The GDP Mirage

Here's a riddle: If a scientist or engineer is laid off, does it affect gross domestic product?

The third-quarter GDP figures, released on Oct. 29, showed the economy growing at a 3.5% annual pace, breaking a string of four consecutive negative quarters. The growth was driven mostly by a surge in the production of motor vehicles and other manufactured goods.

This number was greeted by many economists and journalists as confirmations that the recession is over. What's more, the rise in real GDP, combined with a sharp fall in employment in the third quarter, implies that productivity also soared during the period. Good news, right?

The trouble is that those GDP and productivity growth figures could be significantly overestimated—perhaps by one percentage point or even more.

That's because the official statistics are not designed to pick up cutbacks in "intangible investments" such as business spending on research and development, product design, and worker training. There's ample evidence to suggest that companies, to reduce costs and boost short-term profits, are slashing this kind of spending, which is essential for innovation. Without investment in intangibles, the U.S. can't compete in a knowledge-based global economy. Yet you won't see that plunge reflected in the GDP and productivity statistics, which are still too focused on more traditional sectors, such as motor vehicles and construction.

In effect, government statisticians are trying to track a 21st century bust with 20th century tools. Not only is that distorting the critical data that investors, policymakers, and corporate executives use to evaluate the economy, but it might also be creating a false sense of relief as Americans battle a brutal recession.

Fragmentary Data Here's a sobering sign that companies are robbing the future to pay for short-term profits: Over the past year, U.S. employment of scientists and engineers—the people who create the next generation of products and make the U.S. more competitive over the long term—has fallen by 6.3%, according to a BusinessWeek tabulation of unpublished data. Yet overall employment has fallen only 4.1%. "There are really bright people who are struggling to find a job," says Josh Albert, managing director at Klein Hersh International, an executive search firm for life scientists.

That's a big problem, because the output of such well-educated workers has become an increasingly important part of the U.S. economy in recent years. New research by Carol Corrado of the Conference Board and Charles Hulten of the University of Maryland, to be presented at the annual meeting of the American Economic Assn. in January, suggests intangible business investment came to roughly $1.6 trillion in 2007, compared with about $1.2 trillion spent on tangible assets such as machinery and buildings. In 1995 the two were roughly equal. Going back even further, tangible investments in 1985 were about 40% larger than intangibles.

The Bureau of Economic Analysis, the government agency that compiles the GDP figures, is taking steps to deal with the new realities. Software has been treated as investment since 1999, and the BEA plans to include R&D in the official GDP statistics in 2013, four years from now. But the agency acknowledges that other areas of intangible investment still need to be worked into the numbers. "We think it's important not to ignore the fact that R&D is only part of broader innovative activity," says BEA Director J. Steven Landefeld. For now, though, the U.S. is navigating through the downturn with fragmentary information.

While the statistics don't account for it, there's good reason to suspect intangible investments are falling. Companies are under pressure to cut costs by reducing R&D expenditures and deferring other crucial intangibles, notes Hulten. "Because these are expensed, it looks like a pure win," he says. "You are not seeing the benefits of the intangibles in the financial statements—only the costs." Scarce Venture Capital At the same time, companies, especially those in the pharmaceutical industry, are offshoring more research to China, India, and elsewhere. And plain old fear is paralyzing some companies, says Michael R. Englund, chief economist at Action Economics in Boulder, Colo. They don't want to commit to costly investments if the economy remains weak.

One clear-cut sign that GDP growth is being overestimated: the sharp drop in venture capital investment, which goes directly to new businesses. VCs invested about $12 billion in the first three quarters of 2009, barely half the $22 billion plunked down during the first three quarters of 2008. Some of this shortfall would have been spent on computers and other physical equipment, which would have been picked up in GDP. But most of the drop in VC money would have gone to pay for scientists, engineers, and new product development—all valuable intangible investments that show up nowhere in the published stats.

Similarly, many companies have taken a deep ax to their reported R&D spending, which also doesn't show up in GDP. Alcoa (AA), in an effort to preserve cash, reduced its third-quarter R&D spending by 36% from the year before. "It's a matter of focusing on your priorities," says Alcoa spokesman Kevin Lowery. "We surprised people by announcing a profit [last] quarter." Texas Instruments (TXN), meanwhile, expects to spend $1.5 billion on R&D in 2009, down 20% from 2008, owing to workforce reductions and cost-control efforts. And Johnson & Johnson (JNJ) has reduced its R&D by 13% over the past year.

Adding to the uncertainty, companies report their R&D only on a global basis, not broken out by country. As a result, even though some companies are adding to such spending, there's no way to know how much of those increases are taking place in the U.S. (A survey of business R&D by the National Science Foundation, now under way, will help answer some of these questions, with the first results expected in mid-2010.)

The stimulus package passed in February did include extra government funds for research and development. But even with this bump, a just-released analysis by the Democratic Leadership Council suggests total real spending on U.S. R&D is falling for the second straight year, as the business sector cuts back.

To get a handle on the changes in intangible investment, let's focus on the labor market for knowledge workers. It's not a pretty sight. In the manufacturing sector, nonproduction jobs—which include engineers, scientists, and other knowledge workers—declined at a 7.6% annual rate during the third quarter, almost twice as fast as the loss of production workers. The disparity is particularly acute in such key industries as computers and electronic products, transportation equipment, and chemicals. In the chemical industry, which includes pharmaceuticals, the nonproduction workforce is being reduced three times faster than the ranks of the production workers.

