November 2003
Capital vs. Labor
Capacity or Efficiency
| "I do not believe in the things that I cannot see." |
| -- Everclear How to Win Friends and Influence People |
CONOMICS IS OFTEN JUST A SERIES of tradeoffs. Aside from bad advice, resources are limited, and must be allocated.
During the Cold War the primary debate focused on "guns or butter": Should government spending tilt toward defense buildup (guns) or domestic social spending (butter)? More recently the tradeoff has been a balanced budget vs. tax reductions.
But as the economy begins to strengthen, yet another tradeoff is apparently emerging. This one pits capital spending against job creation.
With businesses struggling to recover from the recent recession, the question is: How will they allocate their limited capital; by spending on new plant and equipment (capital spending) or by hiring additional employees (jobs)?
Given that so far the recovery has been remarkably "jobless" while capital spending has started picking up, it would seem the allocation favors the former. But does it? And more importantly, is this really a meaningful tradeoff?
Positively Uncorrelated
It's funny how sometimes relationships that seem so obvious really can't be confirmed with empirical (observable) evidence. That's one of the reasons why quants are always concerned about "statistical significance" and why even that sometimes leaves them uncertain. We've given examples of this in the past regarding the factors affecting inflation ( Bad Relations) and the relationship between unemployment and inflation ( Let's Put the Phillips Curve to Rest).Well guess what? The tradeoff between capital spending and new jobs may also be questionable -- at least that's what the evidence suggests.
This really jumps out at you if you compare capital spending to the unemployment rate rather than employment growth. To the extent that unemployment is the antithesis of employment growth, and if you think capital spending comes at the expense of employment growth, you'd think it would closely track capital spending. But it doesn't.
Take a look at Chart 1. This is Baseline data going back to 1982. Capital spending is represented by the blue line, the unemployment rate by the yellow.
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Chart 1 Capital Spending and Unemployment 1982 - 2003 |
 Source: Baseline |
Just eyeballing it, there appears to be a negative correlation between the two. This is especially the case since 1990.
Correlation measures how series move relative to one another. If they move in the same direction, they are positively correlated. If they move in opposite directions, they're negatively correlated. If there's no relation between, if they're completely unrelated, they're uncorrelated. The strength of the correlation is measured statistically with +1 representing perfect positive correlation, -1 perfect negative correlation, and 0 no correlation at all.
Although you might think unemployment and capital spending would be positively related, they appear negatively related for the past decade or so, yet statistically they aren't correlated at all.
That's right, no relation at all. At least historically, an increase in capital spending has not resulted in an corresponding increase in unemployment. In fact, a cursory look at Chart 2 would suggest capital spending and employment growth move in tandem. In other words, as capital spending increases, so does employment growth.
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Chart 2 Capital Spending and Employment 1982 - 2003 |
 Data Source: A-T Financial |
That actually makes sense. If businesses are investing in new plant and equipment, new employees will probably be needed to use it. This is statistically borne out by the Baseline data since the correlation grows stronger as capital spending's lead grows. As shown in Chart 2, with no lead, the two have a slightly positive correlation of +.17.
A Different Tradeoff
So what about that dreaded tradeoff between capital spending and jobs? Is everyone worried about something that really doesn't exist? Capital spending has increased, yet the jobless recovery is no illusion. What gives?We'd submit there's a different tradeoff, or at least a different cause for the lack of job creation.
To see why, consider why businesses are favoring capital spending over hiring. Coming out of the recent recession, firms are seeking to return to profitability as quickly as possible.
One way to do that is sell more product. By growing the top line, the bottom line increases as well. This is why businesses have traditionally stepped up capital spending, to increase capacity. Greater capacity has eventually led to the need to bring on new employees, hence the slightly positive relation between the two.
But this time around, businesses are spending to increase efficiency, not capacity. If anything, there's still a capacity glut from the excesses of the 1990s. Yet if production can become more efficient, costs can be cut and the bottom line increased without relying on growing sales.
If there's one thing managements learned from the recent recession, it's the benefits of efficient operation. Many have spent the last three years trimming fat and streamlining processes. We'd suggest that's where the increase in capital spending has been directed. It's resulted in greater profits without bigger payrolls.
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Chart 3 Productivity and Employment 1982 - 2003 |
 Data Source: A-T Financial |
The economic statistics bear this out. Chart 3 compares non-farm business productivity and employment growth. Here there's a slightly negative (-.14) correlation.
This doesn't mean that employment growth falls as productivity rises, only that there's not a positive relation between them. In other words, it's possible to increase productivity without increasing employment. That's exactly what's going on now.
It also doesn't mean that cost cutting automatically must involve layoffs. There are numerous ways to curtail spending other than reducing payroll costs. That's also going on now and is a function of structural shifts in the economy.
Although textile and other production jobs continue to leave this country in deference to cheap labor in Asia and Mexico, the unemployment rate has remained relatively unchanged. Why? Because jobs are being created in the service sector. Productivity can improve there without the major
capital outlays required in production.
This structural change -- the fact that those losing their production jobs are not the ones reentering the work force in service jobs -- explains the appearance of a "jobless" recovery. That will always be the case when the economy undergoes major fundamental changes.
What You Can't See
So there's a whole lot more going on here than a simple tradeoff between capital spending and jobs. In fact, that might not be a tradeoff at all.Quants are always worried about falling prey to the spurious relation. The typical textbook example focuses on population growth in Canada and television ownership in the U.S. Both have been on the increase in the past 50 years so one could postulate a positive correlation between the two. One could even run a regression and find their statistical relation.
Regardless, there's really no relation between the two. What appears to be a fairly strong correlation is simply a coincidence.
We'd suggest the same is true for the apparent relation between capital spending and employment. As shown in Charts 1 and 2, statistics bear this out.
Still economists (who should know better) continue to warn of the dangers of the jobless recovery while failing to see the real threat arising from the economy's structural change. In this instance, it must be easier to believe what they can't see.
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