This is part one of a two-part story on today’s revised GDP numbers. Click here to access Part 2.
This is essentially the same report that I put out when the initial look at GDP was released last month. The new revised numbers are in bold, the original estimates are in normal type and in parenthesis right after them. Thus it will be easy to see where the changes in GDP came from, not just relative to prior quarters, but relative to the first estimate. New commentary will be in italics.
In the fourth quarter, the economy grew at an annual rate of 2.8% (3.2%), up from 2.6% in the third quarter, and up from the 1.7% pace in the second three months of the year. The growth rate was somewhat below consensus expectations of (3.3% for the expected revision) 3.5% and frankly a bit lower than I was expecting. However, the quality of the growth was still extremely high, but not of higher quality than the first look, so overall I would have to say that this was a disappointing report.
So how did we get to the 2.8% (3.2%) overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag on growth? Since the different parts of the economy are of very different sizes, and some tend to be relatively stable, while others can be very volatile, I will focus on the contributions to growth.
In other words, growth points, not the percentage growth rates. After all, a small percentage change in a very big part of the economy can have more impact than a big percentage change in a small part of the economy. To do this I will follow the familiar Y = C + I + G + (X – M) framework, where Y = GDP, C= Consumption, I = Investment, G= Government, X = exports and M = imports.
Personal Consumption Expenditures
The biggest part of the economy by far is the Consumer, or Consumption — or, to be more specific, Personal Consumption Expenditures (PCE). It represented 70.8% of the overall economy in the fourth quarter, and was one of the biggest growth drivers. PCE contributed 2.88 (3.04) growth points, up from 1.67 points in the third quarter and 1.54 points in the second quarter.
The increasing contribution to growth from C is generally a good thing, at least in the short term. Over the long term, our economy is already weighted far to much towards C, and that contribution has been rising over the years. Back in the 1960’s it represented more like 64% of the overall economy.
Our consumption share is also far higher than most other economies in the world. Still, we need consumers to be opening their wallets for the economy to grow, at least in the short term. This is high quality growth, and is very welcome in the current environment. The lower contribution from PCE is a drop (relative to the first look) in both magnitude and quality.
Goods & Services
Consumption can be broken down into two main categories, goods and services. Goods can be further broken down into durable goods, which tend to be big ticket items that will last more than 3 years and Non-Durable goods, which tend to be consumed right away. (For some reason, clothing is categorized as a non-durable good. Clearly the people making those decisions have never looked into my closet.)
Services are by far the biggest part of consumption at 66.43% of PCE and 47.02% of overall GDP. It chipped in 0.68 (0.78) growth points. That is down slightly from contributing 0.74 points in the third quarter and from a net contribution of 0.75 points in the second quarter. This is still a pretty solid increase, but the downward revision here is disappointing.
Services tend to be “produced” domestically, not in China, and also tend to be more labor intensive than goods producing jobs. Normally demand for services is more stable than demand for goods, especially durable goods.
Durable vs. Non-Durable Goods
Within the consumption of goods, consumption of non-durable goods is about twice as large as the consumption of durable goods. However, since people can defer purchase of durable goods like an Auto from Ford (F) more easily than they can defer purchase of a box of corn flakes from Kellogg’s (K), durable goods demand is very volatile. As a result, durable goods tend to “punch above their weight” in determining is the economy is booming or slumping.
Durable goods consumption added 1.44 (1.48) points to growth, up sharply from an addition of 0.54 points in the third quarter and 0.49 points in the second quarter. The high and accelerating contribution from durable goods is exactly what we want to see at this stage of the recovery (well actually it would have been nice to see it earlier, but I’ll take it now).
While clearly it would have been nice to see this revised up, not down, shaving 0.04 points from growth here does not really change the overall picture. The sector is only 12.87% of PCE and 9.11% of overall GDP, yet it contributed 51.43% (46.25%) of the net overall GDP growth in the quarter.
Non-durable goods are 22.78% of PCE and 16.12% of overall GDP. The sector’s contribution to growth rose to 0.76 (0.78) points in the fourth quarter from 0.39 points in the third quarter and 0.31 points in the second quarter. For a “Steady Eddie” part of the economy, this is a nice, solid — and importantly, sustainable — level of contribution to growth.
Overall, the Consumer is doing his and her part in getting the economy rolling again. The strong contribution from the consumer service sector is encouraging. Even though it was revised down, it was revised down less than other areas, and thus actually provided a bigger overall percentage of the growth than it did in the first look. All three parts made solid contributions to growth.
