easier
Fiscal-Easier Money"
“Tight
Money” solution.
Second, the lower interest rates
reduce debt service charges and the debt burden of corporations, reducing
of physical
the financial risk that is associated with the acquisition of
Further, the rental price of capital is decreased because
assets.
the cost of financial capital drops, favoring the substitution of capital
for labor.
Third, cash flow is greater with the higher profits of
a stronger economy, making purchases of plant and equipment easier.
The resulting increases of business fixed investment are translated
into a greater stock of gross plant and equipment, so that by 1980
the "Tight
“Tight Fiscal-Easier
Fiscal—Easier Money"
Money” simulation gives a cumulated $24.2
in business capital formation.
billion rise in
The next largest increase
“Personal Tax Reductions and Easier Money”
is $21.5 billion under the "Personal
Money"
scenario.
Fourth, the low profile
profile of
of short-term
induces
short—term interest rates induces
flows-of-funds from households to the major mortgage lenders, as deposits
remain an attractive investment compared with other alternatives.
The financial intermediaries quickly lend out these funds, given aa
wide spread between the returns on mortgages and other loans or investments.
"Tight Fiscal-Easier
Housing starts in the “Tight
Fiscal—Easier Money"
Money” simulation are 25
to 60% greater than in the baseline, far exceeding the differential
impact arising from any of
of the other
other policies.
costly is the capital
capital formation under the "Tight
How costly
“Tight FiscalFiscal—
Easier Money"
Money” policy?
Table 44 shows that the extra inflation that
is generated ranges between 0.1 and 0.7%, so that Ml growth of between
88 and 9% does not reignite a runaway inflation.
The gains include
a near 1% reduction of unemployment by 1980,
1980, in addition to
to the new
-84-
capital that is accumulated.
An equivalent rise in national output
that was not accompanied by as much capital formation would be
be more
inflationary, e.g., simulation (4) - the ''Personal
“Personal Tax Reductions and
inflationary,
—
Easier Money”
Money" policy.
Finally, Table 77 shows how the various policies affect productivity,
the sectoral shares of GNP, and the capital-output ratio.
TABLE 7. Policies to Stimulate Capital Formation:
Formation:
Effects on Productivity, Sector Shares of GNP,
and the Capital Output Ratio*
labor Productivity
Federal Gov. share
Labor Productivity
(%chg.)
(% chg.)
Federal Gov. Share
of GNP
GNP (%)
(%)
of
Simulation No.
Simulation
77
78
79
80
11
22
0.2
0.2
0.2
0.5
0.5
0,5
0.6
0.2
0.2
0.1
1.4
1.4
1.5
2.0
3.3
3.3
3.0
3.0
0. 3
0.3
0.2
1.3
2.0
1.3
0.5
0.5
0.8
0.8
0.1
0.1
-0.7
-0.l
-0.1
0.5
-0.2
33
44
55
66
77
-
-
-
77
-
-0. I
-0.1
-0.2
-0.2
-0.4
-0.l
-0.1
-0.2
Investment
Real Business Fixed Investment
to Real
Real GNP
GNP (%)
to
l1
2
3
44
55
6
77
78
79
80
-0-.
-0.33
-0.4
-0.4
-0.7
-0.7
-1.1
—1.1
-0.6
—0.6
-0.8
-0.3
—1.0
-1.0
-1.3
—1.3
-0.1
-0.5
-0.8
-0.4
-0.9
-1.3
—1.3
-
-
-
-
-
-
Capital
Ratio (1)
capital Output Ratio
(%)
77
78
79
80
77
77
78
79
80
-.01
-.01
-.01
-.02
—.02
.01
.01
.04
.05
-.07
—.07
-.07
.05
—.02
-.02
.04
.12
.14
-. 10
—.10
-.09
.08
-.03
.06
.05
.19
.19
-.12
—.12
-.07
-.07
.08
-0.2
-1.0
—1.0
-1.1
-0.9
-1.9
-1.4
—1.4
-1.6
—1.6
-2.0
—2.0
—0.4
-0.4
-2.2
—2.2
—1.9
-1.9
a.I
0.1
0.3
-1.1
—1.1
-1. 7
-1.7
-0,3
-0.3
—1.5
-1.5
—1.2
-1.2
0.3
0.5
—
.13
.19
.18
-0.2
-0.4
—0.5
-0.5
-0.3
-0,3
-
—
—
0.1
0.1
*Olfferences
Relative to
to Baseline
Baseline
*Differences Relative
capital stock as a
a proportion of real
(1) net capltal
real GrAP
GNP
contribute
Again, the policies that involve accommodating or easier money contribute
most to improvement in the variables of concern.
Labor productivity
is up sharply in the "Personal
“Personal Tax Reductions and Easier Money"
Money” and
“Tight
Money” solutions, although diminishing subsequent
"Tight Fiscal-Easier Money"
subsequent
-85-
Steady increases appear in the “Easier
"Easier Money"
Money” solution, the
to 1978.
result of aa sustained period of lower interest rates, higher capital
formation, and increased output.
The share of Federal government
spending to GNP is lower
lower in all the simulations, especially in the
“Tight Fiscal—Easier
Money” solutions.
"Tight
Fiscal-Easier Money"
This declining share for the
Federal government frees resources to the private sector, especially
especially
late in the decade.
lower budget deficit.
Also, Treasury financing is much less with the
The result is significant increases in the ratio
of business fixed investment to GNP.
The greatest rises in this ratio
occur in the business tax incentive solutions, however, induced by
a shift in sectoral shares from housing to business capital formation.
Which policies are most effective in promoting business capital
formation?
The simulations clearly indicate the program of permanent
reductions in personal income taxes, slower growth in Federal Government
spending, and easier money in terms of higher targeted rates of growth
of Ml has the greatest impact, at least cost, in terms of the economy’s
economy's
goals.
Over the four years of the simulation, the gross plant and
equipment of business rises by $24.2
$24.2 billion in the “Tight
"Tight Fiscal—Easier
Fiscal-Easier
Money"
Money” scenario.
The next largest increase occurs in the “Personal
"Personal
Reduction-Easier Money”
Money" solution.
Tax Reduction—Easier
All of the other simulations
show substantially lower rises
rises in the capital stock of
of business.
In
inthe
“Tight Fiscal-Easier
Fiscal—Easier
addition, there is aa strong rise of housing in
the "Tight
Money” solution as well, with accumulated increases in housing starts
Money"
for the four years at 806,000 units, compared with the next largest
increase of 594,000 units in the "Personal
“Personal Tax Reductions and
Easier Money”
Money" scenario. Also household capital formation is much
-86-
"'·
¶
larger than in all of the other scenarios,
scenarios.
Thus, the “Tight
"Tight Fiscal—
Fiscal-
Easier Money”
Money" policy
po 1icy has gains in aall
11 the forms of capita
1, with only
capital,
i at 1 on as the major cost.
a moderate rise of
of’ inf
inflation
The reasons for the stronger capital formation under
under the “Tight
"Tight
Fiscal—Easier Money”
Fiscal-Easier
Money" policy include:
1)
a sustained period of low interest rates which stimulates
consumption, reduces the rental price of plant
plant and equipment
to
w stinwiate
st.in1Uiate business fixed investment, and reduces the
costs of outstanding debt to minimize
minimize financial risk and
encourage spending by all sectors;
2)
increased flows of funds from the household sector to financial
intermediaries,
intermediaries, who, in turn, make mortgage money available
to stimulate
stimulate housing;
3)
a reduced share of total economic activity for the Federal
Government sector due to the slowed growth in Federal
spending.
Financial market pressure is eased due to the
resulting drop in Treasury financing and a response by
the Federal Reserve of more bank reserves.
The trading of an easier monetary policy for aa tighter fiscal policy
thus appears to offer the greatest potential
potential benefits for capital
formation in the U.S. economy.
The business tax incentives provide less aggregative stimulus,
because of a much lower impact than accelerator and capacity utilization
influences on fixed investment.
The tax incentives
incentives directly induce some
spending on plant and equipment and ease the financial position
-87-
of corporations.
same time, the revenue loss to the
However, at the sane
Federal government is equivalent to an easier fiscal policy; raising
pressure on the financial markets, causing increases of interest rates,
flows-of-funds into housing, and eventually, reducing
diminishing the flows—of—funds
housing starts.
These last results appear clearly in Tables 66 and 7, where the
share of business fixed investment to real GNP rises the most in the
tax incentive simulations, but housing starts decline.
Thus, the
business tax incentives would probably be more appropriate to apply
employment, shifting sectoral
as the economy approached close to full emplo,~nent,
shares but not exerting much demand pull pressure on the economy.
With the considerable slack in the economy that exists at the start
of the simulations, the increased national output from the stimulative
macro—oriented
macro-oriented policies have a major impact on business fixed investment
through accelerator effects.
Later in the expansion, when there is much
less slack, the increased output would be translated into inflation,
diminishing the purchasing power and spending of the private sector.
Hence, the appropriateness of the permanent tax reductions, easier
money, and slowed Federal government spending is particular to the
Is considerable
current stage of the business expansion, where there is
"gap" to be eliminated before severe demand-side
slack and a large “gap
inflationary pressures are generated.
Capital Formation, Productive Capacity, and Prices
AA major element in the case for capital formation is the potential
beneficial effect on inflation of an increased capital stock.
-88-
The
mechanism by which capital formation can
can affect inflation is twofold.
First, the construction of badly needed capital would prevent bottlenecks
from arising, as was the case in 1973-74.
1973—74.
The bottlenecks and shortages
in productive capacity for meeting demands was a prime cause of industrial
inflation during that period.
Second, increased capital formation
raises the productivity of labor and increases the potential output
of the U.S. economy.
Through a reduction in unit labor costs
costs and rise
in potential real GNP, aggregate
aggregate demand pressures on prices would be
reduced.
