July 26, 2001
Last month, only 77 percent of the capacity of American industry was being utilized. Not surprisingly, the production of business equipment fell by 1.4 percent in that month alone. Who needs to produce equipment when so much good equipment is not being used.
Some economists have taken comfort in the low unemployment rate that persists despite falling employment. How can our economy be in recession when so many people are working?
These low unemployment rates shield the low use of existing assets. Indeed, profits are falling so hard not just because orders are vanishing for some companies but also because equipment and plants are being financed but not used.
Just as industry does not need to produce when the warehouses already are full, they do not need to build vacancy rates are rising. In the past three months, vacancies have shot up above 10 percent for the first time in nearly a decade.
That 77 percent utilization rate is lower than industry performed during the recession of 1990. Furthermore, because of previous decisions to produce equipment and build plants, capacity continues to grow at almost 3.5 percent a year. Developers have sick feelings when the building is rising and the pre-leasing is falling. At that point, however, it is better to complete the building and get some use rather than stop the construction and get nothing but bank calls for interest payments.
This distance between the awareness of changes in economic conditions and the ability to alter economic activity is called the gestation period. For office buildings, construction could continue for more than a year after knowing that the building is not now needed. Production lines for equipment could continue to operate for months to finish supplier contracts before activity is halted.
This gestation period is one of the reasons why economies tend to boom and bust. (Psychological flows from euphoria to depression also account for some parts of the business cycle).
The length of the gestation period and the magnitude of an economic imbalance combine to determine how deep and long weak economic conditions may last.
On this score, our economy currently is showing mixed results. Overbuilding of offices has not been as excessive as before the 1990 downturn except in bubble based economies such as San Francisco. Atlanta is overbuilt and will need to cut construction jobs before building supply can be brought into alignment with building needs. However, the problems are much smaller than ten years ago.
Furthermore, the speed of adjustment to changing conditions appears to be shorter. We have better information and investors react more rapidly to economic changes. Thus, the gestation period is shorter than in previous periods of weakness.
Despite these relatively favorable conditions, the cheap money for communications and technology companies that existed 18 months ago led to spending well in excess of current needs. Computer sales rose because new companies ordered computers to show that they had assets to justify their high stock values. Not only was there a boomlet in equity values, but their was a boomlet in capital spending.
Indeed, we probably have so much communications capacity that some equipment will be displaced by the next generation of technology before it is ever used. This is why defaults are so high in communications and why so little is recovered from the sale of assets from the failed companies.
(Studies indicate that less than 15 cents is recovered for bond holders in many of these bankruptcies. This compares with 50 to 60 cents for more traditional failures.)
I believe that it will take more than a year before non-residential construction can grow again. Communications capital could be depressed for two to three years, while computer products probably will begin to recover early next year.
In the meantime, only about 75 percent of industrial capacity will be used before capital spending again adds to GDP. That would qualify as one of the worst performances for existing capital (and for profits) since the Great Depression.