From: Gerald_A_Levy@MSN.COM
Date: Thu Dec 23 2004 - 10:21:12 EST
Michael P, Thank you for forwarding the section of your book on Keynes re _Empirical Limits to the Study of the Replacement Investment_. I think it was a very good critical survey of the literature on the importance of and problems associated with empirically measuring replacement investment. Did you, though, forward the _wrong_ section of that book? I ask that question since the section you sent does _not_ seem to support the conclusion that "the empirical evidence is that replacement investment does take place more vigorously during downturns, when competitive pressure is strongest." Rather, as the title suggests, it explains the empirical _limits_ to the study of that subject. Indeed, this entire section could be read as a caution against drawing _any_ 'stylized facts' from the empirical data because of the many measurement and definitional problems with the very incomplete and unsatisfactory data which is available (some of those problems are excerpted below). While there are useful and interesting microeconomic examples of replacement investment -- unless I have missed something -- there is no assertion one way or the other by you based on macroeconomic data that the pace of replacement investment occurs more rapidly during contractionary periods. In solidarity, Jerry [...] The exact nature of the replacement decision should be a matter of interest for those who frame economic policy, especially considering the lip service paid to economic modernization. Yet, despite the elegant mathematical tools and the extensive data bases available to economists, we know astonishingly little about actual replacement practices. [...] The difficulty of pin‑pointing the act of scrapping adds a further complication to the analysis of replacement investment. [...] For the aggregate economy, replacement of capital goods is not equivalent to retirement. Many capital goods find their way to second‑hand markets. Plant and equipment, no longer used for their original purpose, are frequently put to other uses or worked less intensively (Foss, 1981a, 1981b and 1985). The inclusion of the multitude of options for redeploying replaced capital goods blurs the boundaries between replacement and expansion. For example, British firms report difficulty in distinguishing the replacement from improvements in technique (Barna, 1962, p. 31). Even when old capital is no longer actively used, it may continue to serve as an inventory of capacity to meet possible future peak load needs (Oi, 1981). [...] Firms may hold what appears to be excess capacity one moment only to face backlogs the next (De Vany and Frey, 1982; see also Steindl, 1976, p. 8). The incentive to use capital rather than labour to meet sudden increases in demand depends, in part, upon the ratio of capital costs to labour costs. For example, in the textile industry where labour is a relatively small fraction of total costs, surges in demand tend to be met by increasing labour inputs rather than capital. By contrast, in coal mining where labour costs are relatively high, industry meets demand shocks by moving pits on‑ and off‑line (Rowe, 1928, pp. 10‑2). [...] In addition to the complications associated with the various possibilities for replacing obsolete capital goods, the common empirical measures of the existing capital stock are seriously flawed. Until recently, imported capital goods were not included in the measures of current investment in the US. [...] Although economists are trained to count in terms of monetary values, satisfactory monetary values are often unavailable except for newly purchased capital goods. Once capital is installed, indicators of its value become increasingly unreliable. Accepted accounting practices are almost entirely based on cost rather than the actual values of installed plant and equipment (Beidleman, 1973, p. vii). Thus, accounting values bear little relationship to the actual economic values (Beidleman, 1976; F.M. Fisher and McGowan, 1983) unless depreciation rates track the actual economic deterioration of plant and equipment. To construct such depreciation formulae is all but impossible. It would require the relative values of two vintages of machines to be independent of changing price ratios. [...] Even if such depreciation formulae could be devised, they probably would not be used. Allowable depreciation is determined as much by political as economic considerations. The book value of much of the old plant and equipment will tend to be insignificant, having been either all, or mostly depreciated away. Such discrepancies are of major importance in the study of scrapping. [...] Government estimates of capital stocks are unsatisfactory. They are constructed on the basis of the perpetual inventory method, which determines the capital stock each year by adding the difference between the value of new investment and an estimate of the annual depreciation of existing capital goods. Unfortunately the assumed pattern of depreciation is based on a predetermined economic life for each category of investment goods, usually based on Bulletin F of the Internal Revenue Service (first published in 1931) or Winfrey's 1935 study, developed from mortality curves compiled by workers at the Engineering Experiment Station of Iowa State College during the 1920s and 1930s (Winfrey, 1935). The capital is then