November 15, 2003

Capacity Utilization

The Economic Policy Institute plots the Federal Reserve's capacity utilization index--how far the U.S. economy is below its productive capacity. By this measure, the total amount of idled economic capacity as a result of the current recession is already larger (as a percent of potential output) than in any post-WWII recession save 1981-1984--and we are rapidly closing in on that one as well:

Economic Snapshots: ...There remains a lot of slack in the U.S. economy. One measure of economic slack is the capacity utilization rate, tracked by the Federal Reserve, which gauges the degree of slack in capital equipment in the U.S. economy. This provides a measure of how much of the economy's potential productive capacity is in use in a given quarter. Full capacity generally occurs before this index reaches 100. The average capacity utilization rate in the U.S. economy since 1967 is 81.6%.

Capacity utilization rates in the U.S. economy, 1967-2003

Of course, this measure of business cycle performance is a measure of business cycle performance: one principal reason that capacity utilization is so low is that the economy's productive potential is growing so fast as businesses take advantage of the steep and ongoing fall in the price of information technology capital.

Posted by DeLong at November 15, 2003 07:28 AM | TrackBack

Comments

This is exactly why I've argued that we're not out of the deflationary woods quite yet. Excess capacity may continue to cause inflation to fall from it's already low, low levels.

Posted by: Kash on November 15, 2003 08:48 AM

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Sorry: I meant "its already low, low levels." Caught it a second too late.

Posted by: Kash on November 15, 2003 08:50 AM

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Yet another explanation of the spike in productivity. Any manufacturing company that's been in business a while has new machines and old machines. If you shut down the lines of old machines and just run the new ones you push up both your productivity and your unused capacity.

Posted by: Dick Thompson on November 15, 2003 08:58 AM

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"This is exactly why I've argued that we're not out of the deflationary woods quite yet. Excess capacity may continue to cause inflation to fall from its already low, low levels."

Yes, but I am far less worried about deflation than about employment and wages. Middle class households must be in more difficulty than 2000. How much middle class pressure there is puzzles me, however. No recession and recovery since 1945 has cost America's middle class households more income than the current period. Home re-financing really does not resolve our problems.

Posted by: anne on November 15, 2003 09:25 AM

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A quick look at that graph suggests that, regardless of the actual numbers, the shape of the current cycle is fundamentally different from that in previous recessions. A sharp and sustained dip has previously been follow by an almost equally sharp and sustained rise. The current situation looks more like driving off a cliff and hitting a few outcrops along the way. "Blaming" low capacity utilization on productivity gains would be nice, except that it kinda suggests that to get the economy back in demand balance might require simply shedding 10 or more of its capacity to produce goods and services. Um.

Posted by: paul on November 15, 2003 09:44 AM

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The capacity use data tell us where we've been, but how much do they tell us about where we are going? One implication that could be drawn is that capital spending won't rise very quickly because there is already plenty of capacity in place, but don't we have a handful of reasons to doubt that conclusion? For one, the real pace of tech-capital investment isn't that low, as Brad has pointed out more than once. Another is that the capacity use rate has not proven very predictive of capital spending in prior cycles - better to look at retained earnings, I think. Much of the tech-related productivity boost since 2000 is, the story goes, due to Y2K precautions. Does that make it a special case? Is it now old (mostly computer and software, both with fairly short product cycles) or new (product cycles are becoming less a factor in making tech purchase decisions). So the capacity use data tell us that capacity has outstripped demand, but since demand has not been falling, this is really just a reflection of the amount of capacity one can buy for a buck right now - more or less what Brad concluded, I guess.

Posted by: K Harris on November 15, 2003 10:22 AM

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Then, what does this tell us about likely demand for labor? There is no reason to believe capital investment will not continue to be strong, but there is no reason to believe labor demand will be strong. Applied Materials is finding strength in demand through the world, but Applied materials has no reason to add workers, especially in America.

This is a different sort of cycle. The longer we take to increase labor demand, the more wage growth is limited. The California supermarket strike-lockout should be a warning to labor of wage and benefit pressures that may continue for quite a while. Of course, we can all go work at
Wal-Mart! Middle class, duh.

Posted by: anne on November 15, 2003 10:36 AM

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This measure of economic capacity has nothing to do with productivity and economic potential. It
is a measure of physical capacity to produce.

Capacity growth in the FR industrial production data is a function of capital spending, not productivity. In tech there is some modification of this. For example, semiconductor capacity is a function of the capacity of the individual semiconductor. So when you move from one generation of semiconductors to another the capacity numbers increase even though you may be manufacturing the same number of semis.

Over the past year capacity growth for all industry was 1.2% and for manufacturing was 1.0%--
about the same as they were at the 1983 and 1989
bottoms. At the peak in 1998 the growth rates were 7% and 8%,respectively.

For the supply side analysts, capacity growth from 1980 to 1994 never exceeded 3%. So much for the Reagan economic boom.

