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When will capital spending come back? Companies set their plans for investment spending on a variety of factors, including their expectations about future sales and how easily they can raise the funds to purchase the new equipment.
But one important influence on capital spending, often overlooked, is the price of the equipment being bought. All else being equal, it's far easier for a company to justify a purchase when prices are lower. Right now, the average cost of buying a new piece of equipment is finally going down, after an upward surge in 2000 and most of 2001 (chart). That decline is one reason to be hopeful that business investment will rebound soon.
To understand the critical role of falling prices, look back at the investment boom of the 1990s. From early 1997 to the end of 1999, the cost of a wide range of capital goods dropped, including computers, light trucks, and medical equipment. The price of computers, especially, plunged at an annual rate of more than 23%. Economists such as Dale W. Jorgenson of Harvard University believe that such price declines were a key force stimulating the Information Revolution.
Starting in early 2000, however, the price declines for computing equipment began to slow as suppliers tried to take advantage of the heavy demand for info-tech equipment. And it wasn't just computers. As the average price of all capital goods rose through 2000 and most of 2001, it's no surprise that companies became more reluctant to spend.
In recent months, though, sellers of capital goods have been slicing their prices. The prices of metal-cutting machine tools, electric transformers, printing equipment, civilian aircraft, and truck trailers have fallen. Computer prices have resumed their rapid decline. That's almost certain to eventually stimulate demand.
But there is one influence that may blunt the impact of lower capital equipment prices. Even as investment goods have gotten cheaper, the ability of companies to raise their own prices has been declining. The price for the goods and services produced by nonfarm businesses is rising at only a 1.3% rate, down from 2.1% a year earlier. As long as companies don't have any pricing power, even cheap investment goods may be too expensive. Housing markets are local, but housing finance is global. The latest data from the Federal Reserve confirms the continued dependence of the economy--and especially housing--on foreign money. In recent years, foreign investors have poured hundreds of billions of dollars into the U.S. annually, with some of the biggest investments coming from Japan and Britain. All together, these overseas monies finance roughly 20% of business and residential investment in the country (chart).
These funds have been playing a critical role in the red-hot housing market. Foreign investors don't make loans directly to home buyers, of course, but they have been gobbling enormous quantities of the mortgage-backed securities issued by mortgage underwriters Fannie Mae and Freddie Mac. Because these securities have an implicit government guarantee, they are very attractive to foreigners looking for a safe investment. In the fourth quarter, for example, foreigners bought 32% of the so-called "agency securities" issued by Fannie, Freddie, and other similar government-sponsored enterprises. All told, non-U.S. investors bought $162 billion in agency securities in 2001, more than triple the 1997 number.
Without the flow of money from overseas investors, mortgage interest rates would be much higher, and it would be much harder to finance the current housing boom. That means U.S. home buyers should take a moment to thank their friends in Tokyo and London for their low-rate mortgages and their big homes. Are successful traders supercharged with adrenaline? Or, as some academics argue, are they cool, dispassionate machines? To find out, Massachusetts Institute of Technology Sloan School of Management finance professor Andrew W. Lo and Boston University neuroscientist Dmitry Repin wired up 10 foreign exchange and interest-rate derivative traders as they worked, monitoring their pulse rates, perspiration, breathing, body temperature, and muscle activity as the markets bounced around during an actual trading day.
They found that cool is not the word for traders. Their bodies responded rapidly to changes in the market such as price deviations, reversals of trend, and changes in volatility. The most experienced traders were calmer overall, but they also had statistically significant responses to market turns, especially changes in volatility, which triggered sweating and higher blood pressure. All of them work at a "major global financial institution" based in Boston and do trades averaging $4 million each.
In a paper appearing in the April issue of the Journal of Cognitive Neuroscience, Lo and Repin argue that emotion may help traders learn from and react correctly to confusing data. They write: "From an evolutionary perspective, emotion is a powerful adaptation that dramatically improves the efficiency with which animals learn from their environment and their past." And if you're looking for Darwinian behavior, says Lo, where better to look than a trading floor? This summer, the researchers plan to get traders to do deals while lying inside a magnetic resonance imaging machine to see which parts of their brains fire up when, say, the yen starts falling against the euro.