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Capital spending still strong

Capital goods orders (a good proxy for business investment) in May broke out of their early-year slowdown, rising 3.5% above the previously reported level for April. They rose at a strong 10.3% annualized rate in the past six months, and are up a solid 10.5% in the past year. This is a key reason to remain optimistic about economic growth, since business investment today is the seedcorn for future growth.

Since hitting a post-recession low in April '09, capital goods orders have surged 39% are now only 3.4% below their pre-recession high. This has been an excellent recovery from the standpoint of business investment, but still disappointing from a long-term perspective. Consider that the level of investment today hasn't increased from where it was in the year 2000, while the economy has grown almost 20% over the past 11 years. There is still a lot of catching up to do. When business investment fails over the years to keep pace with the growth of the economy, that can only mean a slower rate of growth going forward. Investment is needed to raise worker productivity, and productivity—which has averaged about 2% a year for the past several decades—is a major source of growth, which averaged about 3% a year until several years ago.

The lagging pace of business investment over the past decade is also disappointing when you consider that corporate profits after tax have more than doubled in the same period. After-tax corporate profits now stand at 8.4% of GDP, just 20 bps below their highest level ever. Corporations have been piling up massive amounts of cash on their balance sheets in recent years, but it's important to remember that all the money saved by people and business in any given year is always spent by someone else. As it turns out, our federal government has effectively borrowed and spent every dime that businesses have saved since the recovery started. The federal deficit has totaled $2.55 trillion since the recovery started, while total after-tax corporate profits have been $2.06 trillion over the same period.

With businesses unwilling—for whatever reason—to reinvest surging profits, the federal government has stepped in to fill the gap. But since government spending (a portion of which is euphemistically termed investment) is almost certainly less efficient and less productive than private sector investment, the source of our lagging growth (with an output gap I estimate to be almost 10%) becomes obvious. As a country, we have squandered trillions of dollars by allowing the federal government to greatly expand its control over the economy's scarce resources. Federal spending as a % of GDP has grown by an explosive 24% since the end of 2007.

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