Roger W Ferguson, Jr: Reflections on the capital goods overhang
Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, before the Charlotte Economics Club, Charlotte, North Carolina, 18 July 2001.
* * *
I am pleased to have this opportunity to speak to the Charlotte Economics Club. Occasions such as
this provide those of us who work on economic policy in Washington an invaluable way to touch base
and exchange ideas with business leaders around the country. The views that I will set forth today are
my own and are not necessarily shared by other members of the Board of Governors or the Federal
Open Market Committee.
As you know, economic growth has been slow for four quarters after several years of very strong
gains. Perhaps the most striking aspect of this slowdown has been the abrupt deceleration in business
fixed investment. Business investment in equipment and software grew exceptionally rapidly in the
latter half of the 1990s and the first half of 2000, but it moved down in the final quarter of last year and
declined further in the first quarter of 2001. Indicators of second-quarter investment outlays have been
decidedly downbeat.
More dramatic still is the turnabout in a number of high-tech investment categories. Real business
outlays on information-processing equipment dropped at an annual rate of almost 10 percent in the
first quarter of this year after having posted increases that averaged close to 25 percent a year from
1997 through 2000. Within that category, real investment in computers and related equipment showed
no growth in the first quarter of this year after having risen 30 percent or more in each of the seven
years starting in 1994. Outlays for communications equipment swung from growth rates of about
25 percent in 1999 and 2000 to an annual rate of decline of more than 30 percent in the first quarter of
this year. The cutback in business spending on high-tech equipment has led, in turn, to sharp
cutbacks in output at the firms that produce such equipment. Many of these firms have experienced
sharp declines in actual and anticipated profits, and the values of their equities have dropped.
Business fixed investment has always been cyclical, of course. When the economy is speeding up,
businesses typically respond by boosting their expansion plans, and the resulting increment to the
desired capital stock leads to a burst of investment spending. Similarly, when the economy slows,
plans for capital expansion are shaded down, and investment is scaled down or perhaps even
postponed for a time. Because the stock of capital is large relative to the investment spending in any
particular year, a relatively small shift in expansion plans generates a big swing in current
expenditures. This is the accelerator effect that is commonly discussed in economics textbooks.
However, some observers believe that what has been happening recently to business fixed
investment differs in some important respects, or at least in degree, from the normal accelerator
response to a slowdown in aggregate demand. These observers hypothesize that, for a variety of
reasons, including the more subdued prospects for aggregate demand going forward, firms may be
holding considerably more capital now than they would prefer. Reflecting this possibility is the opinion
we hear that there is currently an "overhang" of capital in the economy. According to this view, too
much was put in place too soon, and as a corollary, investment spending will need to remain subdued
for a long enough time in the future to let the actual capital stock come back into line with the desired
capital stock.
In the remainder of my talk today, I wish to explore more fully this question of a capital stock overhang.
Along the way, I will be laying out some analytical distinctions that are important to understanding
exactly what we mean when we talk about an overhang of capital. At the same time, I will try to
demonstrate why a capital overhang is so difficult to identify and estimate in practice. I plan to give
some special attention to those high-tech industries in which the turnabout in investment spending has
been the most dramatic this past year, notably telecommunications industries. Finally, I will have some
brief comments about the implications of a capital overhang for the economy and for monetary policy.
Measuring the capital goods overhang
Capital, by definition, has value because it is expected to generate income in the future. In view of that
orientation toward the future, the value placed on capital can shift considerably as expectations
change. Some of the same firms that might have felt comfortable with their capital stocks a year ago,
or even been of the view that more capital was needed, may now view their capital as being excessive
in light of the abrupt slowing in demand for their products, especially if they extrapolate the slowdown
well into the future. Moreover, values that are placed on particular pieces of capital can change
sharply as advances in technology make one form of equipment obsolete while creating an incentive
for the rapid expansion of the stock of another form of equipment.
It might seem that business executives are the people best positioned to know if capital is indeed
excessive at the moment. However, as is often the case, reports from individual firms cover a wide
range of situations. Reports from high-tech companies at present are notable for the frequency with
which talk of excess capital appears, and we hear reports of overhangs in some other industries as
well. Many firms, particularly in the high-tech sector, have been surprised by the slump in demand or
by the entry of competitors or the introduction of new products. In many of these instances, capital
spending plans have been shelved or delayed. But the anecdotal evidence does not all point in one
direction. A recent survey from the National Association for Business Economics showed that, at least
among the companies that belong to that organization, the number of firms that perceive that they are
still under-invested in high-tech equipment exceeds the number that have over-invested by a
considerable margin. How those numbers translate into dollars is uncertain, of course, but the survey
does remind us that we have to be cautious about the lessons we draw from the anecdotes.
