This is a revision to the post I put up when the first cut at the GDP report came out on 10/30. In it the new numbers are in bold and the original estimates are put in parentheses, thus a number in parentheses does not mean that it has a negative value (those will have a minus sign in front of them, numbers relating to the first or second quarters are left unchanged. New text will be in italics. This should give the reader a clear sense of not only how strong GDP and its components, but also how the latest numbers match up.
The recession is over! In the third quarter GDP grew by 2.8% (3.5%), slightly below (comfortably ahead) of expectations for 2.9% (3.0%) growth. This is a huge improvement over the 0.7% decline in the second quarter and the 6.4% plunge in the first quarter.
The internals of the report were strong as well, although it appears that much of the growth came from things like the Cash for Clunkers program and the extraordinary levels of support that are currently being given to the housing sector.
I will first go over the percentage growth rates for the main components of GDP, and then how much each part contributed to, or subtracted from, the 2.8% (3.5%) growth rate. This is probably the more important part since the size of the different parts of GDP are very different, and a small percentage change in a big component can have more impact than a large change in a small component. Just as a reminder: GDP is equal to the sum of Consumer spending, Investment spending, Government spending and net exports, or Y = C + I + G + (X – M) and I will be using that framework for the discussion.
Growth Rates
The overall 2.8% (3.5%) growth of GDP was almost matched by its biggest component, Personal Consumption expenditures, or PCE, which grew 2.9% (3.4%), a big improvement over the 0.9% decline in the second quarter and the 0.6% increase in the first three months of the year.
It is important to note that during the recession, consumer spending declined far less than did overall GDP, especially in the first quarter, so the consumer was becoming a much bigger part of the overall economy. This is not healthy over the long run, but at this point I think people are happy to get some growth where ever we can find it
Consumers spend on both goods and services, and goods are broken down into durable and non durable goods. The big mover in the third quarter were goods, which increased by 7.2% (8.1%) following a decline of 3.1% in the 2Q and an increase of 2.5% in the 1Q. Spending on durable goods was the real driver, growing at an annualized rate of 20.1% (22.3%) in the 3Q, following a 5.6% decline in the 2Q and a 3.9% increase in the 1Q.
Spending on non-durable goods tends to be much more stable than spending on durable goods. Non-durable goods spending rose by 1.7% (2.0%) reversing a 1.9% decline in the 2Q, which was in turn a reversal of a 1.9% increase in the 1Q. Spending on services tends to be even more stable than spending on non-durable goods. Service spending grew at an annualized rate of 1.0% (1.2%) in the 2Q up from a 0.2% increase in the 2Q and a 0.3% decline in the 1Q
Historically, spending on durable goods has been one of the key drivers to getting us out of a recession, and not spending on durable goods one of the key reasons for falling into recessions. It is the volatility in the sector that makes it important more than its absolute size.
Now, you might wonder, what caused the recession to be so nasty last winter when Consumer spending wasn’t really all that bad? The answer is that Investment really fell of a cliff. The good news is that it is starting to come back.
Overall Gross Private Domestic investment grew at an 8.4% (11.5%) annualized rate in the 3Q, but it still has a lot of lost ground to make up from the earlier part of the year. In the second quarter overall investment spending fell at a 23.7% annualized rate
Now here is the kicker — that was actually a dramatic improvement over the 1Q when investment spending absolutely collapsed, falling 50.5%. Clearly the biggest collapse in investment spending since the Great Depression (and it came on the heels of a 24.2% decline in the 4Q of 2008). To anyone who understood what was going on, those were really terrifying times, and the turnaround from them is absolutely spectacular
There are two basic types of investment: fixed and inventory, and right now we are concerned with fixed investment (I will cover inventory later in the contributions to GDP part).
Fixed investment is broken into two parts, Non-Residential or business investment and Residential investment, which is mostly homebuilding.
