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 months.)

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 capital spending. 

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. 

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