How to predict an Economic slowdown?
Was 2019 indicative of the stagnating economic growth in 2022?
Economic growth, especially after the financial crisis of 2008, is declining in many OECD nations. Declining economic growth has negative effects including a lower rate of productivity growth, stagnating standards of living, and increase in income inequality. Hence, it is important to identify the drivers of economic growth to get ahead of the economic downturn curve. But can we really do that?
Economic growth can be defined in a number of ways — productivity growth, GDP growth, growth in intangible investment etc. Here, I have chosen a relatively narrow definition of economic growth — growth in real GDP — for the simple reason of the ease of analysis.
A vast amount of literature affirms that fixed corporate investment is one of the key drivers of economic growth. Furthermore, an empirical analysis between economic growth and fixed corporate investment for the Netherlands (NL) and Germany (DEU) shows a strong positive relationship between the two variables. Operating under the affirmation that fixed corporate investment is the harbinger of economic growth, then the million-dollar question is —
What drives fixed corporate investment?
A multivariate time-series analysis between fixed corporate investment and 11 other variables for NL and DEU from 1961–2021 indicates that, consumer demand, real net profits of corporates, energy prices, uncertainty indices, unemployment rates, network sector entry / exit barriers and term spreads are statistically significant in explaining the changes to fixed corporate investment.
Fixed corporate investment can be stimulated by increase in consumption demand and real net profits of the firms. Of course, this is under the assumption that the firms make an effort to meet the explicit and tacit needs of the consumers and re-invest a sensible proportion of the real profits to support technological advancement, creation of jobs, and other societal initiatives. Literature on financialization supports the fact that excessive financialization can actually drive down corporate fixed investment, thereby contributing to an economic downturn.
Next, decrease in uncertainty indices and energy prices has shown a statistically significant and positive association with fixed corporate investment. While it is difficult to pin down why business investment is negatively associated with rise in energy prices, one plausible explanation can be that increase in energy prices is indicative of uncertain future and impending doom for many, which can lead to rising uncertainty indices. Uncertainty indices are drawn based on general sentiment of the people by analyzing social media chatter, news articles and other communication sources. Higher indices represent higher uncertainty. Thus, higher uncertainty indices are associated with lower fixed corporate investments as grim economic outlook prompts business owners and investors to postpone their investments. This then trickles down and manifests into a slow economic growth. Did you know that uncertainty indices are heavily influenced by sentiments of people and the resulting stagnating business investment can be the natural output of what the economists call as self-fulfilling prophecies?
Finally, corporate fixed investment also shows a statistically significant relationship with low term spreads and unemployment rates. A plausible explanation for this association is that low term spreads imply low costs of borrowing, thereby facilitating the financing of corporate investments. A pitfall of indefinite low borrowing costs is that it can result into bad loans, formation of bubbles or bad investment choices, if the borrowing goes unchecked. Next, the direction of association between unemployment rates and fixed corporate investment is hard to predict. However, low unemployment rates have exhibited a negative statistical significance with corporate fixed investment. This means that a lower unemployment is indicative of a rise in business investment, which is then expected to manifest itself into better economic growth.
After reviewing these factors, is it possible to answer whether one can predict the onset of an economic downturn?
I would say, yes, partially yes! Fixed corporate investment is one of the main drivers of economic growth and it exhibits a positive statistically significant relationship with economic growth. Therefore, analyzing the time series data of fixed corporate investment should give a fair idea of the onset of an economic downturn. For example, the fixed investment dipped before the financial crisis of 2008 (NL and DEU). Again, in 2020 we see a declining trend in the fixed corporate investment as compared to the previous years.
Finally, analyzing the drivers of fixed corporate investment like the energy prices, consumption demand, real net profits, uncertainty indices etc. should give some indications about the state of economy and the economic outlook.
Before closing this article, I would like to highlight that the analysis to check the drivers of fixed corporate investment was done only for the Netherlands and Germany. Extending the analysis on a global level can lead to the emergence of new drivers of economic growth, previously unknown to us.
