Before the economy turned sour this year, executives at Hercules Inc., a chemical company, had been eagerly preparing to spend nearly a quarter of a billion dollars to modernize and expand its plant and equipment.
With the economy continuing to grow moderately and the market for its wares remaining strong, it had seemed a good time to make such investments. i
A widely diversified, Wilmington, Del., firm, Hercules makes a broad range of products, from plastics to fibers and gragrances. In all, the company was planning to lay out $225 million for capital investment in 1980 -- well above last year's.
But suddenly, in late February and early March, interest rates began to surge and the recession got under way in earnest, prompting Hercules officials to change their minds.
On March 18, the corporation's board announced it was slashing the capital spending budget by $35 million, agreeing to go ahead with only $190 million in new projects. And, depending on the market, more cuts could come later.
"We just didn't like the way the economy was looking," says William W. Bewley Jr., the firm's chief economist, who was in on the decision. "The housing maket was falling fast.We make a lot of paints and coatings."
Hercules situation isn't unique, but it does illustrate one of the perverse effects of a recession:
When the economy turns down, one of the major victims almost invariably is capital spending -- ironically, the very form of investment that's needed to improve productivity and help slow future inflation.
As a result, while in the short run the recession may help ease inflation by dampening demand and reversing inflationary psychology, in the longer run is also will hurt.
The long-run phenomenon is especially significant because, in the current debate among economists, it is exactly what the new "supply-side" school keeps preaching.
When a firm puts off modernizing or expanding production capacity, it deprives itself of the ability to save money on production costs later -- or to meet increased demand when the economy recovers.
Because of that, it almost inevitably ends up having to raise prices more than it would have had to do otherwise.
The cutback in capital spending is almost a certainty in a recession -- no matter how strong investment is at the start or what kind of tax incentives the government provides.
The reason: Companies decide to modernize or expand primarily because they see a potential market for what they will produce. When the market begins to fall off, so does their enthusiasm for long-term investment.
So, today, as the economic outlook continues to worsen, more and more companies are following Hercules' example in canceling orders for vehicles and warehouses. In rural areas, some farmers are killing off their pigs.
"The shape of the market makes more of a difference to business investment than tax incentives and all the like," says Northwestern University economist Robert Eisner, a specialist in capital-spending patterns.
Although Ford administration officials insisted that investment would continue strong through the 1974-75 recession, Eisner points out that capital spending actually plunged 17.5 percent after adjustment for inflation.
With the current recession still in its early stages, the investment cutback hasn't become widespread enough to show up in the statistics, but analysts who monitor capital spending say it may be beginning to slide.
Alan Greenspan, former president Ford's chief economic adviser, argues that while there's no statistical sign of a cutback now, there is "indirect" evidence of some pullback.
Greenspan notes that new factory orders for structural and plate steel -- an early indicator -- fell off in mid-March and apparently have slumped further in April. And capital goods producers report their business has ebbed.
One reason the cutback hasn't begun to show in full is that many capital investment projects, such as new factories or machines, are ordered months or years in advance, and can't be "turned off" easily.
John E. Cremeans, a Commerce Department economist who specialized in investment trends, says it usually takes between nine and 16 months for a recession to have a major impact on capital investment.
The full effect of these cutbacks in adding to the inflation problem comes even later in the cycle, usually when the economy is in a boom period and most needs the increased productivity that such investment would have afforded. m
Hercules' cutbacks so far haven't been major. "We're not stopping any expansion," Bewley says, "and the bulk of our capital spending plan - $190 million -- still is going through."
But the $35 million in cuts includes some labor-saving equipment that could have improved the company's productivity and -- presumably -- helped hold prices down later.
And Bewley's own guess is that the cutbacks will start to spread now, both in his own industry and throughout the economy. "It's just now beginning," he says. "There'll be a lot more."
What can the government do to head off this loss? Analysts point out that President Carter actively sought a recession to help ease inflationary pressures. To give up and spur the economy to soon would only thwart that goal.
Congressional conservatives have been pushing for a "productivity" tax cut -- in the form of new tax incentives designed to spur investment: Increasing the investment tax credit or allowing faster depreciation writeoffs for business.
But Eisner and others still insist that the investment turnaround won't come until firms once again are convinced there will be a market for the goods they produce with their new facilities.
If anything, the liberal economist says, allowing too generous a tax break could well prod firms to undertake less-productive investments that are unlikely to spur productivity. The debate is likely to intensify.
In the meantime, economists are expecting capital investment levels to begin slipping visibly over the next few months as the recession starts to take hold. If so, it could push the economy down even farther.