Most of the policies considered for stimulating capital formation
have both demand and supply effects with the problem one of creating
a balance between demand and supply so that inflation does not rise
too rapidly.
The aggregative policies in simulations (1) (2) and (5)
cause inflation to rise because of a more rapid increase in demand
than in supply.
But the increase in productive capacity that occurs
does serve to mitigate the inflationary pressures created by the macro
macro
policies.
The business tax incentives do not raise inflation by as
much as the general macroeconomic policies.
However, the disadvantage
is that the overall economic stimulus from these policies is minimal.
Thus, the appropriate mix of the two kinds of policies, general macroeconomic
stimulus and business tax incentives, depends on the position of the
economy relative to full employment.
The farther from full employment
is the economy the more appropriate would be the macroeconomic policies
to stimulate capital formation.
But when the economy reaches full
employment,,
it would be more appropriate to rely heavily on the business
employment,~itwould
tax incentives to minimize the inflationary impact of rises in demand.
-89-
In all cases, the impact on inflation from increased capital
formation is not
not great because 1) the additional capital that is created
is only a small portion of the existing capital stock, and 2) the
impact on potential output from aa greater rate of capital formation
is relatively small.
Most production function studies indicate that
increases in the quantity and quality of labor have the biggest impact
on potential output.
The role of increases in the capital
capital stock,
although not insignificant, is much less.
Therefore, the capacity
added through aggressive policies to stimulate capital formation would
only bring small reductions in the inflation of wages
wages and prices.
To prevent a resurgence of inflation then, capital formation
should not be the principal focus of policy.
The best insurance against
such a reacceleration
reacceleration would be a gradual approach to full employment,
with real GNP rising steadily by 55 to 6% for the next few years.
Indeed, growth in real output must slow in later years to insure a
"soft
collision with the
“soft landing"
landing” at full employment rather than a collision
capacity ceiling of the economy.
inflation
Major attempts to reduce inflation
through the route of increased capital formation are doomed to failure,
if only because the demand-side stimulus
stimulus required for appreciable
increases in capital formation would be too massive and the required
size of business tax incentives too great to raise capital formation
high enough for significant reductions in prices.
Inflation must be
attacked in another manner than through policies
policies to raise capital
formation.
Increased capital formation can help fight inflation, at
the margin, by raising productivity and potential output, but should
not constitute the major bastion against the still high inflation that
remains in the U.S. economy
-go,.
-90-
Appendix:
Simulation Results
Description of
of Simulations:
A permanent $5 billion
Personal Tax Reductions: A
bi Ilion reduction in
personal income taxes was assumed for 1977:2. There
There was $20 billion
1979. In
of additional tax reductions in 1978 and $25 billion in 1979.
effect, this simulation assumed that permanent tax reductions are
legislated each year to eliminate an “inflation
consumers’
"inflation drag”
drag" on
on consumers'
because of the
the “bracket”
"bracket" effect on
on taxes
taxes from
from higher
higher
purchasing po,1er
purchasing
power because
7.2% in 1977, 8.2% in 1978, 8% in 1979, and
inflation. Ml growth was 7,2%
6.7% in 1980. The baseline had corresponding growth rates of 7%, 7%,
6.7%
6.8% and 6.8%.
i
Mone•:: A
Personal Tax Reductions and Accommodatino
Mone’
A permanent
$5 billion re uction
uct1on in persona income taxes was assumed for 1977:2.
There was $20 billion of additional tax reductions in 1978 and $25
$25
billion in 1979. The distinguishing feature of this simulation from
billion
the previous one was the accommodating money.
money, Short—term
Short-term interest
rates were kept constant through the provision of sufficient bank
reserves by the central bank. Ml growth was 7.3% in 1977, 8.5% in
1978, 8.8% in 1979, and 7.4% in 1980.
1980. The baseline had corresponding
of 7%, 7%, 6,8%,
6.8%, and 6.8%.
growth rates of
Easier Money: AA 1% higher growth in Ml during 1977 and 1978
~jjerMon,~~:
than in the baseline was assumed. The increased growth was achieved
through centra
central1 bank provision of nonborrowed
nonborro,;ed reserves until the economy’s
economy's
·
performance generated the desired money growth. The result was Ml
8% in 1978, and 7% in both 1979 and 1980. The
growth of 8% in 1977, 8%
5.8%.
baseline had corresponding growth rates of 7%, 7%, 6.8%, and 6.8%.
entjtled easier money, tne
the higher monetary
Although this
tnis simu:ation
simu.ation is entitled
greaf'as ttoo destabi
1ize the economy.
growth rates were not so great~’â~
destabilize
Reductions and Easier
bi 11 ion
~
AA permanent $5 billion
in persohal
personal income taxes was assumed for
or 1977:2, There was $20 billion
of additional
additional tax reductions
reductions in 1978 and $25 billion in
in 1979.
Ml
1979, Ml
growth was permitted to rise 1% above the monetary growth in the "Personal
“Personal
Tax Reductions''
Reductions” simulation during 1977 and 1978, 0.7% higher in 1979,
and remained the same in 1980. The Ml growth rates were 8.2%, 9.2%,
8.8%, and 6.7% from 1977 to 1980.
1980. The baseline had corresponding
6.8%.
growth rates of 7%, 7%, 6.8%, and 6,8%.
Tight
Ti ht Fiscal and Easier Money:
Mone : AA $5 billion reduction in military
assumed for 1977,
spending was assun~e
i
, then a sustained decrease of $10 billion
from 1978 to 1980. AA permanent $5 billion reduction of
of personal income
taxes occurred in 1977:2. There was $20 billion of additional tax
reductions in 1978 and $25 billion in 1979.
1979. Ml growth was permitted
to be 1% above the monetary growth in "Personal
“Personal Tax Reductions"
Reductions” during
1980,
1977 and 1978, 0.7% higher in 1979, but remained the same in 1980.
8.2%, 9.2%, 8.8%, and 6.7%
6. 7% from
The resulting Ml growth rates were 8.2%,
-91-91~~~
1977 to 1980. The baseline had corresponding growth rates of 7%, 7%,
6.8%, and 6.8%.
Investment Tax Credit: AA permanent increase of 2%, from 10
to 12%,
12%, in the tax credit for producers'
producers’ durable equipment, was assumed
1977:1, Monetary policy was not accommodating; other tax
to begin in 1977:1.
and spending parameters remained the same as in the baseline.
Corporate Profits Tax Reductions: AA two-stage
two—stage reduction in
the statutory tax rate on corporate profits was assumed. The rate
1978—80. Monetary
was lowered from 48 to 45% in 1977 and then to 42% in 1978-80.
policy was not accommodating; other tax and spending parameters remained
the same as in the baseline.
—92—
-92-
Formation and
U.S. Economic
Economic Performance:
Capital Formation
and U.S.
"Personal Tax
Tax Reduction"
"Baseline"
“Baseline’ and ‘Personal
Reduction” Solutions
TABLE &
8.
,,
7U
ECONOMY
ICONOMY
RF H 008
GNP (00t CMG,)
8180.
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BtSf.:LlNE
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TABLE
TABLE 9.
-
.
A:.lTJO~
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Continued
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TABLE 10.
Capital
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U.S. Economic
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TABLE 13.
Capital Formation and U.S. Economic Performance:
TABLE 13.
u. s.
Capital Formation and
Economic Performance:
"Baseline"
‘Baseline” and “Investment
Tax Credit”
Solutions
"Investment Ta,
Credit" Solutions
95
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Perforroonce:
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o,
References
1.
1.
Andersen, Leonal
Leonalll C., “Is
"Is There a Capital Shortage: Theory and
Recent Evidence",
Evidence”, Journal of Finance, 31 (May 1976), 257—68.
257-68.
2.
Briminer, Andrew F. and Allen Sinai, “The
Brimmer,
"The Effects of Tax Policy
on Capital Formation,
Formation, Corporate Liquidity and the Availability
of Investible Funds: AA Simulation Study",
Study”, Journal of Finance,
287-308.
31 (May 1976), 287—308.
—
_______
3.
Bosworth, Barry, “Capacity
"Capacity Creation in the Basic Materials Industries",
Industries”,
Brookings Papers on Economic Activity, 22 (1970), 197-341.
197—341.
4.
S. and Andrew S. Carron,
Bosworth, Barry, Duesenberry, James S.
Capital Needs in the Seventies, Washington: Brookings, 1975.
5.
Data Resources, Inc., The Data Resources National Economic Information
System, Amsterd1111:
North-Holland, 1978.
Amsterdam: North—Holland,
6.
Eckstein, Otto, Green Edward W. and Allen Sinai, "The
“The Data Resources
Model: Uses, Structure, and Analysis of the U.S. Economy,”
Economy," InterInternational Economic Review, October 1974, pp. 595-615; reprinted
in L. R. Klein and E. Burmeister, eds,,
eds., Econometric Model Performance,
University of Pennsylvania Press, 1975,
1976, 211-31.
211—31.
7.
Eisner, Robert, "Capital
“Capital Shortage: Myth and Reality”,
Reality", American
Economic Review, Proceedings, 67 (February 1977), 110-15.
110—15.
8.
Fellner, William, Clarkson, Kenneth W. and John Moore, Correcting
Correcting
Taxes For Inflation, Washington, D.C.:
D.C.: American Enterprise Institute
for Pullie
Pu’BTfc Policy Research, 1975.
9.
Friedman, Benjamin M., "Financing
“Financing the Next Five Years of Fixed
Investment”,
51—74.
Investment", Sloan Management Review, 17 (Spring 1975), 51-74.
10.
Fromm, Gary, "Investment
“Investment Requirements and Financing: 1975-1985",
1975—1985”,
Washington, D.C.: National Bureau of Economic Research, October
1975 (mimeo.).
(mimeo.).
11.