While over the long term we can worry that far too much of the overall U.S. economy is dedicated to consumption, and not enough to investment and exports, for right now we want to see the Consumer alive and kicking. Without a doubt he was in the fourth quarter, but kicking less hard than we first thought.
Investment
Investment tends to be the most volatile part of the economy, and thus is the major reason why the economy either booms or busts, even though it is a relatively small part of the overall economic picture. Overall Gross Domestic Private Investment (GDPI) is just 12.08% of the overall economy. Overall GDPI subtracted 3.13 (3.20) growth points in the fourth quarter, a sharp reversal from adding 1.80 points in the third quarter and 2.88 points in the second quarter.
The decline in contribution from GDPI is disconcerting, at least at first glance. Its shrinkage as a share of the economy was dramatic, in the third quarter it made up 12.93% of the overall economy. However when one looks a bit deeper, the picture is much more encouraging. In fact, I would almost call it a reason for celebration, not despair. The operative word there is “almost.” The diminished drag from Investment all came from the parts of investment we want to see, and thus has to be seen as a positive part of this report.
Investment is the key to future growth and as a share of the economy, it is a much lower share of the overall economy than most other large and developed countries. However, not all investment is of the same quality. Fixed investment, particularly investment in equipment and software, is investment that tends to have a positive return on investment and which then drives future growth.
But not all investment is fixed. If companies build up their inventories, that too is counted for as investment, and it tends to be of very low quality. If companies are simply adding to store shelves, and those goods just sit there, then the investment in inventories will be reversed in later quarters. This is exactly the dynamic we are seeing in the fourth quarter numbers.
The inventory cycle is a powerful driver of booms and busts (recessions from 1946 through the early 1980’s were mostly due to the inventory cycle, or at least had the inventory cycle as one of the major components.
The drawdown in inventories accounted for more than all the overall drag from GDPI. Inventory investment subtracted 3.70 (3.70) points from growth in the fourth quarter. That is a sharp reversal from the third quarter, when higher inventories added 1.80 points to overall growth and from the second quarter when it added 0.82 points to growth.
In other words, in the third quarter, 69.2% (1.80/2.6) of the total growth came from adding goods to the shelves, not from people actually buying the stuff on the shelves. This is very low quality growth, especially when it happens for several quarters in a row, and we had five of them where inventories were a big positive player in providing growth.
Then again, those came after eight quarters in a row where inventories were a drag on overall growth. The big negative contribution from inventories this time around is actually good news and was the major reason that overall GDP growth came in lower than I (and most everyone else) was looking for.
While as we have seen over the last few years, a negative contribution in one quarter does not guarantee a positive contribution to the next quarter, getting a bit of inventory correction out of the way now is a good thing. It potentially sets us up for strong growth in the first quarter. After all, if inventories had just been a non-factor, the economy would have been booming at a 6.5% (6.9%) growth rate (then again the growth rate in the third quarter would have been only 1.0% and in the second quarter only 0.9%, so it can cut both ways).
Residential vs. Non-Residential Investment
Fixed investment can be broken down into Residential Investment (mostly homebuilding) and non-residential (or business) investment. Residential investment has been the major thorn in the side of the economy for a long time now. That changed a bit in the fourth quarter, and we appear to be slowly forming a bottom in residential investment, it being up in two of the last three quarters.
In the fourth quarter, residential investment added just 0.06 (0.08) points to growth, but that is a big swing from the 0.75 point drag in the third quarter. In the second quarter, fueled by the first-time-buyer tax credit, Residential Investment added 0.55 points to growth, but that was a big exception to the recent trend. Residential investment is now just 2.27% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble.
Residential investment has been a drag on GDP growth in 14 of the last 17 quarters. We still have a massive overhang of existing homes for sale (including those in foreclosure, and those which are likely to be foreclosed on). Most estimates of the amount of excess housing available today put it at about 1.5 million housing units (including rentals).
With that much excess supply, building more houses is at one level simply a massive misallocation of resources. On the other hand, residential investment has always been historically one of the most important locomotives pulling the economy out of recessions. That locomotive is derailed this time around.
Residential investment is extremely volatile, and as such tends to “punch far above its weight” when it comes to the overall growth rate of the economy. The lack of residential investment is one of the key reasons that the recovery so far has been so anemic.
Eventually, population growth and new household formation will absorb the inventory overhang, and residential investment will pick up. That, however, it not going to happen right away. Still, starting from such a low level, it seems likely that Residential Investment is likely to be a positive contributor to growth in 2011.
