FRBSF Economic Letter
2005-13; June 17, 2005
IT Investment: Will the Glory Days Ever Return?
Investment in information technology
(IT)—that is, business spending on computers, communications
equipment, and software—has
featured prominently in the ups and downs of U.S. economic
growth over the last decade. In the late 1990s, double-digit
growth in IT investment contributed significantly to high
GDP and productivity growth rates. And in 2001, the sharp
contraction in IT investment helped lead the economy into
recession.
While the growth in IT investment has picked
up during the recovery and expansion, it has not regained
the very
rapid pace of the glory days of the late 1990s. Will
those glory days ever return? In exploring this question,
this
Economic Letter looks at one of the main drivers behind
the earlier strength in IT investment—the falling prices
of IT goods, which themselves were brought about by rapid
technological advances in the field. The good news is
that some evidence suggests that continued advances should
help
real IT investment achieve rates of growth that exceed
the growth in other investment goods; however, at the
same time, there are reasons to think that growth in IT
investment
is likely to be more subdued than in the late 1990s.  Falling IT prices and "real" vs. nominal
IT investment
While
many factors may affect IT investment, Doms (2004)
has identified the falling prices of IT goods as a major
driver in the IT investment surge of the late 1990s.
As Figure 1 shows, the prices of IT goods have fallen
extremely
quickly, while the prices of other goods (represented
by
the GDP deflator, a measure of general price inflation)
have risen modestly. For example, according to official
statistics, businesses would have needed to spend $1,963
on IT goods in 1995 for what they could have purchased
for $1,000 in 2004 (and there are reasons that this
figure is understated), implying that prices of IT goods
fell
at an average annual rate of 7.4%.
Real IT investment is
the amount of money spent on IT goods adjusted for the
prices of IT goods. Thus, given the falling
IT prices, the differences in the growth rates for nominal
and real IT investment can be large; in fact, real IT
investment can be rising while nominal IT investment is
falling. Therefore,
when discussing how strongly IT investment is growing,
it is important to delineate clearly between nominal
and real investment. Although the business community, especially
those firms that produce and sell IT goods, tends to
focus
on nominal investment, that is, how much money is actually
being spent, the relevant consideration for real GDP
growth is real investment in IT.
 Figure 2 shows that growth in
real IT investment was especially strong between 1995
and 2000, averaging 24% per year and
adding an annual average of over 0.8 percentage point
to the growth in real GDP. Real IT investment contracted
sharply
in 2001, falling nearly 11%. Since then, real IT investment
has picked back up—for instance, in 2004 real IT investment
grew 15.6 percent, contributing 1/2 percentage point
to GDP growth—but it has not returned to the phenomenally
high growth rates of the late 1990s.
Will IT prices continue to fall?
Prices for IT goods reflect
both improvements in the quality of those goods and
the combined effects of the supply of
and the demand for them. The price declines for IT
goods witnessed over the decades have been largely driven
by
sharp increases in supply, which reflect, in part,
the tremendous leaps in IT technology. Looking ahead
then,
what happens to prices of IT goods will depend on the
pace of technological innovation. Although forecasting
technological
innovation is difficult and fraught with peril, there
is evidence on spending for research and development
(R&D)
that suggests some promise for a reasonably rapid pace
of technological progress in that field going forward.
In
2002 (the most recent official data from the National
Science Foundation), R&D in the computer and software
industries totaled over $46 billion, making up almost one-fourth
of all private sector R&D, which is near the same level
as in the late 1990s and into 2000. This large sum of R&D
spending is likely to produce innovations that will result
in falling IT prices and an increase in the amount of IT
goods demanded by businesses.
Take, for example, the effect
of R&D spending on semiconductors.
Research has shown that advances in the design and production
of semiconductors have played an important role in the
price declines of computers and communications equipment.
One aspect of the technological advances in semiconductors
is the size of individual chip components. Over time, these
components (that is, individual transistors) have become
smaller and smaller; the smaller the components, the more
chips that can be etched onto a wafer, the greater the
number of components per chip, and also the faster those
chips are able to run. The International Technology Roadmap
for Semiconductors (ITRS) (2004) noted that the shrinking
of the size of the components on microprocessors and dynamic
random access memory chips accelerated in the second half
of the 1990s, the period when prices for IT goods also
fell very rapidly. Using the terminology of the ITRS, the "technology
node cycle"—a rough measure for the length of time
it takes for components to shrink by 50%—shifted from
three years to two years in the late 1990s and remained
at two years through 2003.
Looking ahead, the ITRS expects
the technology node cycle to revert back to three years,
a pace that is still very
rapid. The continued shrinking of components should allow
for further declines in the cost of producing chips and
also allow new and better chips to be designed, both
of which will result in falling prices. The changing response
to falling IT prices
Although the future of innovation appears fairly bright
for IT goods, there remains a question of how nominal
IT investment will respond to lower prices (recall that
real
investment depends on nominal investment and prices).
This response to price changes is called the "elasticity" of
demand. The demand for a good is more elastic if people
are willing to increase their spending on it by more than
the amount by which the price of the good has fallen.
 Business
demand for IT goods during the 1990s appeared to be very
elastic; prices for IT goods fell and nominal
spending on IT goods surged; indeed, it surged faster
than spending on other investment goods. Because nominal
spending
on IT grew so quickly, the share of total investment
spending going to IT goods increased rapidly during the
1990s, as
shown in Figure 3. In 1990, nominal investment in IT
goods totaled $132 billion, a bit less than one-third of
private
nonresidential equipment and software investment (E&S).
By 2000, IT investment stood at $402 billion and its share
of E&S investment peaked at 44%, the height of the
high-tech bubble. Since then, the IT share has drifted
down, reaching 41% by the end of 2004.
The drop in IT's share of E&S investment since 2000
could be preliminary evidence that the demand elasticity
for IT investment goods has diminished, that is, that future
nominal demand will be less responsive to lower prices
than it was in the past. Why would the elasticity change
over time? One reason is that the IT sector has matured.
During the 1990s, there was a tremendous buildout of new
computer and communication networks and the initial adoption
of many software programs. Relative to the 1990s, the rate
of diffusion of IT has certainly slowed, damping investment.
Now when IT products are introduced, firms respond by upgrading
their existing IT technology, but the boost from firms
delving into IT has likely been lost.
Summary
Technological progress in the IT area will likely continue
to lower the prices of IT goods, which in turn helps
boost IT spending. However, as the IT industry has
matured, the
response of business spending on IT goods for a given
change in prices may have become more muted recently,
suggesting
that nominal spending on IT goods may not increase as
quickly as it did in the late 1990s. Consequently,
real spending
may also grow at historically modest rates, though strong
relative to other investment goods whose prices do not
fall as fast. Mark Doms
Senior Economist
References
Doms, Mark. 2004. "The Boom and the Bust in Information
Technology Investment." FRBSF Economic Review 2004,
pp. 19-34.
http://www.frbsf.org/publications/economics/review/2004/er19-34bk.pdf
International
Technology Roadmap for Semiconductors. 2004. 2004
Update: Overview and Summaries.
http://www.itrs.net/Common/2004Update/2004Update.htm
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
|
