So, the US is on the mend, they say ? but what about the invisible cut-backs?

Author: By Michael Mandel

This number was greeted by many economists as confirmation that the recession
is over. The rise in real GDP, combined with a sharp fall in employment in
the third quarter, implies that productivity also soared during the period.
Good news, right?

The trouble is that those GDP and productivity growth figures are probably
overestimated by as much as 1 percentage point or more.

That’s because the official statistics don’t pick up cutbacks in “intangible
investments” such as business spending on research and development,
product design, and worker training. There’s ample evidence to suggest that
companies, to reduce costs and boost short-term profits, are slashing this
kind of spending, which is essential for innovation. Yet you won’t see that
plunge reflected in the GDP and productivity statistics, which are focused
on traditional sectors, such as motor vehicles and construction.

In effect, government statisticians are trying to track a 21st-century bust
with 20th-century tools. Not only is that distorting the critical data that
investors, policymakers, and corporate executives use to evaluate the
economy, but it might also be creating a false sense of relief as Americans
battle a brutal recession.

Here’s a sobering sign that firms are robbing the future to pay for short-term
profits: Over the past year, US employment of scientists and engineers ? the
people who create the next generation of products and make the US more
competitive in the long term ? has fallen by 6.3 per cent. Yet overall
employment has fallen just 4.1 per cent.

That’s a big problem, because the output of such well-educated workers has
become a more important part of the American economy in recent years. New
research by the University of Maryland suggests intangible business
investment came to roughly $1.6trn in 2007, compared with about $1.2trn
spent on tangible assets such as machinery and buildings. In 1995, the two
were roughly equal. Going back further, tangible investments in 1985 were
about 40 per cent larger than intangibles.

America’s Bureau of Economic Analysis is taking steps to deal with the new
realities. Software has been treated as investment since 1999, and the BEA
plans to include R&D in the official GDP statistics in 2013. But the
agency acknowledges that other areas of intangible investment still need to
be worked into the numbers. “We think it’s important not to ignore the
fact that R&D is only part of broader innovative activity,” says
BEA director Steven Landefeld. For now, though, the US is navigating through
the downturn with fragmentary information.

While the statistics don’t account for it, there’s good reason to suspect
intangible investments are falling. Companies are under pressure to cut
costs by reducing R&D expenditures and deferring other crucial
intangibles.

At the same time, companies, especially those in the pharmaceutical industry,
are moving more research to China, India, and elsewhere. They don’t want to
commit to costly investments if the economy remains weak.

One clear sign that GDP growth is being over-estimated is the sharp drop in
venture-capital investment, which goes directly to new businesses. VCs
invested about $12bn in the first three quarters of 2009, barely half the
$22bn invested during the first three quarters of 2008. Some of this
shortfall would have been spent on computers and other physical equipment,
which would have been picked up in GDP. But most of the drop in VC money
would have gone to pay for scientists, engineers, and new product
development.

Similarly, many companies have taken a deep axe to reported R&D spending,
which doesn’t show up in GDP. Adding to the uncertainty, firms report their R&D
only on a global basis. So, even though some are adding to such spending,
there’s no way to know how much of the increases take place in the US.

The stimulus package passed in February did include extra government funds for
R&D. But even with this bump, a just-released analysis by the Democratic
Leadership Council suggests total real spending on US R&D is falling for
the second straight year. The labour market in particular shows the effects
the fall in intangible investment is having, and it’s not a pretty sight. In
the manufacturing sector, non-production jobs ? which include engineers,
scientists, and other knowledge workers ? declined at a 7.6 per cent annual
rate in the third quarter, almost twice as fast as the loss of production
workers.

Another big problem not reflected in the GDP statistics is that firms are
retreating from development of new products, especially in stressed
industries. Richard Shellabarger, 59, was a product development engineer.
Before being let go in February he was working on the “next-generation
air bag”. He says: “I was trying to anticipate what the customer
needed.” In retrospect, Shellabarger worries that product development
wasn’t a good place to be in a downturn. “I suppose if you are looking
to cut personnel, you don’t want to short an area where you are delivering
to customers right now.”

R&D isn’t the only type of intangible investment that seems to be
declining. US companies spend $134bn worldwide on worker training ? but they
have been cutting back. The drop started in 2008, when employers reduced
their per-worker “learning expenditures” by 3.8 per cent,
according to the American Society for Training & Development. But some
alternative sources of training are emerging. Autodesk, maker of AutoCAD
design software, has started allowing unemployed architects, artists,
designers, and engineers to download free student versions of many of its
products to help them hone their skills while they’re out of work.

Governments, too, are stepping up funding of training. Stony Brook University,
part of the State University of New York, recently tapped federal stimulus
funds to begin training displaced finance professionals for certifications
in fields such as project management.

Measuring intangible investments such as business R&D and worker training
isn’t easy ? which is one reason why government statisticians haven’t yet
done it. But including such expenditures could make a big difference in the
way companies, investors, and others understand the economy.

Will intangible investments revive soon? Josh Albert of recruitment
consultancy Klein Hersh notes that some firms are starting to hire
biologists again. “It’s the beginning stages of commitment to discovery,”
he says. But that uptick is likely to be negated by two big mergers in the
pharma sector, which will result in huge layoffs and cuts in R&D. The
hookup of Pfizer and Wyeth closed on 15 October, and the merger of Merck and
Schering-Plough is expected to close in the fourth quarter.

Another major trend that will affect intangible investment in the US is
outsourcing. “Companies want us to recruit foreign nationals from the
US to work overseas,” says Mr Albert. In effect, more and more of the
global R&D dollar is being spent abroad, so imports of R&D are
increasing.

This shift in intangible investment is also not well tracked by the GDP
statistics, although it will depress employment of scientists and engineers
in the US. But the economic impacts are murky. Corporate executives have
argued that shifting R&D to China and India benefits the US by improving
the efficiency of the research process. If you can pay two trained
scientists in China the same as one in the US, they say, you can get twice
as much research output.

For now, it’s enough to note that the difficult environment for knowledge
workers means GDP statistics are sending too rosy a message about the
economy. And as the old saying goes: “If you can’t measure it, you
can’t manage it.” Until that improves, it’s going to be difficult to
know if the US is really on the road to recovery.

This article was first published in Business Week

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