Jones, Reginald H., “Why
"Why Business Must Seek Tax Reform?"
Reform?1* Harvard
Business Review, September/October 1975, 49-55.
Business
49—55.
12.
Kendrick, John W., The Formation and Stocks of Total Capital,
National Bureau of Economic Research, New York: Columbia
Columbia University
Press, 1976.
-114-
•
13.
Minsky, Hyman P., John Maynard Keynes, New York:
Press, 1975.
--
Columbia University
14. New York Stock Exchange, The Capital Needs and Savings Potential
of the U.S. Economy: Projections Through 1985°,
l’gB’5’, September 1974.
15.
Saving”,
Simon, William F., “On
"On a Tax Program for Increased National Saving",
Statement before the House Ways and Means Committee, July 31,
1975.
16.
“Financial Instability: A
A Discussion,”
Sinai, Allen, "Financial
Discussion," in E. Altman
and A. W. Sametz, Financial Crises: Institutions and Markets
ma Fragile Environment, New York: Wiley, 1977. in~
17.
“Financial Shortages
Shortages.. . .. Or Surplus?"
Surplus?” in 0.
Sinai, Allen, "Financial
O. Eckstein,
ed,,
ed., Economic Issues and Parameters of the Next 44 Years, Lexington,
Resource~Inc.,
'So-89. - - Mass.: Data Resources,
Inc., 1977, SE—~T’
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“The Integration of Financial Instability
Large—
Sinai, Allen, "The
Instability in LargeScale Macroeconomic Models: Theory, Practice, and Problems,”
Problems,"
paper presented at the Annual Meeting of the Midwest Economic
Association, April 1975, Chicago, Illinois,
Illinois.
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Sinai, Allen and Roger E. Brinner, The Capital Shortage: NearNear—
Term Outlook and Long-Term
Prospect~Econom1c
Long—Term Prospects,
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~18,
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“The Tax Treatment
Tideman, T. Nicolaus and Ronald P. Tucker, "The
Conditions", in H. J. Aaron,
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1976.
- -
.
—
______
f~~1y
21.
U.S. Department of Commerce, Bureau of Economic Analysis,
Analysis, AA Study
Economy-:- 1971—of Fixed Capital Requirements of the U.S. Business Economy,
Ilsa,
- -- - 18O, December 1975.
22.
United States Senate, Committee of the Budget, “Long—Run
"Long-Run Capital
Needs of the Public and Private Sectors",
Sectors”, Seminar on Effects of
Fiscal and Monetary Policies on Capital Formation and Economic
Economic
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Vaccara, Beatrice N.
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"Some Reflections on Capital
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( February
1977), 122-27.
—115—
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“Capital Shortages:
Wachtel, Paul, Sametz, Arnold and Harry Shuford, "Capital
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Wallicti, Henry C., “Is
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Wallich,
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September/October 1975, 30-43.
16-
‘01
Challenge,
MONETARY POLICY AND CAPITAL FORMATION
Jai-Hoon Yang*
Jai—Hoon
The year 1776 gave
gave birth not only to aa great nation but also to aa
great book which shaped our science.
In his Wealth of Nations, Adam
Smith made growth in income the central explanandum of his inquiry and
identified capital formation as the prime
prime mover of growth in income.
It is most fitting, therefore, that the subject matter of this conconference in this bicentennial year of the Wealth of Nations is capital
formation.
II do not believe, however, that the theme of this conference was
chosen merely, or even primarily, to commemorate the bicentennial of
the locus classicus of our science.
The choice of the theme reflects,
II believe, the widely held concern about the adequacy of capital formaformation.’ The precise nature of the sources and significance for monetary
tion.1
policy of such concern, however, does not appear to be well delineated.
delineated,
Accordingly, the purpose of this paper is to provide a diagnosis
diagnosis of the
sources of such concern and what such concern implies for the conduct
of monetary policy.
1‘For
For an expression of “official”
"official" concern, see Economic Report of
34—47. For aa summary of diverse
the President, January, 1976, pp. 34-47.
views, see the Introduction by Eli Shapiro and William L. White to
Capital
Ca ital For Productivity
Productivit and Jobs, edited by E.
E. Shapiro and W. White
(forthcoming,
forthcoming, Prentice—Hall).
Prentice-Ha 1 .
*Dr. Yang
an economist
economist at
The Federal
Federal Reserve
Bank of
of St.
St. Louis.
*Dr.
Yang is
is an
at The
Reserve Bank
Louis.
The views expressed in this paper are those of Dr. Yang.
117
The first section of the paper identifies the three analytically
separable
separable sources of the widespread concern about the adequacy of capicapi-
tal formation.
The sources of concern are organized along the traditradi-
tional dual roles that capital formation (or investment) play in augaugmenting productive capacity and generating income,
income.
The second
section frames the issue associated with capital formation in an exexplicit intertemporal utility maximization paradigm.
In such a parapara-
digm, the issue of how, or even whether, to specify an aggregate
utility functional looms paramount.
The third section explores
explores the
possible role monetary policy may play in deepening the steady state
capital intensity.
This section draws liberally upon neoclassical
monetary growth theory and the theory of money bearing on the
technology of exchange.
Monetary policy would serve the cause of capital formation best by
being directed toward the attainment of full capacity output.
The
implications of such aa thrust of policy for the knowledge required to
define an appropriate monetary policy will be considered later.
A
A
catalogue of unresolved issues is provided whose resolution
resolution is essenessen-
tial for improving the quality of advice given to the monetary policy—
policymakers.
Much attention is devoted, in this section, to the different
concepts of stabilization policy and the feasibility of discretionary
stabilization policies.
In the concluding section, the optimum monemone-
tary policy, in a world of costly information and possible "coordina“coordina-
tion failures,"
identified as one which is systematically free of
failures,’ is identified
118
policy innovations.22 Such a “surprise—free”
"surprise-free" policy regime would miniminipolicy-induced shocks on non—policy
non-policy
mize the risk of superimposing policy—induced
reshocks and enable the homeostatic capacity of the price system to respond more effectively to the changes in the non-policy sources of
shocks.
A
such
A brief discussion of the appropriate empirical proxy for such
an ideal monetary policy concludes the paper.
Sources of Concern:
AA Diagnosis
The widespread concern with the recent and prospective pace
pace of
output growth and capital formation appears to have three analytically
analytically
separable sources.
The first source of concern is the possibility
possibility of
not attaining capacity (full equilibrium) output.
This failure may be
attributable either to the emergence of a capital shortage—labor
shortage-labor sursurPl us economy (to be defined) due to the "putty-clay"
plus
“putty—clay” nature of the
capital stock, or to the emergence (and persistence) of an unemployment
state due to the standard
standard effective
effective demand failure.
Here the focus is
on the income and employment generating function of investment, or with
the role of capital formation in attaining the full employment objecobjec-
tive.
emerHow can the "putty-clay"
“putty-clay” nature of capital stock induce the emergence
of
One can always
gence
of a
a capital shortage-labor surplus economy?
explain such a possibility by resorting to the Keynesian labor supply
function.
A
A temporary excess supply of labor, or its dual, capital
2For the concept of “coordination
"coordination failures,”
failures," see Axel Leijonhufvud,
Lei jonhufvud,
"Effective
Failures,'' Swedish Journal of Economics, Vol. 75
“Effective Demand Failures,”
(1973).
119
shortage, would emerge in response to a reduction in the capital stock,
3
as such aa reduction decreases the demand for labor.3 Of course, such a
phenomenon would not persist unless the price level and the relative
rental prices of factors do not adjust to eliminate the implied nonotional, excess demand for commodities.
commodities.4 However, in aa putty-clay
world, one does not have to resort to this trivial Keynesian case.
One gets the same theoretical result even with a classical labor supply
function.
The decline in the demand for labor (consequent to the rere-
duction in the capital stock) in conjunction with fixed factor proporproportions in a Cobb-Douglas world would yield such a result. 55 The key
point to remember is that in such a world, the marginal product of
labor is
a function only of factor proportions and, hence, even in the
isafunction
3such
stock may be induced by war or by
Such a reduction in the capital stock
an accelerated capital obsolescence or abandonment induced by unexpectunexpected changes in the relative prices of factor inputs, such as the energy
input. In aa putty-putty
could
putty—putty world, capital obsolescence, of course, could
not occur.
4For the concept of notional excess demand, see R. Clower, "The
“The
Appraisal," in The Theory
Keynesian Counterrevolution: AA Theoretical Appraisal,”
Theorx
of Interest Rates, edited by F. Hahn and F.
F. Brechling (London:
Macmillan &&Co., Ltd., 1965).
5For theoretical discussions of the possible emergence of the ununemployment state due to a shortage of capital in a putty-clay world,
"The Economic Implications of Learning by Doing,”
Doing,"
see Kenneth J. Arrow, “The
Economic Studies ((June
June 1962)
1962) and Leif Johanson, "Substitution
Review of Economic
“Substitution
versus Fixed Production Coefficients In the Theory of Economic Growth:
A
A Synthesis,"
Synthesis,” both reprinted in Readings in the Modern Theory of
Economic Growth, edited by J. Stiglitz and H. Uzowa (M.I.T. Press,
"The Factor Proportion
Proportion Problems in UnderdevelopUnderdevelop1969); also R. Eckaus, “The
ed Areas,"
American
Economic
Review
(
September
1955).
Areas,”
(September
120
presence of an excess supply of labor, the real wage would not decline!
The long-run
capilong—run adjustment would entail augmenting or replacing the capistock with a capital stock embodying different technology.
tal stock
A
A second source of concern with capital formation arises from its
capacity—augmenting function.
capacity-augmenting
It derives from dissatisfaction with
decentralthe full equilibrium capacity growth path generated by the decentralized market process.
Here the actual (or prospective) capacity growth
path is compared to some desired growth path.
