Friday, December 18, 2009

Can Capacity Destruction be Good for GDP?

Notice that I state GDP and not "the economy" in the headline (the broken window theory explains why destruction is not good for the economy, BUT it doesn't mean that it won't lead to a better GDP print down the road). As Richard Posner details, there are many issues relying too much on GDP:

But it is necessary to emphasize that it is just a starting point. I disagree with economists who say the “recession” ended in the third quarter. The depression (as I think we should call it if only because of its enormous potential political consequences) has caused massive unemployment with all the associated anxieties and hardships, has greatly reduced household wealth, has caused private investment to turn negative, has cost the government trillions of dollars in lost tax revenues and recovery expenditures (TARP, the fiscal stimulus, the mortgage-relief programs, the auto bailouts, etc.), has undermined belief in free markets and altered the line between government and business in favor government, and is threatening a future inflation while deepening our dependence on foreign lenders. To view a change in GDP from negative to positive as signifying the end of a depression (by which criterion the Great Depression ended in 1933 and again in 1938) is to misunderstand the utility of GDP as a measure of economic activity.
Historical Capacity Destruction

That said, as I initially stated in my post on capacity destruction:
Capacity utilization is utilized capacity / total capacity. This means that the change in capacity utilization may not only be due to a change in the numerator (utilized capacity), but in the denominator as well (overall capacity). And my guess is overall capacity is actually decreasing for the first time since the telecom overbuild collapse in the early 00's.
Reader Dennis Oullet pointed out that while I was correct, I went the difficult route to get to that point (full historically data is available on the Fed's website).

And here is that data showing the year over year change in total capacity going back to the early 1980's.

While the recent period has seen overall capacity removed from the system, the lack of capacity build since the telecom bust (2001) is even more striking (below is a chart showing 8 year rolling periods, which matches the time frame since that telecom bust).

Capacity Reduction --> Higher GDP Print?

Reader dblwyo made an interesting point that:
A complementary notion is that industry grossly under-invested relative to growth in the 00's and drove utilization higher, i.e. let equipment die off. That guess seems to tie a lot of things together.
So while we overbuilt toward the end of the 1990's, we have since under-invested as we outsourced production to cheap Asian labor, grew the economy via the housing / financial sectors rather than manufacturing, and ran into the worst economic slump since the Great Depression (or WWII at a minimum).

Combined with the recent capacity destruction, am I crazy to think that businesses may NEED to invest in new (or upgraded) capacity sooner than many think? My thought is along similar lines of how inventory restocking may lead Q4 '09 GDP to grow as much as 5% (per David Rosenberg):
We mentioned two days ago, there is an outside chance that we could see Q4 real GDP approach a 4-5% range at an annual rate, well above current consensus expectations (currently the Bloomberg consensus is expecting a 3.0% increase in GDP). A good chunk of that is in inventories, not final demand, but so be it.
Why can't capacity replacement lead to higher GDP prints as well (again, separating GDP from the actual economy)? Obviously the timing of this may be off (i.e. I can't imagine it occuring when capacity utilization is near all time lows, unless some new technology springs to life), but as capacity continues to be taken off-line (i.e. destroyed), couldn't the replacement be a surprise upside for GDP?

Source: Federal Reserve