Expected Sales

A large driver of the marginal product of capital is expected future sales. Potential growth can be a proxy for future sales, and the Congressional Budget Office (CBO) publishes forecasts for potential output for years into the future. The potential growth rate of the U.S. economy has downshifted markedly following the Great Recession as a result of trends in place prior to the recession that were masked by the rapid growth leading up to the recession and structural shifts that occurred during the recession (Figure 5.2).

A downshift to expected growth as we have experienced likely weighs on the marginal product of capital. That is, lower expected sales in the future require less capital and the marginal benefit of additional capital in the future is decreased. This is one plausible explanation for the slow pace of business investment during this cycle. When the rate of business investment is compared to GDP growth, investment in the current cycle looks more typical (Figure 5.3).

Capacity Utilization

Capacity is another indicator that can be indicative of business investment plans. Capacity utilization represents the share of resources for production that are being utilized in the mining, utilities, and manufacturing sectors of the economy.³ It is fairly intuitive to state that capacity utilization impacts the marginal benefit of additional business investment. If there is significant excess capacity—as has been the case for much of this cycle (Figure 5.4)—the marginal product of additional capital is likely low as there is already excess capacity that is going unused. Therefore, additional investment is unlikely to be utilized right away making the marginal benefit of the additional capital lower, ceteris paribus. Of course, expectations for the future also are important as capital investment decisions and implementation are not immediate. As discussed earlier, however, lower sales expectations reflected in the downward revisions to potential growth estimates are not supportive of strong capital spending.

It seems clear that the growth rate of the desired capital stock following the Great Recession declined compared to the pace of growth before the recession. This has likely reduced the marginal benefit of additional investment for firms in the economy and been a reason for the sluggish pace of capital investment during this cycle.

Expected Useful Life

Expectations regarding depreciation and the useful life of an asset also impact the expected benefit that asset will provide. A more durable and flexible capital stock suggests that depreciation will be lower and the capital will maintain its productive capacity for longer. Trivially, an asset that is expected to produce for a longer period of time will lead to higher expected profits from that activity, increasing the expected marginal benefit of the asset. In addition, a more durable capital stock is associated with a lower rate of depreciation. Therefore, the required investment to maintain the capital stock declines. This means that an increase in the expected useful life of the capital stock has an ambiguous impact on investment, depending on the increased expected benefit of additional capital investment and the reduced replacement costs to maintain the current stock.

Presently, the capital stock is “old” relative to history (Figure 5.5). While this could be indicative of more durable economic capital, it also may reflect a lack of willingness to invest in new capital because of the uncertainty about the economy. The composition of the capital stock also clearly can impact the average age, as new technologies may have longer or shorter expected useful lives.

In addition, some have indicated that the older age of the capital stock may be a reason for the slower growth in labor productivity during this cycle as older capital, all else being equal, is likely less productive than new capital.

Interest Rates

We now turn to the right side of the marginal benefit marginal cost equation, the marginal cost of capital. This can be a tricky concept to pin down; what exactly is the cost to a firm for their economic capital? Because many firms own their capital outright, we cannot look at rental costs. Therefore, we agree with the notion that the cost of capital can be thought of as the cost of financing the purchases. While the theory surrounding the cost of capital could form a text of its own, we will highlight a few of the important drivers.

Interest rates are an important driver of the cost of capital. Historically low interest rates—both nominal and real yields—should, in theory, lower the cost of capital and supported capital investment, all else being equal (Figure 5.6). As is always the case in economics, it is impossible to measure the counterfactual, and it is likely that capital investment would have been even weaker had interest rates not been lowered like they were following the financial crisis.

In addition, as we have mentioned before, it is rare for the ceteris paribus assumption to hold and a firm’s access to capital markets can vary with market conditions and over the business cycle. Firms trying to raise funds to finance the purchase of economic capital would have likely found it more challenging during the turmoil of late 2011 and early 2012 stemming from the European debt crisis. In addition, lending standards tightened markedly following the recession (Figure 5.7). Thus, despite the low level of rates, firms might not necessarily have been able to borrow to finance their capital investments.

Although interest rates impact business investment decisions, they are clearly not the only factor. The violation of the ceteris paribus assumption can clearly be seen when investigating business investment in Fed tightening cycles (Figure 5.8). As you can see, business investment typically accelerates at the beginning of a tightening cycle. This may seem counterintuitive at first, but taking a broader context, we know that the Fed is generally raising interest rates in a strong economy where the other drivers of business investment compensate for higher interest rates, at least initially.

Corporate Profits

In addition to interest rates, corporate profits are an important source of funding for many businesses. In a frictionless economy, capital investment decisions are independent of the amount of funds available from corporate profits because there are no borrowing constraints. However, there are frictions in the economy, including borrowing constraints and costs associated with borrowing. As such, internally generated funds are often used to finance capital investment. As seen in Figure 5.9, the financing gap—the difference between internally generated cash flow and capital expenditures—was positive for much of the recovery period. As we mentioned earlier, firms were hesitant to invest following the crisis because of uncertainty about the economic outlook and many firms chose instead to pay down debt, buy back stock, or expand through acquisitions rather than capital investment. Capital expenditures have recently picked up, however, leading to the financing gap turning positive. This means that outside funding, or drawdown in cash balances, must finance the difference in internal funds and capital expenditures.

Policy—Tax and Policy Uncertainty Index

Tax policy can also impact the cost of capital for firms. We will not explore the nuances of corporate tax policy in this text, although special tax treatment of interest payments and depreciation of the capital stock can alter the incentives of corporations and the marginal cost of capital. In addition, uncertainty about future policy and the uncertain regulatory environment can weigh on business investment decisions. As you can see in Figure 5.10, policy uncertainty was at extraordinarily high levels following the recession, which likely weighed on capital investment.

Discrete Jumps

Finally, business investment is not continuous. That is, a firm can only add capital in discrete amounts. In an overly simplified example, consider a firm that makes clothing using a combination of labor and capital, which consists of sewing machines. Business is booming for our clothing manufacturer and they would like to expand. Clearly, they cannot add half a sewing machine and can only increase their capital stock by a discrete amount. While this is an unrealistic example for modern firms, it is instructive that a certain threshold must be met for the marginal benefit of capital to be worth the additional costs, and adjustments are not necessarily smooth.