We also have to be a little cautious about the inferences we draw from the recent sluggishness in
investment. In particular, a downturn in investment does not, by itself, imply that firms view their capital
stocks as being too large. The rate of change in the stock of capital reflects both the spending on new
capital - that is, gross investment - and the rate at which capital is being consumed, mainly through
depreciation. Even at rates well below those of a year ago, today's investment still likely exceeds by a
significant margin the pace at which capital is depreciating. Thus, the stock of capital, at least for the
economy as a whole, probably is still expanding at a brisk pace. We can say with a reasonable degree
of confidence that the investment cutback of recent quarters demonstrates that businesses did not
want to continue adding to their capital stocks at quite the pace that they were a while back. But
whether the stock itself is too large is a different question and one to which the answer is less clear.
And because the composition of the capital stock is so enormously varied, the answer will no doubt be
that some forms are held greatly in excess of desired levels, some well below desired levels, and
others approximately at the desired levels.
Alternatively, one might turn to econometric modeling to estimate the magnitude of such an overhang.
The economics profession provides us with the logic for determining whether the stock of capital is
excessive, namely the difference between the desired, or target, capital stock and the actual stock.
However, empirical models are conditioned on a number of assumptions, not only about the
longerrun prospects for economic growth but also about the ways in which capital and labor interact in the
productive process. Such calculations require that desired and target stocks be valued for widely
heterogeneous types of plant and equipment, of differing vintages and in differing states of operating
efficiency. The size of the overhang can be estimated following these methods, but the results are
bounded by wide ranges of uncertainty.
The financial markets have perhaps provided some of the strongest signals that the capital stock
might have started growing too fast in recent years and that it might be excessive in some sectors. For
example, the performance of the stock market has mirrored, in a rough way, what has happened to
business fixed investment. The stock market boom of the late 1990s was associated with a growing
optimism on the part of both firms and investors about future profit growth. Between 1992 and the
peak in 2000, expected long-term earnings growth rates for technology firms in the S&P 500 increased
from 12 percent at an annual rate to more than 22 percent. Similarly, expectations of long-term
earnings growth for telecom service providers - widely anticipated to be beneficiaries of surging
demand for Internet-related services - rose from 8 percent to 15 percent.
Since early- to mid-2000, however, these supportive financial conditions have eroded amid concerns
that Internet retailers and other "dot-coms" face severe challenges in achieving profitability.
Technology and telecommunications stock price indexes began to slump in the spring of 2000, and
financing conditions for start-ups cooled off. In addition, earnings-growth projections for telecom
service providers began to decline around the middle of last year, as intense competition in
longdistance telephony eroded profit margins for existing business lines, and the expansion in demand for
advanced products such as digital subscriber lines (DSL) was less robust than had been hoped. With
a retrenchment in capital spending under way, the drop in expectations for long-term growth began to
extend to manufacturers of telecom equipment and other high-tech gear during the last few months of
2000, and conditions for many such firms have remained difficult in 2001.
Will the overhang be worked off quickly?
The obvious question is: When will the stock adjustment in high-tech capital run its course, and the
supply and demand for capital goods return to balance? This question is not answerable with
certainty. There are reasons to be hopeful and reasons to be cautious.
Just as firms might tend to overestimate their longer-term capital requirements when times are good,
there likely is some tendency to underestimate longer-term needs when the economy is soft. Thus, it
could well be that stocks of capital will not seem so excessive once the economy picks up. Moreover,
as a number of observers have suggested, the fact that a capital stock overhang might be
concentrated most heavily in the high-tech industries has one important silver lining. This advantage is
that, on average, a good deal of high-tech equipment probably depreciates more rapidly than most
other types of equipment. Consequently, with other things equal, the shorter life of some of the capital
currently held in excess amounts would seem to imply that the overhang can be worked off more
quickly than otherwise. There is much to be said for this point of view, and undoubtedly the adjustment
process may progress more quickly than if the overhang were concentrated in other types of
equipment or structures.
