No agreement exists about the causes of the productivity growth slowdown, but economists do agree that the level of investment is a crucial element in the productivity growth process. Figure 6.1 illustrates the connection between growth and investment for selected countries. The relationship between investment and growth is by no means exact, but it is apparent. A major determinant of investment is the level of national saving—that part of GDP not used for private or public consumption. A useful perspective on national saving can be gained by looking at how the various categories of aggregate demand are financed.

Income earners allocate some of their income to pay for their consumption goods and services, and some of it to pay their taxes. What is left over is called private saving, which is used to buy financial assets, such as government bonds or stocks and bonds sold by businesses to pay for their investment in plant and equipment. What determines how much of the saving goes to the government and how much goes to business? The answer, in short, is the interest rate. The government needs to sell enough bonds to finance its deficit, so it bids up the interest rate to get the financing it needs. As the interest rate rises, some businesses decide that it is too expensive to undertake investment plans, and they abandon their plans. In this way, the rising interest rate squeezes business demand for financing down to what is left over after the government has financed its deficit.

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Keynesian analysis viewed investment spending as a component of aggregate demand and focused on its multiplier impact on income. A longer-run view, however, recognizes that investment affects the supply side of the economy by increasing the capital stock and making the economy more productive. In round terms, 60 percent of investment offsets depreciation of existing plant and equipment, 20 percent increases capital in line with annual labor force growth, and the remaining 20 percent serves to increase capital per worker, thus enhancing productivity.

Early attempts to formalize this role of investment viewed GDP as being determined, through an algebraic formula, by the stock of labor, the capital stock, and a term representing productivity. GDP grew because each year the labor force grew thanks to population growth, the capital stock grew thanks to investment, and productivity grew each year (by about 2 percent) thanks to technical change brought about by a continuous stream of innovations. A key assumption was that this rate of technical change is unaffected by the saving and investment levels it helps determine through its influence on the growth rate. The independence of the rate of technical change from investment and saving activity is what is meant by the statement that technical change is exogenous. The lack of such independence means that technical change is determined endogenously by the interaction of saving, investment, growth, and technical change.

Modern growth theory questions this exogenous view of technical change, claiming that technical change is determined endogenously: the level of technical change can be influenced by investment in education to improve the quality of labor and by investment in research and development to improve the quality of capital. Furthermore, the success of such investments could induce more such investment and higher saving to finance it. It is therefore possible that a virtuous circle could develop in which investment creates more knowledge, which in turn spurs more investment. Some have claimed that the United States was experiencing such a virtuous circle during the late 1990s. This endogenous growth theory raises the profile of national saving and investment.

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Inventory behavior is an example of a leading indicator—a variable that consistently changes a few months in advance of changes in macroeconomic activity and that thus can be used to forecast business cycles. Experience has shown that depending on a single leading indicator is unwise, but combining several leading indicators into a composite index produces much better forecasts of business cycles. One such composite is the Index of Leading Indicators, compiled monthly by the Conference Board, a private, not-for-profit, nonadvocacy organization that publishes several other statistical series including coincident, lagging, help-wanted, consumer confidence, and business confidence indices. Check www.tcb-indicators.org/

This composite index provides on average a 12.7-month advance warning of an impending recession. The indicators that make up the index vary as improvements are made; its components in 1999, in order of importance (with weights in parentheses), were as follows:

1. Spread between long-term and short-term interest rates as measured by the difference between the 10-year Treasury and the federal funds rate (.329) (interest rates are discussed in chapter 10).

2. M2 money supply in real dollars (.308) (explained in chapter .

3. Average workweek in manufacturing (.181).

4. Manufacturers’ new orders for consumer goods in real dollars (.049).

5. Standard and Poor’s index of 500 common stock prices (.032).

6. Vendor performance as measured by percentage of companies reporting slower deliveries from suppliers (.027).

7. Average weekly initial unemployment claims (inverted to produce a number that increases during expansions) (.025).

8. New private housing authorized by local building permits (.018).

9. University of Michigan index of consumer expectations (.018).

10. Manufacturers new orders for plant and equipment in real dollars (.013).

A simple rule of thumb often used is that three consecutive months of decline in the index are a sign that the economy will fall into recession.