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


  1. as you said in the original post capacity is also destroyed but increasing productivity and efficiency. So while in general what you say here _can_ be realized the relationship but _should_ not

  2. 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?

    Are you old enough to remember the 1970's? Decrepit auto's, commercial real estate, the use of things until they were broken,unusable? The amount of demand pulled forward from the early 80's until these last few years was what caused the need to increase capacity. Good luck pulling yet even more demand forward now to combat a similar situation.

  3. The increase in productivity is giving a false read. If I as an american citizen operating a company under US laws, outsouce labor/services to a foreign nation and see my profits rise as hiring is done outside the US, my company's productivity increases. The BLS has no way of tracking these out/inflows.

  4. Anon1: Am I old enough to remember the 1970's? Nope... lived through a few of those years, but definitely don't remember.

    Great point about demand being pulled forward, but wasn't a large portion of that demand pulled forward from Asia (which has driven productivity figures per Anon2)? If the world reverts to less interdependence (i.e. less trade), that should on the margin be good for us production of goods.

    Not sure U.S. consumers are ready to revert back to using things til worn out (i.e. I am on my 5th Ipod since 2002), but even if they were things are made at such low quality they won't last (the reason for 5 Ipods was in part due to new technology, but also due to them breaking).

  5. I am Anon1,2 and now 3. Good point about the low quality of goods vs. the 1970's but, with credit contracting,wages stagnant and a still massive hit to wealth, consumption will be muted or diverted(uptick in sales of used, remanuf. appliances).

    The pulling of demand forward worked against both Asia and the US. Asia with manuf. plants, US with office, retail and an explosion in consumer credit over the last 20-30 years.

    Lack of growth in world trade should be good for US manuf. products but the downside is less dollars to recycle into US debt. It appears to me that we are a damned if we do, damned if we don't moment in more than a few very important matters.