The determination of
such aa desired growth path may be based on some implicit criteria or,
more formally, on the solution values of aa full-blown multiperiod
optimization problem involving the Ramsey-type functional, 66
f~ u~(c,t) dt = f~Ft(K~
k, t) dt.
The market-determined growth path is often judged to be suboptimal
or inconsistent with the target path, even when full employment is concon-
tinuously maintained.
tinuously
Myopia, identified
identified by
by Pigou
Pigou as “defective
"defective teleteleMyopia,
scopic faculty,"
marketfaculty,” is often singled out to explain why the market—
intensity stops short of the desired
determined equilibrium capital intensity
(deeper) capital intensity.
The capital intensity associated with the
6For Ramsey Economics concerned with optimal economic growth, see
Capital
Development
S. Chakravarty, Ca
ital and Develo
ment Plannin~,especially
Plannin , especially Chapters
1969 and the forward by Paul Samuelson; also M.
I - IV (M.I.T. Press, 1969)
Intrilligator, Mathematical Optimization
O timization and Economic
Economic Theory,
Theor, Chapter
16 (Prentice-Hall,
1971 . For aa discussion of a functional, which dede(Prentice—Hall, 1971).
fines a real number for any given function defined over aa domain, see
Martin's
R. G. D. Allen, Mathematical Analysis for Economists (St. Martin’s
Press, 1934).
-
121
golden rule of accumulation may be identified
identified as the target intensity.77
“required” policy actions are envisioned as steerIn this paradigm, the "required"
steering the economy toward aa higher growth path of consumption at a cost of
reduced consumptions during the transition periods.
Given the impossiimpossi-
bility theorem of Arrow regarding the derivation of consistent aggreaggregate preference orderings, it is clear that the choice of the utility
functional to be maximized poses aa fundamental challenge
challenge to the solution
of
"inappropriate equilibrium capital intensity”
intensity" problem.
of this “inappropriate
reThe re-
“capital shortage"
shortage” controversy may be interpreted in this context
cent "capital
as expressing the concern about the adequacy of saving to finance the
“required” capital formation.
"required"
The primary concern is about the potenpoten-
"intial "savings
“savings gap"
gap” as opposed to the (Keynesian) concern about the “investment gap"
gap” touched upon earlier.
earlier. 88
7Along the golden rule balanced growth path, consumption per capita
is maximum. See E. Phelps, “The
"The Golden Rule of Accumulation,"
Accumulation,” American
Economic Review (September 1965) and J. Robinson, "A
“A Neo—classical
Neo-classical
Theorem,"
Theorem,” Review of Economic Studies (June 1962).
8There are two diametrically opposed approaches to viewing aggreaggregate capital formation from a longer-run
longer-run perspective. One is that of
"optimization"
"utility-maximization" approach. Under this approach,
“optimization” or “utility—maximization”
aggregate capital formation is viewed as endogenous, that is, as the
outcome of deliberate
deli berate life—cycle
l ife-cyc 1e consumption decisions made by the inindi
vi dual spending units in the economy, given their tastes and perperdividual
ceived market and productive opportunities. In this approach, the
choice of future consumption paths and the current investment decisions
are jointly and simultaneously made. The other approach is the ''con“consistency” or "planning"
“planning” approach. This approach underlies the recent
sistency"
“capital shortage.”
concern for "capital
shortage." Under
Under this approach, the choice of a
future consumption (and growth) path is made outside the market process,
presumably by reference to some collective preference ordering. The
"required"
“required” capital formation is then computed to achieve such aa path.
The concern for capital adequacy in this context is really
really for the conconcern for the potential "saving
“saving gap"
gap” to achieve the "required"
“required” capital
formation and such a concern can arise only under the consistency
consistency
(continued)
122
The third source of the recent concern with capital formation apappears to be associated
associated with the general realization that the size of
current and prospective capacity output has fallen short
short of what was
expected.
This shortfall is due partly to those measures, such as inin-
creased regulatory
regulatory constraints which tend to increase the capital
capital-out-output ratio, and partly to those events, such as an increase in the relarela-
tive price of energy, which accelerated obsolescence of existing capital
stock.
The problem posed by this discovery appears to be essentially the
same as the one associated with the second source discussed above.
In
both cases, capital formation is viewed as aa problem involving interinter—
temporal utility maximization by reshaping the time path of consumption.
However, the urgency with which the problem is viewed may differ,
Inasmuch as the growth path is perceived to be permanently lower than
inasmuch
that which was taken for granted earlier, in the absence of redoubled
efforts at capital augmentation.
Intertemporal Choice and Equilibrium Capital Intensity
Intensjt1
The concern for capital formation is aa derived concern, that is, a
concern derived from the desire to achieve aa fuller utilization of
scarce resources over time and/or to alter the time-shape of consumption
flows, given the full resource utilization rates.
The mode of analysis
8 (continued)
consistency
approach. For the distinction between the optimization and consistency
approach, see Chakravarty, QP_.
7-10; also K. Fox, J. Sengupta
~ cit.,
cit., pp. 7—10;
Policy (North—
(Northand E. Thorbecke, The Theory of Quantitative Economic Poijçy
Holland, 1973), pp. 448-449 and 465-466.
123
implied by the latter concern is necessarily intertemporal in character
and collectivist in orientation.
One posits an existence of an instruinstru-
mentality, such as the state, through which public choice regarding the
desired capital intensity is to be implemented.
The objects of choice
in this intertemporal decision framework are different consumption paths
over time associated with different transformations of dated consumption
options 9
options.
From the constraints in this multiperiod decision problem, e.g.,
the initial endowments of resources, the expected technology of producproduc-
tion and exchange and other initial conditions, one can in principle
derive the feasible objects of choice.
inevitable unAbstracting from inevitable
un-
certainty, and possibly from the Strotz paradox as well, a choice which
maximizes a utility functional may, in principle, be made.’°
made. 10 At this
level of abstraction, all of the information required to define aa set of
technologically feasible consumption paths is assumed to be available
without cost.
Should aa well-defined utility functional be available,
except for the purely computational costs involved, the decision problem
becomes trivial.
9For a modern extension of Irving Fisher’s
Fisher's seminal work on investinvestment viewed as a problem in intertemporal utility maximization, see J.
Hirshlejfer,
(Prentice—Hall, 1970).
Hirshleifer, Investment, Interest, and Capital, (Prentice-Hall,
10The Strotz paradox or phenomenon refers to the possibility
lOThe
possibility that,
even
even
with perfect foresight, time perspective at any point in time
distorts the choice of a consumption path over aa time horizon in such a
way that either the choice is revised or an occasion for regret arises
subsequently. See R. Strotz, "Myopia
“Myopia and Inconsistency in Dynamic
Utility
Economic Studies (Vol. XXIII, No. 62,
62,
Utility Maximization,"
Maximization,” Review of Economic
1956); Chakravarty,
Chakravarty, op. cit., pp. 41-45; also R. Pollak, "Consistent
“Consistent
Planning,”
tEonöiiffc Studies (April 1968).
Planning," Review of tconomfc
124
The principal policy problem in such aa full-information world is to
define a collective preference ordering function over alternative full
capacity consumption paths.
event that the optimum consumption
In the event
path so chosen differs from the market-generated path (evolving
(evolving along a
capacity path), the intertemporal resource allocation decisions will be
centrally directed.
Since, by assumption, the only argument appearing
in the preference functional is the alternative consumption paths, the
conflict over centralized direction and decentralized market direction
of resource use does not arise
arise in this paradigm.
However, a question
regarding the appropriate time horizon remains even at this level of
abstraction inasmuch as the choice of any particular consumption
consumption path
possibility paths
paths
over a given horizon restricts the set of consumption possibility
beyond the chosen horizon.
It does this by predetermining the initial
conditions in the future.
Underlying this view of optimal consumption choice over time are
11
nonmonetary (optimal) growth theories.11
various strands of nonmonetary(optimal)
Different
rates of capital accumulation are associated with different equilibrium
capital intensities and growth paths of income and consumption.
HowHow-
ever, along the balanced growth paths where capital intensities remains
constant, growth rates of income and consumption remain invariant to the
rate of capital accumulation.
In the study of such comparative dynamics,
dynamics,
it is generally assumed that full employment is obtained uniformly; the
11
For a survey of such theories, see F. Hahn and R. Matthews, "The
~For
“The
Theory of Economic Growth: AA Survey,"
Journa 1 , (December 1964);
Survey,” Economic Journal,
also H. Wan, Economic Growth (Harcourt Brace Jovanovich, Inc.,
Inc., 1971).
125
focus of analysis is on the consequences of different consumption—saving/
consumption-saving/
investment decisions on the steady state paths of levels in income and
consumption.
Although the focus is generally on the characteristics of
the steady state paths, the explicitly intertemporal framework enables
considerations of such questions as (1) the feasibility
feasibility of attaining aa
particular path such as the Golden Rule path via the competitive process
and (2) the appropriateness of considering only the steady state values,
but not the transient values, of consumption in devising growth polipolicies.
For example, it is now well known that a competitive solution may
yield inefficient steady state paths should the rate of interest fall
2
short of the rate of growth due to excessive capital deepening.’
deepening. 12
Policy in the LongLong-run
The Nonneutrality of Money and Monetary Po1icy~in
The preference for a market-determined solution to the intertempointertempo-
ral resource allocation
allocation problem is yet another strand characterizing
(optimal) growth theories.