Posted by: SPENCER on November 15, 2003 10:51 AM

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The capacity growth numbers remind me of a very incitefull analysis developed by Jay Forrester of MIT in his Systems Dynamics approach. He used this approach to model why capitalist economies are subject to recurring bouts of boom and bust. His theory tied into capital spending. When a capital spending boom gets underway, the capital goods sectors quickly finds that it has inadequate capacity. So the capital goods sectors starts ordering capital goods from itself to expand its' own capapcity to meet the unexpected strong demand. This create a self-reinforcing feedback loop where the capital goods sector feeds off of itself to create massive excess capacity that prevents capital spending from recovering after the boom peaks.

When you look at the Feds capacity growth numbers you see how this worked. From 1994 to 2000 industrial production of HT grew at a 40%
annual rate while the rest of IP had low single digit growth. Over this period capacity growth in HT was also about 40% -- historically industrial production of HT and capacity growth in HT have always had a tight relationship like this. During the bubble much of the demand for HT came from within the HT sector itself to build its' own capacity. When demand growth slowed just a little in 1999, the HT industry realized that their expectations of future demand growth were too optimistic and cut back on their own capital spending. This created a self-reinforcing feedback loop that caused the collapse of the HT boom. I do not have data on how much of the demand for HT during the boom was from the HT industry to expand its own capacity,
but I know it was not insignificant-- HT is a very HT intensivie industry. Moreover, managements were always talking about demand from other HT firms, and that was clearly not the case over the last few years. Standard analysis is that the capital spending boom was spread fairly evenly throughout the economy.But if you think of the capital spending boom as being highly concentrated within the HT sector
rather than being spread evenly across the economy
it leads to some very different conclusions.
It shows why the economic downturn was concentrated in capital spending and was not a product of tight money or inflation as in other recessions. It also help explain why capital spending has been so slow to respond this cycle
and even now is very weak by historic standards.

Within the Industrial production capacity data you are now seeing capacity growth in the HT sector but capacity growth outside the HT sector is still contracting. Also if you look at capial spending as being highly concentrated in HT the issue of the age of the capital stock and how fast it becomes obsolete takes on even greater importance.

In the production data the same pattern is happening, autos, energy & HT production has bottomed but the rest of manufacturing has yet to bottom.

Interestingly, when I advance this thesis to economists and money managers they look at me like I am kind of weird. But when I present it to HT executive and managers they say, of course, doesn't everyone know that.

Posted by: spencer on November 15, 2003 01:32 PM

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Doesn't anyone else see that chart ump out of your chair bullish? I look at a chart like that and it makes me want to get very very very long the stock market.


Posted by: William on November 15, 2003 02:56 PM

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William said: "I look at a chart like that and it makes me want to get very very very long the stock market."

Why???

Spare capacity indicates that firms have been wastefully spending money building up capacity for which there is no demand. They are wasting shareholders' dollars. Why would you want to give those firms MORE of your money to waste?

Posted by: Kash on November 15, 2003 03:30 PM

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The last deep capacity utilization trough during the period of 1980-1988 in which carryovers of the cold war economic supports for Japan and Germany, in the form of noncompetitive technology transfers and trade advantages, led to a massive deindustrialization adjustment in the US economy. The lateral transfer period of the 1990's, in which the movement of industrial production from Germany and Japan to S.E. Asia and China, had less effect on U.S. capacitity utilization due to the competitive balance which had been reached in the late 1980's between the U.S. and its advanced competitors. The stimulative effect of the price advantages reaped by the U.S. during this period of lateral transfer of industrial capacity between our advanced and developing competitors supported both a high level of employment as well as a continuing level of adequate capacity utilization.
Since 1990 however, the increasing maturity of China's manufacturing industries, as well as the rapid growth of service outsourcing to India, are creating a new dynamic in the deindustrialization process in the U.S. The momentum of this new phase of industrial capacity transfer may lead to a deeper and longer trough in utilization due to the much larger deployable populations and the much lower wages available to our large new competitors as well as to the domestic presence of large numbers of U.S. University trained expatriots from both these countries. This combination of factors as well as the continuing competition from our other trading partners creates not only potentially long term deflationary pressures, but long term capacity utilization pressures as well. Given the twin low wage competition to replace domestic manufacturing and services, as well as direct and continuous Ph.D. level access to sources of innovation in U.S. laboratories and Universities, the length and depth of the current U.S. capacity utilization trough cannot necessarily be predicted through extrapolization from historic examples.

Posted by: BC on November 16, 2003 01:25 AM

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BC wrote: "The momentum of this new phase of industrial capacity transfer may lead to a deeper and longer trough in utilization due to ... the domestic presence of large numbers of U.S. University trained expatri[ate]s from both these countries ...[and] direct and continuous Ph.D. level access to sources of innovation in U.S. laboratories and Universities."