While housing starts did pick up in January, new home sales continue to be dismal. I would not be looking for a big positive contribution from residential investment in the first quarter, but perhaps more positive than the 0.06 in the fourth quarter. We should see better positive contributions from residential investment in the second half of 2011 and even more so in 2012.
However, simply not being a major drag on the economy is a major turn for the better. That bump is almost entirely a function of just how small residential investment has become as a share of the overall economy. The overall bottoming process in residential investment is not over, and it will be a long time before it returns to its historical norm of about 4.4% of the overall economy. However, as it does, it will set off some very strong economic growth.
Structures vs. E&S
Non-residential, or business investment can also be broken into two major parts: investment in structures, such as new office buildings and strip malls, and investment in equipment and software. Investment in structures added 0.11 (0.02) points from growth in the fourth quarter, so it was sort of a non-factor, just as it was in the fourth quarter, when it subtracted 0.09 points and in the second quarter when it added 0.01 points.
Vacancy rates are still extremely high in almost all areas of the country, and in almost all major types of non-residential real estate. We simply don’t need to be putting up a lot of new commercial buildings right now. On the other hand, as the economy improves, we are starting to see some signs of those vacancies being absorbed, and prices for commercial real estate seem to be starting to firm up.
On balance, investment in non-residential structures is likely to be close to a non-factor again in the first quarter. If I have to guess, it will probably be on the positive side, but only slightly. Later in the year and into 2012, it is more likely to be a significant positive force for economic growth, but not yet.
The best leading indicator of business investment in structures is the Architectural Billings Index. That has recently moved up to a neutral reading of 50 after a long period of being deep in negative (below 50, it is constructed as a “magic 50” index like the ISM) territory. That suggests to me that it should be a minor positive contributor to growth in the second half of 2011.
Investment in equipment and software (E&S) is what we really want to see to power future growth, and there the news continues to be good, but not quite as good as earlier in the year. E&S investment added 0.39 (0.41) points to growth, which is not a bad showing since it is only 7.11% of the overall economy. It is down, however, from a 1.02 point contribution in the third quarter and a 1.52 point contribution in the second quarter.
This is the seventh quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.43% of the overall economy. That increase is highly encouraging, but we need to see it continue it climb as a share of the overall economy. This is probably the highest quality form of growth out there, as it is growth that feeds future growth. I would prefer to see even more growth coming from this front, and don’t like the declining trend, but a 0.39 (0.41) point contribution is still not that bad.
As with durable goods, I would have loved to seen this component revised up, not down, but shaving 0.02 points from its growth contribution does not really change the overall picture. Yesterday’s Durable Goods report was discouraging with regard to the likely contribution from E&S spending in the first quarter, provided it is not substantially revised.
Government
Government spending subtracted 0.31 (0.11) points from growth in the fourth quarter, down from a 0.79 point addition in the third quarter, and a 0.80 point addition in the second quarter. I should point out that in the GDP accounts it is only government consumption and investment that is counted as part of G. Transfer payments, such as Social Security, are not included. They tend to show up as part of PCE when Grandma spends her check.
What is counted is what the government pays in salaries to its employees (both civilian and military) and its spending on goods, from highways to fighter aircraft. The slight drag from Government spending indicates that the private sector is now doing it on its own, and this is no longer a stimulus fuelled “sugar high” of growth. At least not one fueled by direct government purchases and direct government employment.
Some of the stimulus shows up in the PCE line due to transfer payments and tax cuts. Remember that over one third of the ARRA was in the form of tax cuts. Thus if you want to argue that the ARRA was a failure in stimulating the economy, you have to conclude that tax cuts don’t stimulate economic growth.
The Federal government was a non-factor in the fourth quarter’s growth, subtracting 0.02 (0.01) points from growth. That is down from adding 0.71 points to growth in the third quarter and from the 0.72 point contribution in the second quarter. Overall Federal Government spending, as defined in the national income statistics, was 8.33% of the economy in the fourth quarter. Of that, 67.09% was spend on Defense, and 32.91% was on Non-Defense spending.
Put another way, just 2.74% of the overall economy is non-defense federal spending (excluding transfer payments) and 5.59% of GDP is spent on Defense.
Defense spending subtracted 0.12 (0.11) points from growth, down from a contribution of 0.46 points in the third quarter and 0.40 points in the second quarter. The non-defense contribution was 0.10 (0.10) points, down from a 0.25 in the third quarter and a contribution of 0.32 points in the second quarter.