Overall Fixed investment rose by 0.3% (2.3%) following declines of 12.5% in the 2Q and 39.0% in the 1Q. Business investment, however, continued to decline, but at a much slower rate, falling 4.1% (2.5%) after 9.6% and 39.2% declines in the 2Q and 1Q, respectively. With massive amounts of unused capacity it is not surprising that businesses are cutting back on their capital spending still.
Business investment comes in two flavors, spending on structures like building new factories, malls and office buildings and spending on equipment and software to go into them. Spending on structures continues to be very weak, falling at a 15.1% (9.0%) annualized rate in the 3Q, but that marks an improvement over the 17.3% decline in the 2Q and the 43.6% collapse in the 1Q. With massive amounts of space sitting idle in offices and empty strip malls littering the landscape, look for new investment in commercial real estate to continue to decline in coming quarters.
Moody’s has estimated that the value of commercial real estate has plunged by 41% since the peak a little over a year ago, and that is hardly an inducement to build more. If a business needs the space, it’s far cheaper to just buy some existing space.
Spending on Equipment and Software (E&S) on the other hand is starting to come back, if only feebly, rising 2.3% (1.1%) after a 4.9% decline in the 2Q and a 36.4% plunge in the 1Q. Look for some stability in this line going forward as the new Microsoft operating system will probably generate a new PC cycle, but with capacity utilization still around 70% I would not expect a boom in orders for new factory equipment.
The real star of fixed investment though came on the residential side, which rose 19.5% (23.4%). This is the first increase in almost four years, and follows declines of 23.3% in the 2Q and 38.2% in the 1Q. The long string of declines had brought residential investment to a record low share of GDP. The extraordinary support of the housing sector by the government, including the first time buyer tax credit, the Fed buying up $1.25 Trillion of Fannie (FNM) and Freddie (FRE) backed paper to artificially suppress mortgage rates and the FHA acting like the old New Century Financial or Washington Mutual on their worst days have played a big role in the turnaround. I seriously question the sustainability of it after the support is removed, and I don’t think the support can continue indefinitely.
Government spending grew by 3.1% (2.3%) in the 3Q, a big slowdown from the 6.7% increase in the 2Q, but more than the 2.6% decline in the 1Q. It was all at the Federal level where spending rose at an annual rate of 8.3% (7.9%) down from a 11.4% increase in the 2Q, but up from the 4.3% decline in the 1Q.
Remember this measure of government spending does not include spending on transfer payments like Social Security and Medicare, which are largely captured in the consumption numbers. Defense spending was the big driver — we are still a nation fighting two wars. It grew at an annual rate of 8.3% (8.4%) down from a 14.0% rate of increase in the 2Q but up from a 5.1% decline in the 1Q.
Non-defense spending rose at a 6.9% (6.8%) annual rate following a 6.1% increase in the 2Q and a 2.5% decline in the 1Q. State and local spending on the other hand is constrained by balanced budget laws and falling tax revenues. It declined 0.1% (1.1%) in the 3Q following a 3.9% increase in the 2Q and a 1.5% decline in the 1Q. They were able to increase spending in the 2Q due to support for the Federal government as part of the stimulus package. Now that support looks like it is being overwhelmed by the plunge in property, income and sales taxes.
International trade has started to rebound, and we saw an increase in both imports and exports. Increasing exports are good for GDP and increases in Imports are bad for GDP, and unfortunately imports rose more than did exports. We were able to improve our overseas sales by 17.0% (14.7%) in the 3Q — a nice turnaround from the 4.1% decline in the 2Q and the 29.9% plunge in the 1Q. Unfortunately we also increase what we bought from overseas by 20.8% (16.4%), a big turnaround from the 14.7% decline in the 2Q and the 36.4% plunge in the first three months of the year. Keep in mind that we import a lot more than we export, so not only was the percentage increase bigger for imports, it was coming off a higher base.