assumed to depreciate according to some fixed pattern, such as double‑declining balances or straight line depreciation. [...] The estimated lifetime of capital introduces further bias in the aggregate depreciation figures. [...] An error of one‑third in the assumed asset life of capital alters the estimated size of the capital stock by about one‑third (Redfern, 1955, pp. 142‑7). The economic lives used for tax purposes often are unrelated to the actual economic lifetime of the plant and equipment. By the time a machine tool is scrapped, three entire generations of tools can be written off (Beidleman, 1976). Feldstein and Rothschild note that the basis for the 1942 edition of Bulletin F lives was never published, although the estimated lives were based on Winfrey's work, as well as conferences with industry and statistical studies (Feldstein and Rothschild, 1974). Even so, these estimates of capital goods lives are not sufficient. For example, Hickman questioned the accuracy of Bulletin F, speculating that the standard of obsolescence applied during the 1930s was atypical because plant and equipment might be less readily scrapped during a depression (Hickman, 1965, p. 241). In fact, a depression may actually shorten the life of capital goods, creating more incentive for scrapping and less for the renewal of plant and equipment (Boddy and Gort, 1971; and Eisner, 1978, p. 182). [...] In effect, the permanent inventory method of calculating capital stock suggests that the retirement of capital is a wholly technical decision, unaffected by prevailing economic conditions. It presumes that no matter what sort of shocks occur, the relative prices of different vintages of capital goods will remain unaffected. The weakness of such assumptions is obvious. You do not have to be a firm believer in the Kondratieff cycle to suspect that technical change does not always evolve regularly, but often seems to come in spurts. Sometimes it will be concentrated in specific industries. At other times, it will be more evenly distributed among industries. In addition, capital decays faster when it is utilized more intensively (Keynes, 1936, pp. 69‑70; Marx, 1977, pp. 527‑9). Certainly statistical evidence indicates that failure rates do rise with capital use (Davis, 1952; Jorgenson, McCall and Radner, 1967). [...] Are we to believe that capital equipment is kept in operation for a fixed period of time, regardless of the prevailing long‑run macro‑economic conditions? Otherwise, the permanent inventory procedure is unjustified for estimating both the capital stock and models of investment. Yet every empirical study of which I am aware suggests that the capital stock decays irregularly. Most observers agree current economic conditions affect the scrapping decision. [...] The decision to scrap a vessel will depend very greatly on anticipated movements of freight rates and the rising trend of repair costs with increasing age ... A sudden increase in the demand for tonnage at a time when new building cannot be increased is likely, therefore, to give rise to some postponement in the scrapping of those types of tonnage in demand, almost irrespective of age. (Parkinson, 1957, p. 79) [...] Ryan found that in the Lancashire cotton industry between 1860 and 1838, 38 per cent of the machinery replacements occurred in the boom years 1906‑1908, 1912‑14, and 1919‑21 (Ryan, 1930, p. 576). Feldstein and Foot wrote: 'Expansion investment causes an offsetting fall in replacement investment, supporting the view that firms postpone replacement during periods of expansion investment and accelerate replacement when there is less expansion investment' (Feldstein and Foot, 1971, p. 54). This conclusion must be taken with a grain of salt, based on the justifiable criticisms of their estimates by both Jorgenson and Eisner (Jorgenson, 1971, p. 1140; Eisner, 1978, pp. 175‑88), which I will discuss later. [...] The unsatisfactory measures of the capital stock substantially complicates the analysis of replacement investment. [...] The figures shown in Table 3.1 are far from perfect. They depend upon voluntary information based on the book values of capital goods replaced. [...] Although considerable information is collected regarding aggregate gross investment, scrapping rarely leaves a satisfactory paper trail. [...] In the absence of any useful public data base, researchers depend on access to private records. [...] Terborgh suggested that purchasing capital goods is akin to participating in a futures market for capital services (Terborgh, 1949, p. 29). A hypothetical futures market for capital services differs from actual futures markets since spot markets for capital services do not generally exist. Futures markets typically develop for widely traded, homogeneous commodities. Most capital services, or even capital goods, are neither widely traded nor homogeneous. Existing futures markets are difficult enough to predict, but the hypothetical futures market for capital services would be even more complex. [...] If firms have a high liquidity preference, they will hoard their money. Sellers of capital goods will have to lower their price to entice other firms to part with their funds. Future values of capital services, reflected in the values of newer capital goods, will be very low relative to the value of current capital services.
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