Such a preference is based
based on various effieffi-
ciency and equity considerations.
quesAccordingly, to deal with the ques-
tion of whether the introduction of money
money alters the market-determined
balanced
balanced growth path, money is introduced explicitly into growth
3
theories both as a medium of exchange and a store of value.’
value. 13
12
see, for example, P. Samuelson, “An
"An Exact Consumption—Loan
Consumption-Loan Model
‘2See,
Money," Journal
of Interest With or Without the Social Contrivance of Money,”
of Political Economy (December 1958); P. Diamond, “National
"National Debt in aa
Model,"
Neoclassical Growth Model
,“ American Economic Review (December 1965)
Accumuand D. Cass and M. Yaari, "Individual
“Individual Saving, Aggregate Capital Accumulation, and Efficient Growth,"
Growth,” in Essays on the Theory of Optimal
Economic Growth, edited by K. Shell (MIT Press, 1967).
1133see
See Samuelson,
gp. cit., pp. 481—482;
“Money and EcoEco—
Samuelson, QQ_.
481-482; J. Tobin, "Money
Econometric~JOctober
~
nomic Growth,”
Growth," Econometri
caTOctober 1965); J. Stein, Money
and Capacity
Growth (Columbia University Press, 1971).
126
When the issue is joined in terms of comparative dynamics involving
two economies,
economies, identical in every aspect but for the use of money, there
is not likely to be much dispute about the nonneutrality of money, even
in the long run.
For example, with the social contrivance of durable
money, the real rate of interest cannot be driven below zero with stasta-
tionary or growing population.
This fact alone will help forestall the
emergence of inefficient steady state path, which is a logical possipossibility in some intergenerational consumption-loan models.
models.14 However,
nonneuthere are likely to be as many different explanations for such nonneu—
trality as there are different diagnoses of the essential differences
between money and barter economies.
The concept of the nonneutrality of money considered above is
fundamentally different from that of the nonneutrality
nonneutrality of monetary
policy in the long run, given an on-going money economy.
,
Here, monetary
policy is to be construed broadly as a vector of actions which results
in the differential growth
gro~thrates
rates in the nominal money
money stock.
There is
as yet no consensus in the answer given to the question of nonneutrality
of monetary policy in the long run because the question regarding the
effect of monetary policy on equilibrium capital intensity is unresolved.
The much-debated classical dichotomy appears to rule in favor of
neutrality of monetary policy in the long run.
However, under the
classical paradigm, the neutrality of monetary policy is obtained under
a specialized monetary policy regime, which insures portfolio balance at
a stable price level.
To clarify this statement,
statement, consider the usual
14 see,
Q_P_. cit.
See, for example, Samuelson, ~p.
127
comparative static analysis of the effect of a one-shot change in the
quantity of the nominal money supply on real variables of the stationary
economy.
The steady state values of the real variables,
variables, including the
real balances per capita, remain invariant,
invariant.
At the new equilibrium,
after the initial disturbance, the price level is higher but constant.
The cost of holding real balances, therefore, remains unchanged and
hence the equilibrium quantity of real balances held is unchanged.
ConCon-
sider now an alternative monetary policy which engineers aa maintained
money supply at some constant rate.
increase in the nominal money
To the exex-
tent such aa policy generates an expectation of inflation, the cost of
holding real balances will rise and the initial portfolio
portfolio balance will
be disturbed.
Whether this policy would
equiwould induce a change in the equi-
librium capital intensity is an open question.
conThe same type of con-
siderations are involved in the analysis of comparative dynamics of an
economy growing steadily at the natural rate of growth.
tentative answers may be given to the question of the nonneu—
nonneuSome tentative
trality of monetary policy in the long run.
In the event that the rate
of increase in the nominal money supply is greater than the natural
rate of growth, neoclassical monetary growth theories (characterized by
the absence of an independent investment function and the presence of real
wealth effect in the saving function) obtain capital deepening.
The
mechanism by which this nonneutrality is obtained, for aa monetary policy
which induces a non-zero rate of equilibrium inflation rate, is known
as the inverse wealth-saving relationship.
A
A consensus appears to have
emerged on the theoretical foundation of the wealth-saving
wealth—saving relationship
.tnduced by changes in monetary policy:
128
both the change in x, the rate
of growth of the nominal money
money supply, relative to the rate of growth in
output and also the way such aa change in xxis
is engineered are crucially
15
policy.15
important in determining the neutrality of monetary policy.
In Metzler's
Metzler’s exploration of the question,
“heretical”
question, he obtained aa "heretical"
result of nonneutral monetary policy even in the context of fully emem16 The conclusion he drew from the analysis
economy. 16
ployed stationary economy.
one—shot open market operation altered (lowered) the equilibwas that a one-shot
equilibrium interest rate,
rate, even though the price level was unchanging in the
new equilibrium, albeit at a higher level.
Real balances in the new
17 This non—
equilibrium.17
equilibrium were greater than in the initial equilibrium.
non-
classical result is due to the capital levy aspect of the operation
(analogous to an increased budget surplus), rather than being due to
operation.’188 For example, such
pure monetary policy operation.
such a pure monetary
once—and—for—all money injection
policy action as a once-and-for-all
injection through government
transfers is not expected to alter the solution values of real variables.
variables.
15
‘5For
For a survey of extensive literature
literature in this area, see A. Meltzer,
“Money, Intermediation and Growth,"
Growth,” Journal of Economic Literature
"Money,
Literature
(March 1969); also Stein, ,gj.
Q.l)_. cit., pp. 21-22.
16
‘6L. Metzler, “Wealth,
Interest,” Journal of
"Wea 1th, Saving and the Rate of Interest,"
Political Economy (April 1951).
17 This conclusion on the new equilibrium real balances is not the
This conclusion on the new equilibrium real balances is not the
one reached by Metzler himself. It is inferred from his conclusion
about the lower equilibrium
equilibrium (real) interest rate and his assumption of
fully employed economy. An additional assumption that the demand for
real
balances is
of private
real balances
is invariant
invariant to
to the
the level
level of
private real
real wealth
wealth is
is sine
sine
~a non.
18see
~p. cit., p. 28.
5ee Meltzer, Q.l)_.
129
Such a policy would result in aa once-and-for-all
once—and—for—all increase in the price
level but would
would affect neither the equilibrium real wealth, including
including
the real balances, nor the equilibrium
equilibrium market and real interest rates.
inIn contrast, a pure monetary policy designed to permanently in-
crease the growth rate in nominal money relative to that of output has aa
nonneutral, positive effect on the capital intensity in the Tobin-type
9 In such models, the deepening in
Neoclassical monetary growth models.’
models. 19
the equilibrium capital intensity is obtained through the following
mechanism:
(1) an increase in the anticipated rate of inflation
inflation engiengi-
neered by a well-publicized permanent increase in the rate of monetary
expansion increases, through the Fisher effect, the market interest rate;
(2) the entailed increase in the cost of holding real balances reduces
the equilibrium amount of real balances; (3) the fall in real wealth
ocweal
oc-
casioned by the reduction in real balances increases the rate of saving
and the rate of capital formation through the posited inverse wealthinsaving relationship.
····
.... ..The capital deepening and a lower real rate of interest are the results.
~
.-·
The logic of this line of thought points to the implementation of an
accelerated target rate of anticipated inflation if accelerated capital
formation is desired.
This intuitively anomalous result stems from the
19 The conclusion holds only for an on-going
monetary economy. RelaRelaon-goingmonetary
tive to a barter economy, aa monetary economy has a lower capital
capital intensiintensiTobin-type Neoclassical monetary growth models. Such models
models
ty in the Tobin-type
are characterized by the absence of an independent investment function
and the presence of real balances in the saving function. See Tobin, QE_.
flp,.
Stein, QE_.
47-48; also M. Sidrauski,
cit., and Stein,
pp. cit., pp. 6-9, 33-34
33—34 and 47—48;
"lnfl
ati on and Economic Growth,”
Growth," Journal of Political Economy (December
“Inflation
1967).
130
130
invalid use of ceteris paribus.
Systematic destruction of real money
capital occasioned by the increased expected rate of inflation in the
model merely shifts preferences regarding wealth portfolio composition,
without affecting the attainable global production frontier.
no real productive role in the model.
Money plays
Money is nonneutral only in the
sense of altering the preferred asset compositions but very much neutral
"effective" global production possipossiwith respect to the attainable or “effective”
bility frontier.
attainMoney, however, is a productive asset (i.e., it affects the attainable production frontier) fundamentally because, by reducing transactransactions cost, It
it increases the scope for division of labor.
Derived fifi-
nancial innovations based on the existence of money, in the form of
primary and indirect securities, further the extent of division of labor.
Increased degree of specialization
specialization moves outward the attainable producproduction frontier because the distribution of resource ownership and producproductive opportunities happen to be in general “non—coincident.”
"non-coincident."
From this
perspective of the role of money in the technology of exchange, then,
any attempt to promote capital deepening
deepening by engineering aa programmed
anticipated inflation must be judged quixotic.
What would be the effect of the open market operations of the type
the central bank engages in, whereby the non-interest bearing base
money is exchanged for interest bearing government debt? Whether or not
an open market operation has a nonneutral effect on the equilibrium
capital intensity and growth path depends crucially on the extent of tax
discounting (the capital levy aspect) and upon whether the operation is
part of a plan to permanently change the growth rate in money relative
131
to the growth rate in output.
With perfect discounting of future tax liabilities
liabilities associated with
interest bearing government debt, i.e.,
i.e. , government bond is not aa part of
private net wealth, and a one-shot
one—shot open market purchase, the effect on
the equilibrium capital intensity would be as negligible as in the preprevious case where once—and-for-all
once-and-for-all increase in the nominal money stock
was brought about by pure government transfers.
In the event
event that tax
one—shot open market purchase would be
discounting is imperfect, a one-shot
equivalent to the Metzler’s
Metzler's capital levy case.
In the event the open
market purchase is part of a well—publicized
well-publicized program to engineer aa
change in the rate of anticipated inflation, such an attempt to induce
capital deepening by monetary acceleration would again appear to be
quixotic.
The two analytically separable questions regarding nonneutrality
may be restated as:
(1)
Does money matter in the long run?
