Is Capital Investment Taxiing Up The Runway For Takeoff?

Bill Clinton's pledge to spur both public and private investment could, assuming it is implemented, contribute to a "surprisingly strong and long upswing in the capital-spending cycle." So argues economist Joseph G. Carson of Dean Witter Reynolds Inc., who points out that tax credits to stimulate capital spending should reenforce the effects of other emerging factors that favor investment.

Perhaps the most intriguing development is a recent change in the famous "Q" ratio, the name chosen by Yale University economist James Tobin to designate the relationship between the value the stock market places on corporations, on the one hand, and the current cost or replacement value of their physical assets, on the other. According to Tobin's theory, businesses tend to accelerate capital investment when the Q ratio moves above 1 -- that is, when their stock market value exceeds the cost of replacing their physical assets. And Carson's calculations, based on current equity prices and recent investment spending, suggest that this ratio has finally edged above 1 this year for the first time in more than two decades.

A high Q ratio tends to spur capital spending because it tells companies that additional investment in new equipment is likely to create capital gains for their shareholders. By contrast, when the stock market values corporations' physical assets at less than their replacement cost, managements will tend to seek other uses for their cash.

Indeed, Carson points out that a strong capital-spending upswing failed to develop in the early 1980s despite favorable tax laws precisely because the market value of financial assets was at a historical low relative to real assets. So, many companies either went on acquisition binges or bought up their own shares. "In other words, it was cheaper to buy another company than to build or expand one's own asset base." Now, however, the pendulum has swung in the other direction, and it's cheaper to build than to buy. At the same time, manufacturing operating rates are 8 to 10 percentage points above where they were when the past two cyclical upturns began, while the average age of the factory sector's capital stock has reached a 40-year high. And for the first time in recent memory, corporations have been generating significantly more cash internally than they have been devoting to capital spending.

In sum, says Carson, "the underpinnings of a strong upswing in business investment are falling into place."

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