Nonetheless, in the interest of exploring more fully the potential dynamics of high-tech capital
investment, I would like to take a few minutes to examine why an overhang might take longer to work
off than we might like or expect. And I have to emphasize here that I am focusing on some parts of the
high-tech sector, not the sector as a whole, and certainly not the economy as a whole.
One reason an overhang could persist is that some types of high-tech capital do not depreciate
rapidly. For instance, unlike the equipment that sends signals down the optical fiber, the fiber itself
probably has a useful lifetime that is reasonably long. Optical fiber today is not greatly different in
quality from the fiber of a few years ago, and there is little physical deterioration once the fiber is in the
ground. All this suggests that the excess capacity of total fiber could take quite some time to work off.
And presumably other types of equipment and structures are similar in this respect to fiber.
Second, depreciation rates are partly a reflection of economic obsolescence; that is, capital often
loses value because of the expectation that it will soon be replaced by newer, more advanced
equipment. However, the replacement decision is, to some degree, at the discretion of the firm that
owns the capital. In the context of weaker-than-expected demand for their products, and hence
weaker cash flow, businesses may decide that they prefer to hang onto their existing computer
hardware, software, and communications equipment for longer than they otherwise might.
Accordingly, it might presently be the case that high-tech equipment is not as short-lived as we think it
usually is. Adding further to firms' willingness to hold on to their existing equipment through the current
period is the apparent absence of new "killer apps", break-through technological advances in
applications such as e-mail and web browsers that in the past have spurred investment in software
and in complementary goods like computers and communications equipment.
A third reason for caution in assuming that the overhang will be worked off quickly is that even if
hightech depreciation rates remain elevated, new investment could continue feeding into the capital stock
because of planning lags, lengthy building times, or costly irreversibilities. For example, a national
optical network can take years to roll out - longer than the average time to build a nonresidential
structure. If demand falls below expectations, a firm might decide to persevere to completion of an
investment project with a lengthy building time, but may be left with a capital good that is ill-suited to
the conditions that prevail at the time of completion.
Lastly, the situation of the high-tech industries is also complicated by some considerations that are
difficult to capture in the normal calculations of investment and depreciation. One such factor is the
changing market structure of the high-tech sector. In the mid-1990s, deregulation in the telecom
industry and the rise of the Internet led to a surge of entrants into the high-tech areas. These startups
not only generated a good deal of spending on capital goods themselves, they also forced incumbent
firms to invest and innovate to keep up, even as profits were eroding. Survivor mentalities may have
caused the competing firms to push capital outlays further than they might have otherwise, on the
notion that the short-term losses recorded in stretching to expand market share could be made up
later as competitors fell by the wayside.
The creation of the long-haul fiber optic network, the part of the network that runs from city to city,
provides perhaps the best illustration of the excesses that can develop as firms rush to establish their
market positions. The creation of these networks may also indicate the complexities involved in
determining the size of a capital overhang in a particular industry. In 1995, just three firms had
significant long-haul fiber optic networks in the United States. By 2000, however, there were nine such
firms, and by the end of this year, there will be several more. In some regions of the country, the
numbers are larger still, with some major cities in the Midwest being served by as many as twenty
long-haul firms.
The competing long-haul firms have laid huge amounts of fiber over the past few years. Not only do
numerous firms compete, but each firm also has the incentive to put in place more fiber than it might
need in the immediate future. As I mentioned before, the optical fiber itself is long-lasting, and the
quality of new fiber has tended to increase only slowly over time. Thus, with the risk of obsolescence
low, investment could be targeted more toward anticipated long-run needs. Moreover, fiber itself is
relatively cheap. By contrast, the vastly greater expense in building a network is the construction cost
associated with laying the fiber. Indeed, back-of-the-envelope calculations suggest that the cost per
mile of fiber is something like $170, whereas the cost of installation is more on the order of $125,000
per mile. In that context, it is not surprising that firms would lay excess amounts of fiber in a given
trench once the ground is broken.
In contrast to the fiber itself, the equipment that is used to transmit and receive data over the network
has been subject to very rapid technological change, and the economic considerations of investing in
this type of equipment are similar to those for computers and other types of capital goods that rapidly
become obsolete because of the fast pace of technological change. Although some overhangs of the
transmitting and receiving equipment may be present, the stock of such equipment has likely been tied
more closely to current and near-term demand than is the case for fiber. Accordingly, the extent of
overcapacity for this equipment is likely to be less severe. Moreover, two forces should operate in the
direction of resolving any overhang in relatively speedy fashion - namely, that the equipment
depreciates rapidly, and also that the amount of information being transmitted over the Internet is still
growing very rapidly, roughly doubling each year since the start of the 1990s.
