PETER K. CLARK StanfordUniversity Investment in the 1970s: Theory, Performance, and Prediction ONE of the most widely perceived characteristics of economic recovery since early 1975 has been the relatively slow growth of business fixed investment. At the end of 1978, for example, real GNP was 13.8 percent above the value attained at the cyclical peak five years earlier. By con- trast, the performance of real nonresidential fixed investment has been poor. Its previous peak value, reached in the first quarter of 1974, was only surpassed in the second quarter of 1978. Even by the end of 1978, it was only 8.1 percent above the earlier peak. During the past five years, the apparent sluggishness of nonresidential fixed investment has generated pronouncements about the declining in- centive to invest and warnings that investment performance must be im- proved to maintain the growth of real income and of the supply capacity needed to reduce inflationary pressure. For example, in a widely publi- cized speech in October 1977, Arthur Burns examined business fixed investment and found: "In the two-and-a-half years of this expansion, real capital outlays have increased only half as much as they did, on average, over like periods in the five previous expansions. The shortfall Note: I gratefully acknowledge comments by Roger E. Brinner and William D. Nordhaus and the research assistance of Martha M. Parry during the early stages of my work on investment. I especially thank Data Resources, Inc., for providing access to its forecast simulations, and Stephen H. Brooks for contributingguidance and assistancewith the software. 0007-2303/ 79/0001-0073$00.25/O0? Brookings Institution 74 BrookingsPapers on Economic Activity, 1:1979 has been especiallymarked in the case of majorlong-lived industrial con- structionprojects."' The outgoingRepublican administration's Council of Economic Ad- visersstated in its reportof January1977: "Thegrowth of nonresidential fixed investmentin 1976, especially in the latter part of the year, was low for this stageof the recovery."2The new Democraticadministration's Council was still worried about fixed investmentin January 1978: "It appears, however, that total investment outlays during the expansion have fallen somewhatshort of those implied by historicalrelationships of investmentto its determinants."3Because business investmentplays an importantrole both in the determinationof currentaggregate demand and future growth of real income, it is appropriatethat this perceived "low investment"be analyzed in an explicitly quantitativeway, using econometrictechniques. Much of this paper is devoted to just such an econometric analysis; it combines data on investment,output, capital stock, and priceswith existingtheories of investmentbehavior to provide a quantitativereview of the performanceof nonresidentialfixed invest- ment since 1973, and the possibilitiesfor improvingthis performancein 1979 andbeyond. Four Questionsabout Investment Behavior While the econometricevidence is being discussed,the readershould focus on the following four questions,which the analysisis designedto answer. To what extent can the steep 1974-75 drop and subsequent slow re- covery of nonresidential fixed investment be explained by the standard theories of business investment? To answerthis question,the actual path of investmentsince 1973 is comparedwith the path forecastedby severaleconometric models. These comparisonsserve three purposes. First, if the best availablemodels consistentlyunderpredict or over- 1. Arthur F. Burns, "The Need for Better Profits," address at Gonzaga Univer- sity, Spokane,Washington, October 26, 1977, p. 3. 2. Economic Report of the President,January 1977, p. 37. 3. Economic Report of the President,January 1978, pp. 70-71. PeterK. Clark 75 predictsince 1973, it could indicate either a change in behavioror the existenceof additionaldeterminants of investmentthat have been ignored because they remainedrelatively constant before 1973. For example,if increased regulation since 1973 has significantlylowered the rate of returnon nonresidentialcapital, this reductionshould show up as a nega- tive differentialbetween actual and predicted investment. Second, a comparison of the predictions of various econometric models for the five-year period from 1973 to 1978 provides a good "specificationtest," especiallybecause that intervalincludes substantial variationin investment,output, and other relevantvariables. If some of the models predict well, the policy prescriptionsderived from them shouldbe givenmore weight than the policy conclusionsbased on models thathave little predictive power. Third, post-sampleprediction over a five-yearperiod allows a good test of the hypothesisthat a considerableamount of "post-datamodel