Contributions to Growth
Not all components of GDP are created equal. Some are very big, and others relatively small. Some tend to be very stable over time, and some tend to swing violently from quarter to quarter. The bigger and more volatile they are, the more they will impact the overall growth rate of GDP. Thus looking at just the percentage changes in the componenets does not tell the full story. Of the 2.8% (3.5%) total growth, how many points were added or subtracted by each part of the economy?
The biggest part of the economy is the Consumer or PCE, over all it contributed 2.07 (2.36) of the 2.80 (3.50) points of total growth. In the second quarter it caused 0.62 of the 0.70 total decline in the 2Q. In the first quarter it actually offset 0.44 points of the 6.40 total decline. In other words, excluding the consumer the economy would have contracted 6.84% rather than 6.40%.
Within consumer spending, spending on goods added 1.60 (1.79) points after subtracting 0.71 points in the 2Q and adding 0.56 points in the 1Q. Spending on durables was the main driver, adding 1.34 (1.47) points after subtracting 0.41 points in the 2Q and adding 0.28 in the 1Q. Non durable goods added 0.26 (0.31) points after subtracting 0.29 in the 2Q and adding 0.29 in the 1Q.
While spending on services is much more stable than spending on goods, it is also a much larger portion of the consumer wallet. Service spending added 0.47 (0.57) points to the overall GDP growth in the 2Q, up from adding 0.09 points in the 2Q and subtracting 0.13 in the 1Q. It is the volatility that gives durable goods there importance to the economy not the overall size. In the third quarter total spending on durable goods was at a $1.055 Trillion annual rate, just 15.4% of the $6.852 Trillion spent on services, but durables goods had an impact on economic growth that was 158% bigger.
Investment spending was a big swing factor in the 3Q. It added 0.91 (1.22) points to overall growth. That is a HUGE improvement over the 3.10 point subtraction in the 2Q and the 8.98 point implosion in the 1Q. Unfortunately. 0.87 (0.94) points of that contribution came from inventories. Inventory investment is the “worst” type of GDP growth since large increases in one quarter are usually reversed in the next quarter, or in this case, large declines being reversed upwards.
In the 2Q inventory investment subtracted 1.42 points from overall growth and in the 1Q they subtracted 2.36 points. Even in the 4Q they subtracted 0.64 points from growth. Three straight quarters of sharply lower inventories is highly unusual and we were due for a bounce. Perhaps we have one more quarter of a solid contribution from inventory investment, but I would not expect it to last much beyond that.
Overall fixed investment added just 0.04 (0.28) points to growth, but that sure was a nice improvement over the 1.68 point subtraction and the 6.62 point disaster that was the 1Q.
However, it was not coming from the business side. Business investment subtracted 0.40 (0.24) growth points in the 3Q, so it is still very soft, but at least it is not imploding like it was earlier in the year. In the 2Q it subtracted 1.01 points and in the 1Q it took away 5.29 growth points. Within business investment it was spending on structures that caused the problem with a deduction of 0.55 (0.32) growth points while spending on E&S offset 0.15 (0.08) points of that. In the 2Q both sides of business investment were drags on the economy with investment in Commercial real estate subtracting 0.69 growth points and spending on equipment deducting 0.32 points. The 2Q was in turn a major improvement over the 1Q disaster where spending on structures subtracted 2.28 growth points and equipment spending subtracted 3.01 points.
Housing finally helped the economy in the 3Q, adding 0.45 (0.53) points to growth, after a string of 15 straight quarters where it was a drag on the economy. In the 2Q it was a 0.67 point drag and in the 1Q it was a 1.33 point drag. The long decline has, however, made housing a much smaller share of the overall economy. In the 3Q residential investment totaled only $360.9 billion, or 2.52% of the overall economy. At the peak of the housing bubble it represented 6.34% of the overall economy. Thus the 19.5 (23.3%) increase in residential investment had far less of an overall impact than it did in the past.
