We've spent some time discussing the current slump in the housing market in recent months, and we don't know how long it will last. But it may not be the big threat to the economy that everyone is making it out to be. When the housing market slumps, it has a huge effect on consumer spending-slowing it way down. But even with the builders' challenges, lowering home prices, and the fallout of subprime mortgages, which all have troubling effects on the housing market, we may be facing something more troubling in business capital spending.

    Business spending may be a significant overlooked risk to the Fed's forecast of moderate economic growth this year, economists say. When spending growth tapers off, a slowdown in hiring almost always follows. That's important, because when businesses expand their operations they also add to their payrolls. Job growth over the past couple of years has been the primary support under consumer spending, so any sharp slowdown in capital spending would most likely have an even broader impact on consumers than the weakness in housing. The combination might force the Fed to shift its focus more toward shoring up growth.

    Here's some data, courtesy of BusinessWeek magazine, to back this up. Inflation-adjusted expenditures for things like computers, heavy machinery, factories, and warehouses grew only 3.9 percent per quarter during the final three quarters of 2006, after increases averaging 8.2 percent in the previous three quarters. Spending in the final quarter of 2006 dropped for the first time in almost four years, and there's more weakness to come. In January and February, orders for capital equipment fell sharply, putting them far below their fourth-quarter level and suggesting the economy will struggle to reach a 2 percent growth rate in the first quarter.

    What is interesting about this weaker spending pattern is that it has occurred during a period when the fundamental drivers of business investment have been generally strong. Based on robust earnings and record profit margins, the prospective returns on new plants and equipment have been high, even as investment costs have been low. The cost of borrowing in the credit markets remains relatively cheap, and banks, on balance, have not tightened their lending standards for their corporate customers. Companies are also showing exceptionally high levels of corporate cash and solid balance sheets.

    This is telling us that businesses are using a lot more caution in capital spending. Companies have been rocked by one uncertainty after another since 2000, including recession, corporate scandals, terrorist attacks, war, and a tripling of oil prices. The latest round of worries began last year amid growing fears that the housing recession would spread to the rest of the economy. Those concerns have been reinforced by the subprime loan debacle and another bounce in the price of oil back to more than $60 per barrel.

    On February 27, the stock market took a big dip after hearing about the big subprime mortgage mess. Since that date, business executives are less optimistic than in previous years. Those attitudes are driven by real estate woes and a nearly 20 percent resurgence in gasoline prices since late January.

    The current slowdown in capital spending is actually part of a longer-term hesitancy on the part of businesses to expand their plants and equipment. Throughout this five-year expansion, the growth in outlays has failed to match the pace of the 1990s expansion, even prior to the boom late in the decade.

    Companies are spending less on their internal equipment. According to Federal Reserve data, the amounts of money non-financial corporations have spent on equipment and software hasn't grown any faster than that sector's gross domestic product. That suggests the 4.4 percent growth rate in equipment outlays in 2006, the slowest in three years, has been insufficient to keep up with the rate at which old computers and machines are wearing out.

    Companies aren't only wary about spending. They also seem unwilling to borrow for anything other than financing stock buybacks and taking their businesses private. Recent Fed data shows non-financial corporations last year, on net, retired a record $602.1 billion in equity. Companies seem interested in cutting their overall cost of capital, but that isn't translating to wanting to take advantage of cheaper capital to invest in expanding their operations.

    So, why are we seeing this apparently paradoxical situation? A plausible explanation is that businesses are indeed acting more prudently, especially in light of the heavy demands investors have placed on companies to perform. Capital-spending decisions depend most crucially on prospects for demand, which has slowed in recent quarters, with little to suggest a pickup. Recent news that sales of new single-family homes plunged to the lowest level in more than six years, along with new evidence of falling house prices, only reinforces the perception that demand is softening.

    This might have something to do with profit expectations as well. Businesses may be worried that the profit they have been able to make throughout the past few years is about to slow down, and they could be right. With labor markets tightening and productivity slowing, the cost to produce goods is going up-much faster than the rise of actual prices. That means the profit margin on many goods and services is getting squeezed, a factor that could hammer earnings as revenues slow.

    That might already be happening. Public companies publish their earnings expectations in advance, and many companies make announcements throughout the year to tell the public how well they are doing compared to their expectations. The ratio of negative to positive earnings pre-announcements for the companies in the Standard & Poor's 500-stock index for the first quarter of 2007 is running at 3.3, according to Thomson Financial. That is, for every pre-announcement by a company saying it will beat its earnings expectation, more than three companies expect to miss their projections.

    Even though the United States is experiencing a housing recession, the factors influencing it are merely ancillary to the bigger issue of capital spending. According to Federal Reserve Chairman Ben Bernanke, the U.S. economy actually is expanding, even in light of these negative aspects. The key to the influence of this economic expansion will be the spending decisions of U.S. businesses and, in coming months, they will continue to act with marked prudence until they see proof that the economy is solid.