karl-henrik pettersson

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U.S. resource allocation does not seem to be particularly effective

This graph (clic for bigger picture) shows the capacity utilization in the U.S. industry for nearly a 50 year period, from 1965 until 2010. Looking at the figure, and looking beyond the cyclical swings, the most striking is the downward trend. During the period, capacity utilization has fallen by around 10 percentage points – from the 85% level to 75% level. It is spectacular. Both that the level is so low, (for example, the Swedish industry’s capacity utilization in the 2000s was around 85-90%). And that trend looks like it does (in Sweden, capacity utilization rather had a rising tendency, at least after 1980).

The question is what the decline in capacity utilization in U.S. industry depends on. There must be a structural explanation, and it must have something to do with too much investments, obviously more than what meets the demand. I can imagine a number of interpretations:

Too high profits, firms have had – simply put – too much money to spend. It is no secret that companies, and it’s not just for U.S. companies, in recent decades have had a return on capital that is higher than what the market would actually require given the price of capital (the risk-free real interest rate), inflation expectations and risk. In particular, inflation has fallen dramatically from the 1970s onwards, and we have hardly seen any downward adjustment in the industry’s return on capital as a result of lower inflation expectations.

Bad management, or – if I would express myself with more care – deficiencies in corporate governance. And that applies not least in the U.S. Michael Jensen, one of the most renowned and interesting finance economists (and American), has made some calculations regarding the quality of American big business investments in the 1980s. The results reported are astounding. The horror example is General Motors (GM). Jensen calculates that GM during the 1980s made an error in resource allocation in the order of $100 billion (which roughly corresponded to 1.5% of U.S. GDP in the 1980s!). In other words, had GM put the capital invested on these disastrous projects on a banking account, the shareholders would have been $100 billion richer. Clayton Christensen, another well-known American professor, has shown that AT & T through three failed mergers and acquisitions in the 1990s “burned” about 350 billion kronor ($ 50 billion) and, as he adds, “… destroyed even more in shareholder value.”

Too easy to borrow. Most companies can’t self-finance their investments so they have to take help of banks or the capital market for the funding. During this period, especially during the 1970s and ´80s when the credit market was deregulated, it became easier for companies to finance their investment projects in the banks and, for the big companies, on the capital market. It could well be that the credit allocation here and there became too lax. During certain periods, for example in the late 1990s when the IT euphoria was at its worst, and from 2003 to 2007 when the economy was booming, there was, not least in the U.S, a pure go-go atmosphere in the financial markets. This may have contributed to bad investments, which in turn, all else being equal, contributed to declining capacity utilization.

An explanation may also involve structural changes in demand. One can speculate that changes in customer demand have gone so quickly that U.S. manufacturing companies have not kept up with the pace. It should, in this case, in particular apply to investment-heavy industries where lead times are long between the investment decision and the production start. The automotive industry could be such an industry. Now, I do not know how the U.S. automotive industry´s capacity developed during the period after 1965, but if the downward trend looks the same as for the entire industry, then it would be a contributing explanation.

And there might be other explanations. Nevertheless, the picture of a trend decline in capacity utilization in U.S. industry should be of grave concern. The picture tells of a country in which the allocation of resources in the industrial sector, the most important sector of the economy, is not very efficient. It must be particularly disturbing as other Western countries have not as clearly shown the same tendency. In Sweden, the industry’s actual capacity utilization had, according to Statistics Sweden (SCB), a slight upward trend, from the level of 80-85% to 85-90%, for the period 1980-2010.

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2011-04-28

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