(Part 1 of this article can be found here.)

Business Investment: 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 0.19 (0.11, 0.02) points to growth in the fourth quarter. With the revisions, it has turned into a fairly significant swing factor from the third quarter when it subtracted 0.09 points and in the second quarter when it added 0.01 points.

Vacancy rates are still 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. The best leading indicator of Non Residential Investment in Structures, the Architects billing index, has now been slightly positive for four straight months now. That, however, has about a nine-month lead time on the contributions to GDP growth.

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.

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 0.54 (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 0.54 (0.39, 0.41) point contribution is still not that bad. As this is perhaps the highest quality source of growth of all, the upward revision is welcome news.

Government

Government spending subtracted 0.34 (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 drag from Government spending indicates that the private sector is now doing it on its own, and this is no longer a stimulus fueled “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 (0.02, 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 spent 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 vs. Non-Defense Spending

Defense spending subtracted 0.12 (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, 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 — however unlikely — these cuts were to make it through the Senate and signed by President Obama, they 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 Governments

State and local governments were a 0.31 (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 can not borrow legally to cover operating deficits, the 0.31 (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 raise 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. Combined, the spending cuts at the state and local level, and the spending cuts at the Federal level, if they go through, are probably the biggest threat to near-term economic growth.

Net Exports

The biggest positive swing by far in the fourth quarter was net exports, adding 3.27 (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 earlier looks is discouraging, but not entirely unexpected after the Trade Deficit rose in December. The trade numbers were discouraging in January, so it is unlikely that we will again see such a large contribution from net exports in the first quarter.

Both sides of the net export equation helped out. The contribution from higher exports rose to 1.06 (1.18,1.04) growth points from 0.82 points in the third quarter and was just slightly below the (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 the President’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 2.21 (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.

In the January trade report, exports were still going strong, so they will add to growth in the first quarter, but the import side surged, and will be a drag on growth in the first quarter. Most of the deterioration in January came on the non-oil side of the deficit. Given the surge in oil prices due to the instability in North Africa, and the Middle East, it is virtually certain that the trade deficit will increase again in February.

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.

Trade Deficit & Oil

About half of our overall trade deficit comes from our addiction to imported oil. Unfortunately, a weaker dollar is not likely to help significantly ion this front, as when the dollar weakens, the price of oil tends to rise.

However, if we can start to replace imported oil with domestically produced energy we could substantially boost the overall rate of economic growth. While ultimately we would want to do that with renewable sources, such as wind and solar, they mostly produce electricity, and oil is mostly used as a transportation fuel. We do, however, have very abundant supplies of natural gas, and the technology for using natural gas as a transportation fuel is already very well established. We need to take steps NOW to transition to the use of more natural gas as a transportation fuel to replace oil.

Ethanol really is not that good of an answer since the production of corn to be made into ethanol for fuel requires using a lot of oil. Our decision to use a very large percentage of the corn we grow for fuel rather than food is a factor in driving up food prices around the world, and those rising food prices have been among the sparks for the unrest. However if we can move to ethanol made from things like sawgrass, or the corn stalks that are left over from the corn harvests, that would be a major step forward. Bio-fuels based on algae are also another promising area.

A weaker dollar would help significantly on the other half of the trade deficit, the part that is made up of all the stuff lining the shelves at Wal-Mart (WMT). “King Dollar” is a tyrant and needs to be deposed. It will help on reducing imports as foreign goods become relatively more expensive and producers fill demand from domestic production. That does not happen overnight, however.

The trade deficit is a far bigger economic problem than is the budget deficit, particularly over the short and intermediate term. The fact that we are making significant progress in bringing it down is extremely welcome news.

Upward Revision Modestly Good News

The upward revision to overall GDP growth is good news, but one should not get too carried away about it. Almost all of it can be explained by less of a drag from inventories, the lowest quality for of growth. On a more subtle level, though, the upward revisions to fixed investment were very good news. The consumer is still doing his part, but not by quite as much as we first thought.

While we want the consumer to be strong right now, it is even better to see strong business investment. Over time that would start to rebalance the economy towards one where we invest and export more, and consume less. That is an adjustment that we clearly have to make, but it is an adjustment that has to be made slowly, over time. The best way for that to happen is to have business investment growing more quickly than government spending.

We have been making good progress on exporting more, but we still import way too much, most notably for oil. Given that we are already the world’s third largest oil producer, and our share of production is more than three times our share of the world’s reserves, we cannot simply drill our way out of the situation. We do however have massive reserves of Natural Gas. Shifting over to more use of Gas (and renewables like Wind and Solar) would go a very long way in reducing our trade deficit and thus boosting GDP growth.

Growing at 3.1% (2.8%, 3.2%) is not all bad, especially when the quality of growth is very high, and considering that Residential Investment is still missing in action. It is higher than the average growth between the second quarter of 2001 (when GW Bush took office) through the fourth quarter of 2007 (when the Great Recession started), of 2.4%. If the entire Bush Presidency is considered, (1Q01 to 4Q08) growth averaged just 1.8%. So far growth has averaged just 1.5% under Obama.

Of course the economy was in a far worse condition when Obama took office than when Bush took office. Obama’s economic policies could not really have had much of an effect on growth in the first quarter of 2009, as the ARRA was not even passed until the quarter was 2/3s over, and he did not even take office until it was almost 1/3 over. If the first quarter of the presidential term is ascribed to the president leaving office, then the average growth under Obama rises to 2.4% and that of Bush falls to just 1.6%.

While the House seems determined to cut spending in the near term, they are doing their best to make the real problem — the long-term structural deficits — worse, not better. The non-partisan CBO has estimated that the Health Care reform will save nearly $1 Trillion over the next decade, so repealing it would add significantly to the long-term structural deficit.

The Bush tax cuts, along with health care costs, are at the heart of the structural deficits. Neither side wants to repeal all of them, but doing so would cut the deficits by $3.7 Trillion over the course of the next decade. That is almost as much as all of the changes suggested by either of the two recent deficit commissions. Repealing the top end of them would put a smaller, but still significant $700 billion dent in the structural deficit (over a decade).

Cutting spending too fast is likely to be counterproductive, just as it has proven to be in the U.K., which recently announced that its economy shrank by 0.5% in the fourth quarter. Granted, they had some crappy weather, but then again so did we in the fourth quarter. The drag from State and Local Government spending is likely to accelerate it in the first quarter, and we do not need to compound that with a major drag from Federal government spending. Having the overall government being a non-factor at this stage of the economic cycle is probably about where we want to be.

Don’t Get Too Excited

All things considered, I would rather see GDP growth revised upwards than downwards, but it is hard to get too excited about this report. First, it is old news. Second and more importantly, most of the upward revisions came from the inventory side. Within the non-inventory part of the economy, on balance there was not much change.

Less contribution from the consumer and more from business fixed investment is, in my mind, an upgrade in the quality of growth, but the quality differential between consumer spending and business fixed investment is lower than the quality differential between inventories and everything else. The smaller contribution from net exports is a diminution in the overall quality of growth. Still, relative to the third quarter, not only was growth higher, it was of far higher quality.   Net-net, I see this as a positive report, but just a minor positive.
 
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