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Commentary: What's Crippling Capital Spending?


By Rich Miller

A revival of capital spending: It's what practically all forecasters are counting on to carry the economy forward in the second half of the year. Indeed, economists at the White House, the Federal Reserve, and across the country say a pickup in business outlays is needed if growth is to strengthen. Sure, the economy is recovering from last year's recession, but so far most of the oomph is coming from a turn in the inventory cycle. With free-spending consumers finally showing signs of slowing down and the housing market looking frothy, economists say Corporate America must boost outlays to keep the economy purring in the second half.

But economists better not hold their breath. The swoon in the stock market, amid nearly daily revelations of corporate accounting scandals, is threatening to turn hopes for a second-half revival of capital spending into a mirage. The market decline is raising the cost of capital to companies, depressing business confidence, and prompting chief executives to concentrate on cost-cutting and accounting rather than equipment expenditure and expansion. "The stock slump is putting corporate management on the defensive," says John Lonski, chief economist at debt-rating agency Moody's Investors Service. The result: The economy could end up expanding far more slowly in the second half than at the 3.5% pace many forecasters expect.

Even before the slide in stocks, expectations for a pronounced increase in capital-goods spending in the second half were looking iffy. Yes, new orders for capital goods--everything from heavy trucks to PCs--picked up in April. But actual shipments fell, and order backlogs declined, suggesting that companies were canceling old orders faster than they were placing new ones. What's more, a weekly survey of old-line capital-equipment producers by consultants International Strategy & Investment Inc. found that their business tailed off sharply at the end of May and into June, to their lowest levels since last November.

Now there's a real risk that Wall Street's woes could turn what was shaping up as a bad situation into something worse. How so? In part, because the stock slump is affecting business confidence by hitting CEOs where it hurts most: in the pocketbook. Stock options now account for 80% of executive compensation. By BusinessWeek's calculations, the average CEO lost an astounding $15.4 million in pay-related wealth last year, thanks to the steep drop in the market in 2001. With share prices also eroding this year, the hit to corporate honchos is only getting worse. "That feeds directly into CEO confidence," says Goldman, Sachs & Co. chief economist William C. Dudley.

It's not just lower stock prices that are shaking confidence. Business leaders are under attack as never before for playing fast and loose with company books during the go-go years of the late 1990s. So they're hunkering down, rebuilding battered balance sheets, and cutting costs in a bid to regain investor trust. And with many industries still awash in excess capacity and the economic outlook so uncertain, CEOs see little reason to rush ahead with plans to boost spending and expand capacity. "Capital spending is constrained," IBM CEO Samuel J. Palmisano told analysts on May 15. "Everyone is driving towards consolidation and savings." And spending on software is no better than hardware. "It certainly is every bit as challenging, if not even somewhat tougher, than it was in Q1," Kenneth A. Goldman, CFO of software maker Siebel Systems Inc., told a Bear, Stearns & Co. conference on June 11.

So could the downbeat mood sour the economy in the second half? That prospect clearly worries President Bush's chief economic adviser, Lawrence B. Lindsey. He sees a risk that corporate chieftains and investors will overreact to the excesses of the late '90s and pull back too far. "When the excesses were happening, people might have been more skeptical," Lindsey says. "But now there may be excessive risk aversion."

There may be good reason to expect an eventual pickup in capital spending. Profits and cash flow are reviving, and productivity has stayed strong. But as long as gloomy CEOs remain under a cloud, the risk increases that the revival of spending will occur later and come in weaker than generally hoped. And that could translate into sputtering growth in the second half. Miller covers the economy and Fed policy from Washington.


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