(2)
Does monetary policy matter in the long run?
The answers considered above in terms of the prevailing paradigms of
comparative
statics
atemporal .
comparative
statics
and comparative dynamics are atemporal.
only with the steady state solutions.
They deal
Given that the objective of moneGiven
mone-
tary policy is the optimization of a given objective functional over the
relevant policy horizon, there is no presumption that the choice among
primarily, upon
the various policy options can be based solely, or even primarily,
the characteristics of the steady state solutions.
Nor is there any
presumption that the focus should be on the characteristics of transient
response to the chosen monetary policy action.
action,
132
The explicit interinter-
temporal choice framework indicates that the policymaker must assess
the characteristics of both the transient and steady state
state responses of
the economy to the chosen policy action.
The above way of viewing the
the elements of an optimum policy appears
to make the requirements for such a policy stringent.
However, such aa
oversimplification in the following fundacharacterization is itself an oversimplification
fundamental sense:
impTicitly assumes that aa policymaker has reliable
it implicitly
information about the past evolution and current state of the economy.
characteristics of the initial condicondi—
That is, it is assumed that the characteristics
20 In
tions are known and the requirements for observability are met.
the absence of such assumptions, the recent history of shocks to the
the economy has not yet fully adjusted, must
be identiidentisystem to which the
must
be
fied and allowed for in assessing the likely evolution of the economy,
both with and without the contemplated policy action.
In addition, the
behavioral parameters of the model
model are implicitly
implicitly assumed to be timetime—
and policy-invariant.
policy—invariant.
To the extent such assumptions do not hold, the
efficacy of any pol
icy action chosen on the basis of the projection of
efficacy
policy
such aa model will be attenuated.
20In
1n control system theory, observability or
or reconstructibility
reconstructibility rerefers to the property of the model
model which enables one to determine uniqueuniquely the past states of the system from a set of currently available obobservation data. See M. Aoki, O
mal Control and SS stem Theor in
0 timal
Dynamic Economic Analysis (North-Holland Publishing Company, 1976 ,, pp.
108-11.
133
Is There a Role for Monetary Policy In Promoting CCapital
Formation?
ital Formation?
Perusal of the recent literature
literature dealing with the capital formation
problem indicates that the focus placed on monetary policy is primarily
from the perspective of nonneutrality of monetary policy in achieving
21 The question
the full capacity output.21
question regarding the nonneutrality of
autonomous monetary policy on equilibrium capital intensity is seldom
raised explicitly
explicitly in aa policy context.
The role designated for monetary
accommopolicy, in achieving the full capacity output, is typically an accommodative one of keeping the market interest rate from rising, while
while a
stimulative fiscal policy, such as accelerated depreciation and investinvest22
ment tax credit, is undertaken to promote investment.22
The debate concerning the efficacy of such a policy revolves around
assessments of its likely effects.
different assessments
In the first
first instance, the
condebate is an
an empirical one arising from the absence of reliable or con-
sensus scenarios for the evolution of the economy under alternative
policy regimes.
Also absent is a consensus reading of the true state of
the economy.
For example, is the underutilization of capital stock as
23 If
widespread as the measured capacity utilization
utilization rates indicate?
indicate?23
If
21 See,
see, for example, B. Bosworth, “The
"The Issue of Capital Shortages,”
Shortages,"
Needs,"
and R. Eisner, "The
“The Corporate Role in Financing Future Investment Needs,”
both in U.S. Economic Growth From 1976 to 1986: Prospects, Problems and
Patterns, Vol. 33 - Capital, Studies prepared for the Joint Economic
Economic ComCommittee, U.S. Congress, November 15, 1976, and the works cited therein.
22 See,
see, for example, A. Brimmer and A. Sinai, "The
“The Effects of Tax
Policy on Capital Formation,"
Journal
of
Finance
(May
1976).
Formation,”
23 since this passage was written, the Federal Reserve Board pub23
pubSince
lished aa substantially revised series on capacity utilization rates.
The utilization rate for the third quarter 1976 was revised upward
seven percentage points, from 74 to 80.9 percent.
—
134
the numbers are to be believed, would not policies designed to increase
utilization rates directly be more likely to be more effective
capacity utilization
in inducing investment than the policies designed to reduce the rental
price of capital?
If, on the other hand, the numbers are regarded as
having substantial downward bias because of the underestimate of the
extent of capital obsolescence (due to increases in relative price of
energy, and more stringent regulatory requirements), would not policies
24
designed to stimulate investment be more effective than otherwise?24
on capital
Related uncertainty about the extent of policy effects on
formation emanates from our incomplete knowledge about the effect of exexpectations on the way market participants perceive and respond to aa
policy measure.
preThere appears to be an emerging consensus that the pre-
vailing state of expectations plays an important role in shaping the reresponse to certain policy measures.
However, aa successful modeling of
the formation and revision of expectations (policy, price, income, etc.)
has been elusive.
Consider, for example, the problem of assessing the
relative merits of interest rates and monetary aggregates as the
the targets
of monetary policy.
Recent analysis by Sargent and Wallace shows that
Poole’s apparently sensible results, that the choice depends on the
Poole's
structural parameters and the covariance structure of the disturbance
terms, are conditional upon the implicit
implicit acceptance of the adaptive
24
24For an analysis which adduces significant indirect evidence
corroborating the view that there is such aa downward bias, see D.
“The Link Between
Karnosky, "The
Bet1veen Money and Prices - 1971—1976,”
1971-1976," Review,
Federal Reserve Bank of St. Louis (June 1976).
—
135
25 Should expectations be generated rationally,
hypothesis.25
expectation hypothesis.
Poole's results no longer hold.
Poole’s
Even when it is granted that our reading of the current state of
unthe economy is accurate, i.e., that there is widespread, persistent un-
employment of both capital and labor, we cannot formulate an appropriate
policy in the absence of a correct diagnosis of the causes of such perper-
sistent unemployment.
It would not be enough to single out deficient
aggregate demand as the proximate
proximate cause, even if it were true.
true.
What is
required is an analysis of how such a deficiency emerged and why it perpersists.
Keynes’
For example, consider Leijonhufvud’s
Leijonhufvud's interpretation
interpretation of Keynes'
diagnosis of the root cause of the Great Depression.
The persistent dede-
ficiency in aggregate demand was diagnosed as reflecting
reflecting the "co-ordina“co—ordinafailure” between the saver and the entrepreneur, due to a "low"
‘low”
tion failure"
26 In the latter phase
price of capital goods relative to money wages.26
“low” price was due to the pessimistic state
of the Depression, this "low"
state of
entrepreneurial
expectations.
entrepreneurial
expectations.
An implied policy prescription was fiscal
'
policy
a outrance, with an accommodative
accomodative monetary policy, desiqned to
policy!!_
25 w. Poole,
“Optimal Choice
Choice of
of Monetary
Poole, "Optimal
Monetary Policy
Policy Instruments
Instruments In
In aa
Simple Stochastic Macro Model
,“ Quarterly Journal of Economics
Model,"
(May
1970); T. Sargent and N. Wallace, "Rational
“Rational Expectations, the Optimal
Monetary Instrument and the Optimal Money Supply Rule,"
Rule,” ,Journal
Journal of
Political Economy (April 1975).
26 A. Leijonhufvud,
of
Leijonhufvud, On
On Keynesian
Keynesian Economics
Economics and
and the
the Economics
Economics of
Keynes (Oxford University Press, 1968), p. 409.
136
falsify the inappropriate entrepreneurial expectations.
falsify
In the earlier
phase of the downturn, it
it was based on a ''high''
“high” market interest rate,
rate,
is, a market rate higher than Wicksell's
Wicksell’s natural rate, not the
that is,
state of entrepreneurial expectations.
'
Monetary policy
i outrance would
policy~
have been the prescribed response to bring the market rate down to the
rate. 27
natural rate.
The following diagnosis of the causes of the current malaise is
consistent with the relative price interpretation presented above.
The
initiating cause was the totally unforeseen reduction in the nation’s
nation's
wealth (productive capacity) occasioned by the rise in energy prices and
various regulations.
The implied reduction in capital intensity would
cause a rise in the marginal productivity of capital and lower the real
wage of the labor in aa world of malleable capital.
However, in a world
of putty—clay
putty-clay capital, the downward adjustment of the real wage is dedeinvestment of vintage capital as well
layed and follows the replacement investment
inter-industry shifts in employment.
as inter—industry
Further, since the initial rere-
duction in wealth and increased uncertainty regarding income and employemployment prospects induces increased rate of saving, aggregate demand is rereduced unless the implied increase in demand for future goods
goods by savers
is effectively
effectively transmitted to the entrepreneurs.
In the absence of an
effective price signal to devote a greater proportion of current reresources for capital accumulation, the unemployment state emerges and
persists.
27
27Ibid~p
Ibid., pp. 409-416.
409-416.
137
Complicating the adjustment process are (1) widely held non-homonon-homogenous inflation
inflatiQn expectations, (2) the overhang of the threat of yet
putty—clay nature of capicapianother bout with an incomes policy, (3) the putty-clay
tal which dampens the speed of adjustment toward new relative prices of
capital and labor, and (4) an observed increase in the supply of labor
induced by wealth and other effects.
An additional factor which complicompli-
cates and lengthens the adjustment in relative prices of capital and
labor is the existence of indexed wage contracts, which became more
prevalent as the legacy of previously unforeseen inflations.
If labor
bargained in terms of the real wage that prevailed in the wealthier
period, the full equilibrium adjustment would not be obtained until the
economy attains the previous wealth and capital intensity level via
capital accumulation.
Given the diagnosis of wealth loss due to capital obsolescence,
the case for policy actions which accelerate the rate of capital acac-
cumulation appears compelling.
Unfortunately,
Unfortunately, such permissive policies
adjustm~ntprocess.
may cause a delay in the market adjustm~nt
process.