While residential investment is still near a record low share of the overall economy, I have serious questions about the sustainability of the increase. The extension and expansion of the tax credit as is now moving through the Congress might keep things going for the next few quarters, but after that things are likely to fall apart again. Most of the tax credit is going to those who buy existing homes, rather than new homes, and thus it is a very inefficient way of increasing residential investment. It is however, an open question if we really want to be directing resources into housing given the glut of housing units in the country. Just like we saw with the Cash for Clunkers program, it is probably just encouraging those folks who might have bought later to buy now. Cash for clunkers was a much smaller program, totaling only $3.0 billion, yet is had a huge impact on the economy, most of the improvement in consumer durable goods came from autos.
The tax credit is also tricking people into thinking that the house is more affordable that it really is, just the way that teaser rate ARM’s did, and we saw just how well that worked out. The FHA is handing out mortgages with only 3.5% down and people can use the tax credit for that ridiculously small down payment. This has future disaster of biblical proportions written all over it. The next bailouts will not be of the banks like Bank of America (BAC) and Citigroup (C) but of the FDIC and the FHA.
Direct government spending had a small but positive impact on overall growth in the 3Q, adding 0.63 (0.48) points a fairly significant slowdown from the 1.33 contribution in the 2Q, but better than the 0.52 point drag in the 1Q. All the help came from Washington , not city hall or the statehouse.
The Federal government added 0.65 (0.62) growth points, down from 0.85 points in the 2Q but up from a 0.33 point drag in the 1Q. The Pentagon was the main factor in all three quarters, with defense spending adding 0.48 (0.45) points in the 3Q following a 0.70 addition in the 2Q and a 0.27 point drag in the 1Q. Non-defense spending was sort of a non issue, adding just 0.17 (0.17) points in the 3Q, not much difference from the 0.15 point contribution in the 2Q, and up a little bit from the slight 0.06 point drag in the 1Q.
State and Local governments are not allowed to run operating deficits, and so when faced with declining tax revenues they have to cut back, unless Uncle Sam helps them out. Well Washington is helping, but its not enough and S&L spending was a 0.02 (0.14) point drag in the 3Q. The Federal help was enough in the 2Q and so the contribution to growth in the 2Q was a positive 0.48 points. In the 1Q, before the stimulus package could get much traction S&L spending was a 0.19 point drag.
Net exports had been just about the only bright spot in the first half of the year, even though it came the wrong way, from both imports and exports plunging, only with imports falling more than exports did. That reversed in the 3Q as both showed a nice expansion, but our appetite for foreign goods outstripping the desire for U.S. goods and services abroad. The increase in exports added 1.71 (1.49) points to growth, but the increase in imports was a 2.53 (2.01) point drag, for a net negative contribution from net exports of 0.82 (0.52) points. In the 2Q falling exports subtracted 0.45 points but plunging imports added 2.09 points, for a net imports net help to the economy of 1.64 points.
In the first quarter, as world trade came to a near standstill, net exports were just about the only positive you could find for the economy. Yes, plunging exports subtracted an awful 3.95 points of growth, but the fact that we were buying practically nothing from overseas added 6.58 growth points for a net aid to the economy of 2.85 points. In other words, if the U.S. were a closed economy in the first quarter, growth would have fallen not at a 6.4% rate, but at a 9.25% rate.
Overall
Relative to the first cut at the data, the downward revisions were broad based, with smaller contributions from all major areas of the economy, with the exception of the government. Of particular concern is that fixed investments contribution to growth virtually disappeared.
Investment’s share of GDP is near all time low’s and that is not a good thing for the future of the country. Inventory investment really does not count in this regard. The trade deficit (net exports) continues to be a major problem. While consumption spending growth was revised lower, it still grew faster than overall GDP, indicating that it continues to grow as a share of the economy.
This country needs to move its economy towards one that is focused on investment and exports, not one dominated by consumption, and consumption of imported goods in particular. Still, even though it was not as good a report as the original, it sure is an improvement over the second quarter, and especially over the fourth quarter.
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