Agreed. U.S. higher education, particularly the public university system has subsidized capacity development overseas for a long time; but now those nations can offer a more favorable environment for college grads seeking work. Whatever measures of inflation might indicate, the cost of living in any of the high-tech corridors in the U.S. has grown out of proportion to what a recent graduate can afford. It's more attractive for those workers to go home where they can be near family, live comfortably *and* save money. (That's not counting the better-paid foreign nationals employed at sensitive research labs and information security posts in the U.S.) Meanwhile, U.S. taxpayers lose our investment in professional and skilled labor. American higher education does not always behave like a system designed to advance national interests.

Posted by: William in Beijing on November 16, 2003 03:58 AM

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Far be it from me to defend the "fools", whom I believe are properly named. But I don't think it is fair to imply, even obliquely, that the low cap ute rate is somehow evidence of failure at the Bush Admin. Nor do I think that the proviso below the chart leaves BDl entirely innocent of having made the charge.

Rapid productivity growth is a good thing -- full stop. If the utilization rate is too low, that is the fault of monetary policy, which has failed to provide sufficient demand to meet the potential.

You can blame the Bushnicks only to the extent that you think the zero bound on rates is now relevant and that fiscal policy therefore has an important demand stabilization role. With the monetary policy debate now focused on when the Fed TIGHTENS, I don't think the zero bound is that relevant. Or more to the point, people at the Fed do not act as though they believe it is relevant.

Posted by: Gerard MacDonell on November 16, 2003 05:56 AM

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Gerard- last time I looked, Monetary policy was down to its last bullet. The problem is precisely the lack of a coherent fiscal policy that would stabilize demand. We have overcapacity, yet states are cutting back on building infrastrcture (buildings, roads, sewers, communications networks, etc) that would utilize that excess capacity. The Bushniks deserve full blame for not doing the obvious and for handing over our Social Security taxes to wealthy campaign contributors so they can buy bonds issued to cover the increasing federal debt. That debt has risen by almost 20% since Mr. Bush took office.

Effective monetary policy requires sound fiscal policy. This administration dropped the fiscal ball. Debate about when the Fed tightens is nonsense. The Fed will not tighten for a year or more. Interest rate hikes will come in Oct of 2004 or later, not any sooner. Why are you blaming the Fed for speculation about tightening when they have made it perfectly clear that interest rates will remain very low until inflation reappears.

Posted by: bakho on November 17, 2003 05:42 AM

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Spencer, I just recently received a copy Richard Koo's latest book on Japan entitled "Balance Sheet Recession". He makes a similar case to the Japanese malaise as Mr. Forrester.

I think his thesis is somewhat interesting because it proposes that the basic business function during these declines isn't always to increase profits. His proposition rests on the basic assumption of Keynes and monetarism of profit maximization being misplaced during these downturns. His basic point is that if a lot if firms are concerned with decreasing their debt at the same time there will be sharp declines in invesment demand. Unless consumers alter their savings patterns, interest rates will fall.

Why will companies suddenly not want to borrow to increase profits? In Japan's case, Koo suggests this was due to the sudden decline in asset values that made the highly leveraged Japanese companies technically insolvent. These companies had otherwise competitive industry positions so they switched to debt payment to repair their balance sheets.

I haven't yet read how Koo might suggest this applies to the U.S. right now, but I would surmise much of it depends "the age of the capital stock and how fast it becomes obsolete" as you have mentioned. In the bubble run-up there was also the usual merger mania. Since mergers are rarely beneficial to the buying companies (in the short-term at least), a lot of U.S. companies were left with debt overhangs that they had to work off. In addition, technical changes made a lot of companies' assets obsolete. This may well have left many companies facing a Japanese style problem of technical insolvency.

I haven't read enough to see what Koo says but I can already guess the major problem on the consumers' savings incentive side. Japan's aging population has a great need to save for retirement, thus a rapid decline in business demand for money could very well lead to a quick decline in interest rates. U.S. consumers tend to be more likely to react to changes in buying incentives, but high consumer debt will limit the positive impact of low rates to some degree. Nonetheless, in our current environment housing and other consumer driven interest sensitive industries have been holding the whole shebang above water.

The policy implications are pretty stark. Primarily it means that monetary policy will be particularly ineffective during these downturns. Fiscal policy will be extremely important since any decline in current economic activity will simply damage balance sheets further and monetary policy will not induce many of these companies to invest until their balance sheet problems are worked out.

Koo's book reads a lot like a an LDP defense even LDP was behind the basic structural problems that induced high leveraging and asset inflation in Japan that would underpin its current problems. Nonetheless, I'm finding Koo's proposition intriging. I'll have to read Jay Forrester's work after I'm finished. Thanks.

Posted by: Stan on November 17, 2003 07:44 AM

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It is never difficult to make mistakes. Even though Koo says that during these times firms aren't trying to increase profits during these declines they actually are. They simply aren't reacting as "profit maximizers" are assumed to in the face of declining interest rates.

Posted by: Stan on November 17, 2003 08:28 AM

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