Stimulative polipoli-
cies might be interpreted as harbingers
harbingers of either greater inflation, the
imposition of an incomes policy, or both.
would always exist in this uncertain world.
But such possibilities
So the central policy issue
is, as always, a Bayesian one of constructing aa useful state—and—time
state-and-time
dependent decision matrix and assigning the best
best state-of-the-arts probprob28 The task of assigning
state-and-event—spaces.28
ability weights to state-and-event~spaces.
28For the Bayesian approach to decision-making under uncertainty,
5chlaiffer, Applied Statistical Decision Theory
see H. Raiffa and R. Schlaiffer,
(MIT Press, 1961); also Fox et al., ~
.QE_. cit.,
cit., Chapter 9.
138
utility weights to event-spaces would be that of the policymaker.
utility
The requirements for an effective policy sketched above appear to
demand an impossible prescience of the economist-advisor.
Since the
Since
source of difficulty is our ignorance of the precise nature of the
state and structure of the economy (inclusive of the error structure),
it may be inferred that there is little that the economist can
can contricontribute.
However, such an inference is unwarranted.
unwarranted. Absence
Absence of precise
29 does not entitle one to
quantitative or even qualitative knowledge29
invoke the principle of insufficient
insufficient reason.
Rather, it
it forces one to
policies.
recognize the limited scope for discretionary stabilization policies.
As aa consequence, the focus is directed once again to the question
fundamental to macroeconomic theory - namely, to what extent can the dede—
centralized, real-world economy be regarded as aa self-adjusting
self—adjusting system?
This question was forcefully raised by Keynes in 1935,
1935, and reopened
in 1969 by Leijonhufvud in his apt paraphrase of aa question posed by aa
30
microbiologist:30
microbiologist:
29We
we have not yet resolved such fundamental qualitative issues as
invariance of the parameters of the estimated
the time- and/or policypolicy— invariance
model. See, for example, R. Lucas, "Econometric
“Econometric Policy Evaluation: AA
Critique,"
Journal
of
Monetary
Economics
(Supplement 1976).
Critique,”
Mone~~~yjconomics
30
30J.
J. Keynes, “A
"A Self-Adjusting Economic System?"
System?” The New Republic
(February 20, 1935); A. Leijonhufvud, Keynes
and the Classics: Two
~
nes' Contribution to Economic Thepa
Theor (The Institute
Institute of
Lectures on Ke
Keynes’
Economic Affairs, July 1969
1969)..
139
"An
“An economy (organism) is an integrated unit of
structure and functions. In an economy (organism),
all transactors (molecules) have to work in harharmony. Each transactor (molecule) has to know what
the other transactors (molecules) are doing. Each
transactor
(molecule) must be able to receive mestransactor
messages and must be disciplined enough to obey orders.
How has the economic system (organism) solved the
problem of inter-transactor
inter—transactor (molecular) communicacommunication?"
tion?”
The importance of price information and price incentives as signals
and disciplines in the coordination of activities
activities of decentralized
transactors is clearly captured in this paraphrase.
The significance of
questioning the homeostatic capacity of the economy is that it
it forces
the analysis into an explicit general systems perspective, where time,
history, and uncertainty play essential roles.
It leads one to rere-
examine the theoretical and empirical foundations underlying various apapproaches to stabilization policies.
Such a reexamination reveals that
different
different approaches
approaches are based on different diagnoses of:
(1) the dydy-
namic properties of aa particular economy, such as its stability, speed
and amplitude of response, observability and controllability,
controllability, and (2)
the attained (or attainable) state of the arts in quantitative macromacro-
economic policy.
Consider the following alternative concepts of
31
policy:31
stabilization policy:
31 For a fuller
31
fuller discussion of the concept of stability
economstability used in economics and the alternative concepts
concepts of stabilization policy, see L. Andersen
and J. Yang, 'The
"In‘The Economy as a Control System: Implications for “Inherent"
Model in} and Simulation, Volume 55 Part
Part 22
herent” Stability Issue,'
Issue,’ in Modeling
1974) and J. Yang, “The
(Instrument Society of America, 1974
''The Inherent (In)
stability of the Economy: An Interpretation,"
Interpretation,” (unpublished paper, 1975).
stability
140
1. The economy is unstable; hence, it
it must be made stable.
1.
Since
stability is aa concept associated with the nature of response
of a given dynamic system to aa given stimulus, the objective of
the stabilization policy is to change the response characterischaracterissystem,
tics of the system.
so—
Such aa policy would
would be a subset of a so-
called structural policy;
2.
2.
The economy is inherently stable but its speed of adjustment is
unsatisfactory.
The aim of policy again is to change the nana-
ture of the system's
system’s response to aa given stimulus;
3.
The nature of the response
response of the system to a shock is satissatisfactory.
The root cause
cause of difficulty lies,
lies, however, in the
nature of disturbances impinging on the system.
The thrust of
disturbances.
policy is to neutralize the effects of such disturbances,
Such
aa policy may be termed “purely
"purely compensatory”
compensatory" and its successful
implementation limited only by our ability to forecast the ararrival of shocks, and to neutralize them;
4.
4.
The quality of response of the economy
econoffiY to different sources
and/or magnitudes of shocks is not uniform.
It
It is useful to
classify shocks along policy and non-policy
non—policy origins and the
former into monetary and non-monetary lines.
The aim of monemone-
tary stabilization
stabilization policy is the avoidance of policy—induced
policy-induced
monetary shocks.
Here, shocks are to be construed
construed as "innova“innova-
tions''
tions” in the given time series.
These various concepts of stabilization policy provide aa framework
to assess different approaches to stabilization
stabilization policy.
Such approaches
range all the way from Simon's
Simon’s constant money supply rule to the optimal
141
32
feedback control with stochastic time—varying
time-varying coefficient
coefficient model.
mode1.32
The recent rediscovery of the optimal control framework (pioneered
by Ramsey in the 192Os)
1920s) for stabilization policy has had the salutary
effect of redirecting our attention to the fundamental normative and
positive issues involved in policymaking.
positive
In this framework, policy
decision problems are explicitly
explicitly acknowledged as Bayesian and inter—
intertemporal.
explicitly chosen.
The policy horizon must be explicitly
Uncertainty
about the model structure, observational errors, and nonpolicy shocks
must also be confronted by the decision maker.
Even the problem
problem of
stochastic preference could be dealt with, at least formally.
The concon-
trol approach also gives content to the short-run
short—run and long-run
long—run distincdistinctions, which are often left imprecise.
distincOne may well argue that the control framework blurred the distinction between rule vs. authorities.
Even the stochastic feedback concon-
trol with filtering, which specifies a policy reaction function, may be
construed as aa form of rule.
But, such an interpretation misses the
essential distinction that aa Rule is characterized by the absence of
policy "innovations."
“innovations.”
In an uncertain world, even if
if the agents were
privy to the same information set and the control law guiding the monemonetary authority,
authority, ex post evolution of policy will have “innovations”
"innovations" rereflecting either the model or exogenous non-policy shocks.
32
32H.
H. Simons, “Rules
"Rules vs. Authorities in Monetary Policy,”
Policy," Journal of
Political Economy (February 1936); G. Chow, Analysis and Control of
J. Kalchbienner
Kalchbrenner
Dynamic Economic System (John Wiley and Sons, 1975), also 3.
"On the Use of Optimal Control in the Design of Monetary
and P. Tinsley, “On
Policy," Special
Special Studies
Paper, Federal
Federal Reserve
Reserve Board
Policy,”
Studies Paper,
Board (July
(July 1975),
1975),~
142
It is the inevitable
inevitable lot of a decision maker to act, even in the
presence of uncertainty.
Acquisition of knowledge helps us to reduce
uncertainty, but the inadequacy in the current state
state of our knowledge
of both the model and error structure of the economy is considerable.
considerable.
The recent explorations into the potential role that modern optimal concontrol theory could play in the conduct of stabilization policy helped to
redirect our attention toward many of the unresolved normative and posiposi-
tive issues in policymaking.
Aside from the fundamental problem of
choosing the objective functional, the problems arising from delayed obobservations and the absence of a clearly dominant model have been thrust
into the center stage where they properly belong.
As aa consequence, we
rehave richer and better defined substantive issues to guide further re-
search and base policy deliberations.
Unfortunately for policymakers,
the clearest signal to be extractextract-
ed from this exploration is that modeling the workings of the modern
decentralized economy is more like modeling aa biological
biological system than an
engineering system.
The problem of stochastic
stochastic time-varying coefficients
context. 33 In addition, it has been forceforcenaturally arises in such a context.
fully impressed upon us that expectations must be modeled to understand
and “control”
forma"control" economic behavior but the processes determining the forma-
tion and revision of expectations are only dimly understood.
For
33The time-varying
time—varying parameter models include random—coefficient
random-coefficient
models and systematically time-varying
time—varying models, depicting, for example,
the motion of guided missiles over space. For many important aspects of
modeling and estimating time-varying parameter systems, see the report
on a recent symposium on such systems in Annals of Economic and Social
Measurement (October 1973).
143
example, a prominent explanation of the phenomenon of stagflation
stagflation runs
in terms of divergent price expectations between the consumer and the
34
producer.34 The problem is that we do not as yet know how to reliably
model and influence these expectations.
Outline of An Optimum Monetary Policy
This diagnosis of the state of the arts,
arts, in conjunction with the
empirical judgments regarding the inherent stability
stability of the economy, and
the sources and effects of shocks, suggests an outline of the "optimum
“optimum
35 Stabilization
monetary policy"
policy” for stabilization.
stabilization.35
Stabilization must be construed
as the effect
of
effect
of policy which permits an approximation to a
a fully cocoordinated solution characterized by the absence of excess demands and
excess supplies in all markets.
