Skill Level Appropriate for all
- You probably make investments, in your retirement account, in the equity of your home, or in your education, and you only make investments when you think they'll pay off. Businesses also make investments, every time they buy a piece of equipment like a forklift or build a new warehouse. Now, your personal investing in financial markets isn't a part of GDP, but those business investments are. That includes commercial offices, equipment, and intellectual property products like software and R&D.
While business investment is only between 15 and 20% of GDP, it's a big swing factor for overall economic growth since it can drop like a stone or surge with changes in business confidence and expectations and it's one of the four critical parts of GDP. It's officially called Gross Private Domestic Investment and it's compromised of three parts, investments businesses make, residential investments, and inventories.
One caveat is that when we exclude inventories and talk about the investments businesses make and residential investments, we call that fixed investment. After all, houses, equipment, warehouses, those are fixed often quite literally to the ground, but inventories can change frequently like the way stores stock up months before Black Friday and holiday shopping, but then might stock out before New Year's. Plus, business investment is also something we need to realize can swing hard and fast.
So, what drives business investment and why can it swing like that more than consumption for example? Well, the truth is that business investment has the potential to swing because far fewer people make decisions about business investment. In US economy with well over 300 million people, most people are consuming all of the time. But with business investment, there are often strategic decisions that cause big pullbacks in investment immediately and that's because a small handful of people are making those decisions.
If the CEO of a construction company sees interest rates are rising, that executive could pull back millions of dollars in investment with the click of a mouse. This is compared to the 300 million people who will keep consuming unless their jobs disappear. Look at it this way. If you're responsible for making the investments in your business like buying new computers or furnishing a new office, but the unemployment rate is rising or profit margins are falling, you don't wanna be the one to go out on a limb for your business.
You could end up cutting your own branch off with a saw right out from under you. You'll be the one who could get fired. Even CEOs can be fired by their boards. You don't wanna make a big recommendation to spend and then see the company lose money on its investment decisions because if jobs get cut, you might be the first one to go. If the CEOs of the 10 biggest public companies decide to reduce their investments, this could have a massive negative impact on investment as a part of GDP.
The economy could slow or fall into a recession which is when GDP growth goes negative. Economies grow when businesses invest, but businesses need to feel secure that consumption will be there, that there will be a return on their investment. Business executives and consultants alike like to talk about low hanging fruit, like a tree with apples that hang at a level you can just reach up and pick with no effort. That's low hanging fruit. When an economy is growing slowly like after a recession, businesses wanna get new business that isn't expensive to get.
It needs to be easy like the fruit that hangs low on a tree you can get with no effort and not much effort is good at that part of the business cycle and business investment will hold back until they see bigger returns. And as the economy strengthens and consumers regain confidence and spend more, companies are willing to make bigger investments. They might buy the equivalent of a step stool to get a little more fruit, the apples a couple branches up, and then a ladder. And the next thing you know, they might end up buying the equivalent of a gold plated diamond encrusted cherry picker going for the very last apple at the top of the tree.
That's when you know the economy is rocking. Of course, I'm not really talking about fruit. I'm talking about incremental investment decisions that businesses make. When times are tough, they hold back on investments. And when times are good, they'll spend money to make money. How does your business feel about making investments right now? Are they looking for low hanging fruit or are they ready to get out the gold plated diamond encrusted cherry picker?