Anyone who suggests that it is possible to cure the budget deficit by only cutting non defense spending excluding transfer payments like Medicaid and Social Security is someone who quite simply should stay off of Jeff Foxworthy’s show, since they clearly are not smarter than a fifth grader.
Social Security has its own dedicated revenue source, and has been running a surplus every year since 1983, and has thus been subsidizing the rest of the Federal Government. With Social Security, Medicare/Medicaid, Veterans Benefits, Defense and interest payments off the table, cutting $60 billion or more from the rest of the fiscal 2011 budget — as the House recently did — means dramatic cuts to the rest of the government.
If (unlikely as it is) they were to make it through the Senate and were signed by President Obama, those cuts would have a significant negative effect on economic growth in the second and third quarters. Federal non-defense spending would become a major drag on the economy, probably to the tune of over 1.00 growth points. That lower growth would result in lower tax revenues, which would mean that the net impact on the deficit would be far less than the $60 billion advertised.
State & Local
State and local governments were a 0.29 (0.10) point drag on the overall economy, down from a 0.09 contribution in the third quarter, and a 0.08 point contributor in the second quarter. Frankly, given the severe fiscal problems that most of the states are facing, and since they cannot borrow legally to cover operating deficits, the 0.29 (0.10) drag is a major positive surprise, although the revised number is more like one would expect.
A big part (apx. 23%) of the ARRA has gone to helping State and Local Governments to help them avoid having to either cut spending drastically or rise taxes. The ARRA funding is starting to dry up. I would expect that S&L government spending will be a drag on growth in first quarter GDP and that the size of the drag will increase, but it will not be enough to really slow down the overall economy.
The drama going on in Wisconsin is not going to be enough on its own to make a major impact, but it replicated across the country it would. The 8% cut in take-home pay (in the form of higher contributions by the employees for pensions and health insurance) for state employees has been agreed to by the unions. Thus it will probably happen, regardless what happens to collective bargaining rights. Those employees will undoubtedly respond by lowering their spending, and thus slow the economy. Economically it is the same thing as an increase in taxes, it just happens to fall entirely on people who work for the government.
Net Exports
The biggest positive swing by far in the fourth quarter was net exports, adding 3.35 (3.44) points to growth. In other words, if we had not had an improvement in the trade deficit in the fourth quarter, the economy would have actually fallen in the fourth quarter. That is a huge improvement over the 1.70 point drag in the third quarter and the massive 3.50 point drag net exports were in the second quarter.
To some extent, this is a bit of the flip side of the inventory swing, since some imports go into inventories. Still, this is extremely good news, and represents very high quality growth. The lower contribution from net exports relative to the first look is discouraging, but not entirely unexpected after the Trade Deficit rose in December.
Both sides of the net export equation helped out. The contribution from higher exports rose to 1.04 growth points from 0.82 points in the third quarter and was just slightly below the 1.18 (1.08) point contribution in the second quarter. The U.S. has actually been doing quite well on the export front, and we are well on our way to meeting Obama’s goal of doubling our exports from 2009 to 2014.
That is very nice, but when it comes to GDP growth, it is net exports that count, not just exports alone. If our exports double, but our imports also double, we will be in a deeper hole than if both had remained unchanged. It is the import side that was the massive swing factor. Each dollar of imports is a subtraction from GDP, so falling imports is a very good thing from a GDP accounting point of view. Falling imports added a stunning 2.17 (2.40) points to growth in the fourth quarter, a massive turnaround from being a 2.53 point drag in the fourth quarter, and a 4.58 point drag in the second quarter.
Can that sort of contribution be sustained? That is a hard question to answer. A weaker dollar would sure help the cause, and there is plenty of room for further improvement. Net exports are still a huge drag on the economy, just less of a drag than they were.
Our trade deficit is still unsustainably large. On the other hand, I would not count on a repeat of this sort of massive contribution again in the first quarter or for 2011 as a whole. About half of our overall trade deficit comes from our addiction to imported oil. Unfortunately, a weaker dollar is not likely to help significantly on this front, as when the dollar weakens, the price of oil tends to rise.
Of course, oil prices can rise for reasons other than a weak dollar. Turmoil in oil-producing regions can also do the trick, as we have seen over the last few weeks. The higher oil prices we have seen so far are not enough to turn net exports back into a drag on the economy, but they sure could cut into the positive contribution.
This is part one of a two-part story on today’s revised GDP numbers. Click here to access Part 2.
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