January 1 , 2003
Sometimes even economists miss the forests for the trees.
When industrial production was released last week,
economists were quick to note that activity rose slightly while the use of
capital also rose. Some
acknowledged that without an increase in auto production, a fourth consecutive
decline in industrial activity would have occurred.
Furthermore, zero financing no longer has the zing it did
in the past model year. (The fact
that sticker prices on new cars were increased sufficiently to offset zero
financing and leave monthly payments unchanged from the previous year almost
certainly is at work here. In the
last model year, zero financing meant lower monthly payments, which was
strongly received by consumers.)
Although the gains are not large, auto inventory is again
growing. Ford already announced
that its production will be pared next quarter.
Thus, the positive contribution from auto production appears to be a
very temporary condition.
What was unnoticed was the same gains in production as in
capacity utilization. This means
that industrial capacity is no longer growing.
(It grew 1% in the past year but appears to have stalled in recent
The absence of capacity growth is a rare event.
The last time industrial capacity showed no growth for an entire year
was in 1932, at the depths of the Depression.
No one is yet saying that capacity will not grow in the
next twelve months. But to get
capacity growth now, we will need to have significant increases in capital
spending. Indeed, the current
level of capital spending is doing no more than maintaining the current level
of U.S. capacity.
Two reasons account for this major restraint to capacity.
First, so much idle capacity exists that technology embedded in the new
capital must be dramatic to justify new spending.
Otherwise, operating existing equipment remains more cost effective
than building and operating new equipment.
Second, corporations are not convinced that they will be
paid for their investments. Corporate
profits remain anemic. After
falling nearly 21 percent in 2001, after tax profits may show only high single
digit gains this year. The trend
is encouraging but the level of profits remains sparse.
However, I already alluded to a reason why capital
spending should begin to improve even before profits show stellar gains or
capacity use rises. The
technology embedded in the new equipment may be so much better than existing
processes to make those idle production lines obsolete.
When we measure capacity, we ask whether the resources
are available, not whether they can be cost effective at or near prevailing
price. To a great extent, they
are not cost effective.
As the latest equipment continues to lower production
costs (a natural result of capital spending in all sectors except health and
the military, but that is another story), that unutilized capacity becomes
less and less likely to ever be used again.
Capacity utilization currently is 75.6 percent.
At a rate of slightly over 83 percent, past cycles show that price
pressures will begin to surface. When
capacity use hit 90 percent for industrial materials, the economy was headed
toward a decade of double digit inflation.
It will take some time for economic growth to be strong
enough to push utilization into that inflation range, but only small amounts
of growth will be needed to create profitability for new investments.
My own guess is that when utilization becomes higher than 77 percent,
new capital with embedded technology will become a must for American
industries competing with the lower labor costs of international competitors.
In short, what was overlooked in the industrial
production report was the beginning foundations for significant expansion in
Some real estate investors already are aware that similar
opportunities may soon confront them. Occupancy
is down, forcing current rents down. This, in turn, has reduced the ability to finance new
construction. However, the lower
interest rates have actually allowed those able to refinance to actually lower
costs faster than rents are falling.
Indeed, a study nationwide showed that despite a 9
percent reduction in rental rates, office space is selling for 8 percent more
per square foot than a year ago.
While the real estate example is not completely comparable to the conditions facing investors of industrial equipment, it demonstrates that use and profitability are two different conditions. In the end, profitability is the more important factor in determining future economic activity.