Meanwhile, there is a shortage of what is sometimes referred to as "last mile" capacity, the component
of the network that runs from a long-haul node in a particular geographic area to individual businesses
and homes. In view of that shortage and of the excess amount of long-haul fiber, patterns of
investment are shifting. Industry analysts expect that in 2001 more fiber will be laid by cable
companies and short-haul providers than by long-haul providers, and this gap is likely to widen in
coming years. Thus, even in the hard-pressed telecommunications industry, we are probably going to
see continued rapid expansion in some types of capital, even as overhangs of capital may persist in
other areas.
Macroeconomic implications
For the economy as a whole, it seems likely that the overall stock of high-tech capital will grow rapidly
over time, even if installation of some types of high-tech equipment and structures may be slowing
down. The economic benefits of making such investments still appear to be quite persuasive in many
cases. There is no evidence of an end to the growth in the amount of information that can be put on a
computer chip. Computers coming on the market are getting more powerful year by year, and their
prices still are falling quite rapidly. The pressures on firms to remain competitive should keep them
from putting off investments in new, lower-cost products for very long. All in all, I am hopeful that we
will look back on the present concerns about excess stocks of capital as only a temporary interlude in
the ongoing transformation of the economy toward more and more advanced technologies.
In terms of macroeconomic performance, the increase in the high-tech capital stock is important
because of the boost it has given to the growth of structural productivity over the past few years.
Productivity growth has benefited not only from an increase in the amount of capital per worker,
especially of high-tech capital, but also from the enhanced efficiencies that have been made possible
in combining labor and capital in the workplace. I realize, of course, that measured productivity growth
has not been all that impressive in recent quarters. That weakness, however, almost surely is a
reflection of the sluggishness of the economy, rather than a sign that structural productivity might be
reverting to the slow rate of growth that was evident before the mid-1990s. I continue to be cautiously
optimistic that the prospects for healthy gains in productivity over the longer term still are quite
favorable.
In light of the overhang in some types of capital, some have wondered whether monetary policy might
be less effective in combating the current economic weakness than otherwise. After all, conditions in
short-term money markets, by themselves, are unlikely to induce substantial further investment, for
example, in the long-haul fiber network. However, it would be a mistake to focus on only one channel
of monetary influence, such as the impact that policy might have on the demand for high-tech
equipment. Monetary policy works on a wide variety of spending, including housing, consumption
expenditures, and net exports, and the channels through which policy works range broadly across the
financial markets. Just as in the past, an easing of policy is likely, over time, to provide impetus to
growth of demand in the aggregate, even if it does not immediately lift the prospects of the
hardpressed firms in some high-tech industries.
Nonetheless, despite our aggressive easing actions of the first half of this year, I believe that it is too
early to say definitively that the current period of subpar growth has ended. Given the likely magnitude
of the capital goods adjustment that I have just discussed, as well as other forces, I expect only a
gradual pick-up in the rate of growth later this year. Against that background, I continue to believe that
the balance of risks seems to be toward continuing weakness in the economy.
Conclusion
In sum, although it is difficult to determine how large the overhangs of capital might be at present, they
seem likely to exert at least a modest amount of drag on the economy over the near term, even as
growth picks up. Over time, though, the discrepancy between actual and desired stocks of capital will
be worked off, both as actual holdings diminish through depreciation, and as target holdings increase
with the revival of aggregate demand. The overhang does not require that we alter our basic approach
to monetary policy: We still maintain the ultimate objectives of price stability and maximum sustainable
employment. Mainly, the overhang factors into our thinking through the risk it might pose to the
intermediate-term outlook for economic activity and employment. Over the long term, the current
problems almost surely will be resolved in the ways that markets have solved past problems of capital
misallocation: Investments that no longer seem likely to earn the profits that had been expected will be
written off, at the same time that capital is being reallocated toward emerging opportunities. Overall, I
remain cautiously optimistic about the long-run prospects for investment in new technologies, and for
the beneficial implications that will have for the U.S. and world economies.