First, the optimum monetary policy must be an accomodative policy
policy
in the ultimate sense of permitting, more efficiently
efficiently than any other
feasible policy, a full coordination of temporal and intertemporal plans
units.
of decentralized transactor units,
given the observations that
Second, given
34K.
34
K.
Brunner and A. Meltzer,
Me 1tzer, "Introduction,"
Journa 1 of Monetary
“Introduction,” Journal
Economics (Supplement 1976).
35For a fuller discussion
indiscussion of the competing
competing diagnoses
diagnoses of the inherent stability of private enterprise economies, see J. Yang, QP_.
gp~. cit.
and works cited therein; in particular, see L. Andersen, “The
"The State of
the Monetarist Debate”
Debate" and accompanying "commentary"
“commentary” by K. Brunner and
L. Klein in Review, Federal Reserve Bank of St. Louis (October 1973) and
K. Brunner’s
Brunner's book review of Conference on Econometric Models of Cyclical
K.
Behavior, edited by B,
B. Hickman, 1n
in Journal of Economic Literature
(September 1973), pp. 926-33.
144
the money economy is particularly vulnerable to shocks which attenuate
“money conventions,"
conventions,” the pol
policy
icy must be one that maximizes
the use of "money
transacthe probability of preserving money conventions in all planned transac36 Third, the optimum policy must be "surprise-free,"
tions.36
“surprise-free,” in order
tions.
that monetary policy not constitute
constitute an additional shock to which the
economy must respond.
Subsumed under this requirement is that monetary
policy be credible in the sense that an announced change in policy (for
whatever reason) is believed.
Fourth, the indicator of monetary policy
must be chosen such that it is as free of false signals as feasible.
What would be the basis
basis for identifying an empirical proxy for such
a policy? The basis must be the accumulated understanding of the role
which money and the price system play in coordinating the intertemporal
consumption and production plans of decentralized decision units.
The
major elements of such understanding are:
1.
Unanticipated inflations generate false trading and distribudistribution effects.
Mill and Fisher understood this, whereas the in—
innot. 37
flationists of the Birmingham School did not,
36 For the concept of money conventions, see A. Hart, Discussion in
36
money
Proceedingssofa
of a Sm
Symposium
osium on Inflation:
Inflation: Its Causes, Consequences
Conse uences and
Proceedin
Contra
,
edited
by
S.
Rousseas
New
York
University,
1968,
Control,
(New
1968), p. 56.
37For Mill’s
Mill's surprisingly modern debunking of
of the inflationist arguargument (advanced by the Birmingham currency school) essentially in terms
of the distinction between anticipated and unanticipated inflation,
inflation, see
J. S. Mill, Principles of Political Economy (Reprints of Economic
ClassEconomic Classics: Augustus M. Kelley, 1961), pp. 550—551;
550-551; for further references to
je~J,Q,~hejj3eou,,,2f
J. Viner, Studies
in the Theory of
the Birmingham school advocacy, see 3.
& Brothers
Brothers Publishers, 1937), p. 281 and
International Trade (Harper &
ThiTheory
Lord Robbins, The
Theory of Economic Development (MacMillan, 1968), p.
134. Fisher made a clear distinction between the effects of the antici—
antici(continued)
145
2.
Inflation expectations, when present, are most likely to be
non-uniformly held.
Such expectations inhibit the formation
of futures contracts, in loan and employment, defined in fixed
monetary units.
The function of money as the standard of dede-
ferred payments is attenuated and, as a consequence, the use of
a money convention in evaluating futures contracts
contracts is disdiscouraged.
couraged.
3.
Even the polar case of perfectly (uniformly and correctly) ananticipated inflation has undesirable consequences.
While it is
a useful concept for some theoretical inquiry, its occurrence
is not likely to be significant empirically.
4.
4.
Inflation expectations are not generated randomly, nor are they
sustained in the absence of accommodating growth in the money
supply.
5.
Once inflation expectations are generated and incorporated in
loan and wage contracts, vested interests would emerge to opoppose the subsequent monetary evolution which would falsify the
embodied inflation expectations.
The reason that inflation exex-
inflations
pectations appear to decay slowly is that actual inflations
tend to keep pace to validate
validate the prevailing expectations.
37 (contfh’ued)
(continued)
pated and unanticipated inflation, as illustrated in the following quoquothe real evils of changing price levels do not lie in these
tation: '' ....the
changes~~.
changes p~~se,
bbut
ut in the fact that they usually take us unaware. It
has been shown that to be forewarned is to be forearmed, and that a
foreknown change in price levels might be so taken into account in the
See I. Fisher, The Purrate of interest as to neutralize its evils,''
evils,” See
Pur—
chasm
Classics: Augustus M.
chasing Power of Money, (Reprints of Economic Classics:
Kelley, 1963),
1963 , p. 321.
“.
.
146
•
6.
Indexing of time contracts generates problems of its own,
38
especially with supply-induced shocks. 38
especially
7.
The concept of the optimum supply of money, or optimum rate of
•
inflation, can only be defined relative to the attainable or
inflation,
effective global production possibility frontier.
“noThe "no-
tional” global production
attaintional"
production possibility frontier is not attainable in the presence of transactions costs,
costs.
The optimum money
money
supply enables the attainment of the outer—most
outer-most frontier inside
the
the notional frontier, for any given financial technology.
The
reason is that, for aa given
given financial technology, the optimum
money maximizes the extent of specialization by minimizing the
broadly—conceived
broadly-conceived transactions costs. 39
8.
8.
The distinctions between higher prices and rising prices on
the one hand, and rising prices and aa rise in inflation expecexpectations on the other are seminal distinctions for understanding
38A problem of “over-exhaustion”
"over-exhaustion" of the total product may emerge
economy's productive capacity.
with an unanticipated reduction in the economy’s
For the problem associated with aa transition into aa regime of completecompletely indexed economy, see J.
3. Yang, "The
“The Case for and Against Indexation:
Perspective," Review, Federal Reserve Bank of St. Louis
An Attempt at Perspective,”
(October 1974), especially
especially pp. 33 and 6; also M. Friedman, “Monetary
"Monetary
Correction,"
Correction,” in Essa
Essayss on Inflation and Indexation (American Enterprise
Institute for Public Policy Research, 197
1974),, especially p. 45.
•
39 For a survey of the state
state of the arts, including references,
references, rerelated to "the
mi crofoundati ons of money,"
“the new microfoundations
money,” see R. Barro and S. Fischer,
“Recent Developments in Monetary Theory,"
Theory,” Journal of Monetary Economics
"Recent
(Apri 1 1976).
(April
147
147
monetary phenomena.
phenomena. 40
Fisher, and Marshall before him, considered the property of an ideal
monetary policy from the perspective of intertemporal coordination
through the price system.
Both prescribed a policy directed toward sese—
41’
curing both ex ante and ex post stability
stability in the monetary yardstick.
yardstick.4
Their prescription is consistent with the broad contours of the roles of
money and the
the price system summarized
sumarized above.
the adoption
They proposed the
stability goal.
of indexation, the tabular standard, to achieve their stability
goal.
it would be difficult
difficult to achieve
Without the use of indexing, however, it
ex post stability continuously.
Since there are problems with indexing, and more fundamentally, bebecause achieving
achieving ex ante stability would be sufficient to approximate
“optimum”
ideal policy, my suggestion for an empirical proxy to the "optimum"
policy outlined above would have two elements:
moneFirst, specify a mone-
tary aggregate as the indicator of policy on the relative controllability
basis; second, direct the policy consistently toward the prevention of
the emergence of inflation expectations.
For a growing economy on aa
balanced growth path without technological progress, such aa policy would
40 The
rhe various diagnoses of the causes of inflation in terms of the
advariants of market power hypotheses (such as the union monopoly or administered pricing)often do not make the distinction between higher and
rising prices. The second distinction between the unanticipated and ananticipated inflation is, of course, of pivotol
pivotal importance.
41 See
see A. Marshall, “Remedies
"Remedies for Fluctuation of General Prices,”
Prices,"
in Memorials of Alfred Marshall, edited by A. Pigou (New York: Kelly
and Millman, Inc., 1956); I. Tfsher,
Fisher, Stabilizing the Dollar (New York:
MacMillan,
MacMillan, 1920).
148
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42
aim at providing nominal money stock growing at the natural rate.42
~us
ion
Conclusions
•
This paper identifies the sources of the widespread concern about
capital formation, primarily
primarily to uncover those aspects which monetary
policy may successfully address.
It has been shown that the usual focus
is on the nonneutral effect of monetary policy on
on capacity output rather
than the more intractable and speculative possibility
possibility that monetary
policy may be nonneutral with respect to equilibrium capital intensity.
The proper framework in which to assess the impact of monetary
policy on capital formation was judged to be intertemporal and, under
uncertainty, Bayesian.
Several concepts
concepts of the role of stabilization
policy were explored, and different
different approaches to such aa policy, ranging
from Simon's
Simon’s constant money rule to the modern stochastic optimal
optimal concon-
trol, were considered.
The problems of formulating aa policy were illuillu-
strated for aa particular diagnosis of the genesis of the current ecoeconomic malaise.
The outline of an optimum monetary policy was given
given in terms of an
an
absence of policy innovations, for a world where uncertainties about oboberror structures dominate.
servations, expectations, and model and error
The
intertem—
perspective maintained throughout was that of coordinating intertem•
•
poral decisions through the market system.
After briefly identifying
the major elements of the accumulated evidence regarding the roles of
42To help implement such aa policy for a growing economy, where
capital intensities, the rate of population growth and technologies
change, poses a severe
economist-advisor,
severe challenge to the economist-advisor.
149
‘1
money and the price system, an empirical proxy for the optimum monetary
specified in terms of the money supply and directed toward
policy was specified
preventing the emergence of inflation expectations.
•
•
150
@FedFRASER