construction"has been used in the formulationof'the econometricmodels of investmentnow in use. If "data mining"is an importantproblem, predictionerrors outside the sampleperiod shouldbe significantlylarger thanwithin-sample estimation residuals. Which models or variables best explain the behavior of business fixed investment? In particular, how important are interest rates and other capital cost considerations? This question is central to the analysis of investment;if investment reacts to the rental price of capital servicesin the short run, then direct investmentincentives, such as the investmenttax credit or accelerated depreciation,may be appropriatetools for shifting aggregatedemand. In addition, the effect of market interest rates on investmentdemand becomes an importantconsideration in the design of policy. If output is the primarydeterminant of business fixed investmentin the short run, then the pro-cyclicalnature of investmentis the most im- portantconsideration in policy design. Only the long-run effects of tax incentivesfor investmentneed to be considered,and short-runvariations in interestrates are not as crucial. What policies are likely to be most effective in maintaining or in- creasing the share of nonresidential fixed investment in total output over the next few years? One of the most disturbingcharacteristics of the U.S. economyin the 76 BrookingsPapers on Economic Activity, 1:1979 1970s has been sluggishperformance of productivitygrowth. Between 1948 and 1965, labor productivityin the nonfarmbusiness sector grew almost3 percenta year. Between 1965 and 1973, this figuredropped to about2 percenta year. And between1973 and 1978, productivitygrowth slowed furtherto only 1 percenta year. While reliableestimates are not yet availableof the effect of nonresidentialcapital accumulation on pro- ductivitygrowth since 1973, most economistsfamiliar with the data at- tribute a substantialrole to slow growth in the capital stock. If the accumulationof fixed capitalis an importantdeterminant of productivity growth,policies designedto increasethe shareof outputdevoted to busi- ness fixedinvestment become more important. What are the investment prospects for 1979-81? Once the econometricmodels of investmentdemand have been esti- matedfor the 1954-78 period,they can be used to projectnonresidential fixed investmentfor the next threeyears. Various assumptionsabout the pathsof output,interest rates, and the stockmarket can be testedto deter- mine theireffect on the futurecapital stock and the investmentcomponent of aggregatedemand. The purpose of this paper is to obtain quantitativeanswers to these four questions.First, five models of business investmentbehavior are developed analytically. These models roughly span the considerable range of disagreementamong economistsabout the determinantsof in- vestmentin fixed capital.4Next, the models are estimatedfor equipment and structuresfor the period from 1954 to mid-1973. Following a dis- cussionof the estimates,they are used to projectinvestment in equipment and structuresfrom 1973:3 to 1978:4. These projectionsprovide quan- titativeanswers to the first three questionsabove. To investigatefurther some puzzlingaspects of the results for the recent period, the behavior of variouscomponents of structuresand equipmentis analyzed.Finally, forecastingequations derived from the 1954-78 periodare used to assess the prospectsfor businessfixed investmentthrough 1981. 4. By using a number of models, the problem of "model dependence" in the analysis is reduced. The reader can see how his favorite model explains the data and compare the results with those from competing models. This multimodel approach has been used previously by Bischoff and Kopcke. See Charles W. Bischoff, "Business Investmentin the 1970s: A Comparison of Models," BPEA, 1:1971, pp. 13-58; and Richard W. Kopcke, 'The Behavior of Investment Spending during the Recession and Recovery, 1973-76," New England Economic Review (November-December 1977), pp. 5-41. Peter K. Clark 77 The Modelsof BusinessFixed Investment Five models of business fixed investment are discussed below: ac- celerator,cash flow combined with accelerator,neoclassical, modified neoclassical,and securitiesvalue. These models are almost identical to the ones studiedby Bischoff, except that his simple cash flow model has been replacedby one that includesan acceleratorterm.5 No seriousinves- tigatorof U.S. investmentbehavior has proposeda model that is based on cash flow alone. Thesefive modelsare each appliedto two componentsof real nonresidentialfixed investment:expenditures on producers'durable equipmentand expenditureson structures.6 GENERALIZED ACCELERATOR MODEL Models of the acceleratortype relatinginvestment in fixed capital to changesin outputhave