Associate Professor of Finance
James R. and Helen D. Russell Professor of Finance; Senior Associate Dean for Strategy and Academics
In the early 2010s, economists began noticing a puzzle: the economy was recovering from the recession, yet businesses didn’t seem to be investing as much as they should be in capital assets like real estate, buildings, and equipment.
“Firms’ profits recovered pretty strongly, so we kept waiting for investment to pick up too,” says Janice Eberly, formerly the U.S. Treasury’s chief economist and now a professor of finance at Kellogg.
Economists had expected companies to invest heavily in the years after the downturn, especially in the category of “property, plant, and equipment,” or PPE for short. After all, interest rates were still low, and firms should have been eager to initiate the expensive capital projects—say, building a factory or buying new machinery—that they put on hold while times were tough. “But capital investment never really took off,” Eberly says.
Economists devised various theories as to what had caused the mysterious drop in investment. But “ultimately, a lot of these explanations didn’t work,” says Nicolas Crouzet, an associate professor of finance at Kellogg. So Eberly and Crouzet began to wonder if the investment puzzle may actually reflect a much larger economic trend: that businesses were systematically moving their investments away from physical assets and into “intangible” capital, such as software, intellectual property, and research.
In a new study, Eberly and Crouzet test that theory, finding that for the last 20 years, companies have been consistently shifting their expenditures away from PPE and into intangibles.
And this shift is not merely an economic curiosity. “The increase in intangibles tends to be associated with market concentration,” says Eberly—that is, the trend of industries like healthcare, technology, and consumer retail to become dominated by fewer, larger firms with greater market share.
While this concentration has led to some gains in efficiency, the researchers find that it has also made it easier for some firms to engage in anticompetitive behavior, such as marking up their prices.
What’s more, the shift towards intangibles could make it harder for policymakers to regulate the economy. When companies rely on PPE investment, the Federal Reserve can influence their behavior by adjusting interest rates—but since companies that invest heavily in intangibles rely less on loans, regulators may need to look to new tools for encouraging growth or tamping down inflation.
Eberly and Crouzet examined investment rates across four industry groups—healthcare, consumer retail, high tech, and manufacturing—from 1995 to 2015. (They obtained industry-level figures for these investments from the U.S. Bureau of Economic Analysis.)
They found that tepid levels of PPE investment had actually begun in the early 2000s, predating the financial crisis, and coinciding with a period of rapid growth in the tech industry. They also found that between 2000 and 2015, the actual rate at which companies invested in capital was about 8 percent lower than economists would have predicted—“pretty large,” according to Eberly.
The rise of intangibles may make the economy more resistant to traditional forms of economic policy.
Eberly and Crouzet wondered: Had the missing PPE investment truly disappeared or had it simply been supplanted by intangibles?
“People have looked at intangibles before, but not as an explanation for weak capital investment,” Eberly says.
To test their hypothesis about the PPE investment gap, Eberly and Crouzet needed to track how companies invest in intangibles. However, intangible assets are not typically counted as capital on company balance sheets.
“Basically, accounting standards are a little bit behind on this,” Crouzet says.
“It was kind of a learning experience to realize that accounting data does not reflect the reality of the new economy.”
To get around this problem, the researchers had to sort through the firms’ expenditure data and figure out which expenditures were intangible capital. They ended up assembling a dataset that described nearly 5,000 individual companies’ investments from 1995 to 2015.
But because this dataset was not airtight—“We had to make some judgment calls” about which expenditures were likely intangibles, Crouzet explains—the authors wanted to verify their results. So they also obtained data from the Bureau of Economic Analysis, which they used to capture industry-level investment in intangibles across healthcare, consumer retail, high tech, and manufacturing during the same period.
When Eberly and Crouzet compared both of these measures of intangible investments against the observed investment gap in PPE, the relationship was clear at both the firm and industry levels. “We can explain about two-thirds of that gap using intangibles,” Eberly says. “That’s pretty significant. In our field, when we can explain even 10 percent of a phenomenon, it’s a big win.”
Next, Eberly and Crouzet wondered if the shift towards intangibles was influencing another economic trend: market concentration.
There were several reasons to think these two phenomena may be related. Firms built on intangibles tend to be able to scale faster, which can increase their market dominance. “Amazon can add new products to its e-commerce platform much more easily than you could add new products to a physical production line,” Eberly explains. “And once Amazon has 10 million products, you definitely want to sell there, because that’s where everybody’s looking.”
Furthermore, the protections available for intangibles—such as brand copyrights and patents on R&D—help ensure that nobody else can copy a company’s intellectual property, limiting competition.
Eberly and Crouzet found that, indeed, market concentration within an industry is on average higher when that industry invests more intensely in intangibles. But they found that whether this kind of concentration is good or bad for the economy as a whole depends on the industry.
In consumer retail, for example, market concentration appeared to fall in the “good” column—that is, economies of scale allowed companies to increase their efficiency, while consumers saw no price markups. “Walmart and Amazon are very efficient at what they do,” Eberly explains. “You may not like it, but there is little evidence of price markups.”
Meanwhile, in the healthcare sector—where large pharmaceutical firms maintain significant market power over the prices of certain patented drugs—increased intangible investment was clearly associated with higher markups.
The manufacturing industry saw neither increased efficiency nor price markups, which made sense given that this sector saw a relatively small shift towards intangible investments (and, thus, market concentration). But the high-tech industry showed both effects at once. “Apple can distinguish its phone from lots of other phones and hence charge a higher price,” Eberly explains. “That reflects both its technology and also its market power, because it has a distinct product.”
The rise of intangibles may also make the economy more resistant to traditional forms of economic policy.
When a firm’s growth depends on physical capital, they often need to borrow money or use funds over long periods of time. So by raising or lowering interest rates, the U.S. Federal Reserve can either encourage or discourage those investments, an important lever that policymakers use to pump the gas or brakes on the economy at large. “Incentivizing companies to invest can help lead an economy out of a recession,” explains Eberly, while raising interest rates can help slow the kind of rapid expansion that leads to inflation.
Intangible investments, however, “are much less sensitive to the interest cost,” Eberly says. A high or low interest rate could determine whether or not a steel company chooses to build new factories—but it’s less likely to determine whether or not a software company is able to expand. “You can make innumerable copies of successful software at very low cost, and they also depreciate quickly,” she explains.
Furthermore, unlike a building or a piece of machinery, a firm’s intangibles (such as its logistics system or its brand design) often cannot be easily transferred to another firm. “So it’s much harder to convince a lender to use intangible capital as collateral,” says Crouzet, meaning intangible-intensive firms may be even less likely to rely on loans, and therefore less responsive to interest rates.
Altogether, the tools of policymakers “may not be as powerful as they have been in the past,” Eberly says.
So how might the central bank regain some control over economic levers? If lenders start allowing firms to borrow against their intangible capital, then monetary policymakers “might have more bite,” says Crouzet. (However, he notes, this would require changes that extend well beyond monetary policy—for instance, businesses would need to more widely adopt accounting standards that recognize the value of intangibles.)
At any rate, Eberly says, policymakers need to recognize the new reality they face. “They have to anticipate that the economy will not always behave as it has in the past.”