Shaken confidence—declining investment

Snapshot for October 16, 2002.

Shaken confidence—declining investment
How soon can the revival in consumer confidence seen so far this year translate into increased business investment and, in turn, a stronger economic recovery? Based on patterns exhibited in past recoveries, we may have quite a while to wait. Though consumer confidence began rising again in the first two quarters of this year (after two full years of decline), business investment, measured as a share of GDP, has continued to fall. By the 2nd quarter of this year, it had dropped for seven straight quarters to a low at 10.7%, a level not seen since the 3rd quarter of 1994.

Prolonged declines in business investment have been among the main causes of recent recessions and slow recoveries. Such declines occur — and persist — as long as businesses do not anticipate enough future consumer spending to justify new investments. One way businesses gauge the outlook for consumer spending is by tracking consumer confidence: rising confidence, over a long enough period of time, bodes well for future spending. Indeed, over the past several decades, rises in business investment have followed rises in consumer confidence with some regularity.

However, there is a considerable lag time. Following each time that consumer confidence hit bottom in recent recessions, it has taken an average of 4.5 quarters before business investment followed suit. For example, after consumer confidence began to revive in the 4th quarter of 1990, business investment only started to recover some four to five quarters later, in the 1st quarter of 1992. This suggests that — if consumer confidence actually hit its bottom at the end of 2001, and continues to climb in the months ahead — we can expect business investment to continue falling through early 2003, or almost another three quarters, before staging a recovery. Of course, whether consumer confidence continues to rise will depend in large part on improvement in consumer income; that is, more jobs and better wages.

This week's Snapshot by EPI research assistant Brendan Hill and EPI economist Christian Weller.

Check out the archive for past Economic Snapshots.