You know the economy's in trouble when businesses lose their animal spirits. That's a term British economist John Maynard Keynes used to describe the intangible "naive optimism" that causes companies to cast aside fear and push ahead with plans for investment and growth. Clearly, fear is now taking over. Through February, orders for capital equipment have fallen for two months in a row. Outlays for business construction are down for three consecutive months. Companies are slashing inventories as demand weakens, and they are trimming payrolls in an effort to cut costs and salvage productivity as profits shrink. It's all straight from the scripts of past recessions.
What's not in the standard story line, however, is the unsettling fragility of the credit markets, which has sent a chill through would-be risk takers all across Corporate America. The financial upheaval has not only made credit more costly and more difficult to obtain, even for top-grade corporate borrowers, but it has cast a pall of uncertainty over the future. The standard forecast calls for an economic recovery in the second half, but amid the current financial tension there isn't much faith in that outlook, and businesses are pulling back.
Dwindling Business Construction
The economy will feel the loss. Last year capital spending on new equipment and buildings contributed half a percentage point to the economy's 2.2% growth rate. Outlays in the second half grew at a 7.7% annual rate, but now appear to be grinding to a halt. Through February, shipments of nondefense capital goods excluding aircraft were running below their fourth-quarter level, as were business outlays for construction. Both are key inputs for the government's data on gross domestic product.
The drop-off in business construction will be a major loss. Its strength last year offset 40% of housing's one-percentage-point subtraction from overall economic growth. Business construction, reflecting tighter credit and weaker demand, now is likely to turn from fourth-quarter growth to a first-quarter decline.
Business retrenchment is part of the self-reinforcing contraction common to recessions. Trends in the growth of capital spending and payrolls are tightly correlated, and as companies cut back, consumer income and demand suffer, further depressing the desire to invest and expand. Indeed, payroll weakness has broadened greatly in recent months, extending well beyond housing and manufacturing to services. Inflation-adjusted consumer spending has posted almost no growth since November, with acute weakness in car sales, and spending will remain severely challenged until fiscal stimulus checks hit mailboxes in May and June. Even then, if businesses remain holed up this summer, any spending boost could be only temporary.
Global Profits, Domestic Pain
Nothing lifts animal spirits like the scent of profits, and that's a key problem. The government's comprehensive roundup of fourth-quarter earnings showed a small 2.5% gain from a year ago but with striking crosscurrents. Domestic profits were down 6.5%, while earnings from the rest of the world soared 42.8%, the largest gain in 27 years, spurred by solid growth overseas and the lower dollar.
However, domestic profits are more important for U.S.-based capital spending. Finance sector earnings dropped 16.4%, which was much less than Wall Street numbers show because government data treat writedowns differently. It was still the largest decline in 14 years. But it's not just finance. Profits of nonfinancial corporations were flat from a year ago, and down sharply from the third quarter, while margins dipped to a two-year low. That squeeze is sure to continue as revenues slow further.
One plus is that businesses began the year with strong balance sheets and few excesses in inventories and production capacity. Nevertheless, survival instincts are now supplanting animal spirits, and the need to cut costs, lift productivity, and preserve shareholder value will add yet another drag on the economy.