Neglecting New Products "The job market just dried up like you wouldn't believe," says Craig Eyermann, a 41-year-old mechanical engineer in Phoenix who was let go from his job at TRW Automotive (TRW) in February 2009. Besides his master's degree in engineering, Eyermann also has an MBA, can write (he runs the Political Calculations blog), and has experience in a variety of industries, including aerospace and transportation. Despite his skills, the job search has been difficult. Says Eyermann: "There have been a very large number of job postings that simply evaporated over the past several months, as the work upon which they were based has failed to materialize."

One big problem not reflected in the GDP statistics is that companies are retreating from development of new products, especially in stressed industries. Richard Shellabarger, 59, was a product development engineer in Auburn Hills, Mich., for Autoliv (ALV), a Swedish-American maker of seat belts and air bags based in Stockholm. Before being let go in February he was working on the "next- generation air bag." "I was trying to anticipate what the customer needed," he says. In retrospect, Shellabarger worries that product development wasn't a good place to be in a downturn. "I suppose if you are looking to cut personnel, you don't want to short an area where you are delivering to customers right now," he reflects.

Shellabarger's former employer, Autoliv, cut its global research, development, and engineering staff by 10% from the third quarter of 2008 to the third quarter of 2009. The main reason for the job decline was a reduction in the contract work Autoliv did for automakers, according to Mats Odman, the vice-president for corporate communications. "As a result of the crisis, [automakers] said, 'We're not going to develop many new models.' There is a lag effect here, and that is catching up now for us." At the same time, Autoliv reduced its own R&D budget by 20% in the first nine months of 2009, compared with the same period in 2008.

Shellabarger has a bachelor's degree in mechanical engineering technology. But even a PhD in organic chemistry didn't protect Shawn Kerrick from losing his job in April at Eastman Chemical (EMN) in Kingsport, Tenn. "I was the only PhD in my area of the company," says Kerrick, 43. A richer pedigree "puts a target on your back," he says.

R&D isn't the only type of intangible investment that seems to be declining. U.S. companies spend an enormous amount on worker training—$134 billion worldwide—but they have been cutting back. The drop started in 2008, when employers reduced their per-worker "learning expenditures" by 3.8%, according to the American Society for Training & Development. No data are available for 2009, but "from anecdotal evidence, obviously there's a lot of cutback," says Pat Galagan, executive editor of publications.

Ideally, a big burst of training would occur during a period of creative destruction such as this so that people can acquire the skills needed for the jobs of the future. The problem is how to pay for that training, since unemployed people don't dare spend money on long-term training when they're worried about short-term survival.

On a positive note, some alternate sources of training are emerging. Autodesk (ADSK), maker of AutoCAD, has started allowing unemployed architects, artists, designers, and engineers to download free student versions of many of its products to help them keep their skills sharp while they're out of work. "Just fill out a form and say you're unemployed," says Ken Bado, Autodesk's executive vice-president for sales and services. So far, Autodesk says it has about 11,000 participants, who also receive free or greatly discounted classroom training on using the software.

Governments, too, are stepping up funding of training. Stony Brook University, part of the State University of New York, recently tapped federal stimulus funds to begin training displaced finance professionals for certifications in fields such as project management. "People were banging down our doors," says Patricia Malone, director of corporate training and education at Stony Brook. "We were able to accommodate an unbelievable amount of people in a very short time. The bad news is, we ran out of money very quickly." A Coming Revival? Measuring intangible investments such as business R&D and worker training isn't easy—which is one reason why government statisticians haven't yet done it. But including such expenditures could make a big difference in the way companies, investors, and others understand the economy. Let's do a back-of-the-envelope calculation. In the four quarters ended last June, business spending on tangible investments—equipment and structures—as reported by the BEA dropped by about 20%. If intangible investments had dropped at the same rate, it might have knocked an additional 1.5 percentage points off the -3.8% GDP growth rate. If intangibles fell by only 15%, that might have taken 1 percentage points off GDP growth. (These calculations require making heroic assumptions about price changes and other difficult-to-observe figures, so they should be treated as very rough estimates.)

Since manufacturers are still cutting nonproduction workers, there's a high likelihood that intangible investment was still plunging in the third quarter. That suggests GDP and productivity growth in the third quarter could be overstated by one percentage point, and perhaps more.

Will intangible investments revive soon? Albert of Klein Hersh notes that some companies are starting to hire biologists again. "It's the beginning stages of commitment to discovery," he says. But that uptick is likely to be negated by two massive mergers in the pharma sector, which will result in huge layoffs and cuts in R&D spending. The hookup of Pfizer (PFE) and Wyeth closed on Oct. 15, and the merger of Merck (MRK) and Schering-Plough (SGP) is expected to close sometime in the fourth quarter.

Another major trend that will affect intangible investment in the U.S.: outsourcing of R&D to China, India, and other countries. "Companies want us to recruit foreign nationals from the U.S. to work overseas," says Albert. In effect, more and more of the global R&D dollar is being spent abroad, so imports of R&D are increasing.

This shift in intangible investment is also not well tracked by the GDP statistics, although it obviously will depress employment of scientists and engineers in the U.S. But the economic impacts are murky. Corporate executives have argued that shifting R&D to China and India benefits the U.S. by improving the efficiency of the research process. If you can pay two trained scientists in China the same amount as one in the U.S., they say, you can get twice as much research output. But if U.S.-based companies are doing their research and product development overseas and their production there as well, it's tough to see how ordinary workers in the U.S. will gain.

But that's another story. For now, it's enough to note that the difficult environment for knowledge workers means the GDP statistics are sending too rosy a message about the economy. And as the old saying goes: "If you can't measure it, you can't manage it." Until that situation improves, it's going to be difficult to know if the U.S. is really on the road to recovery.

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