GDP: Good News

Everyone – well almost everyone – predicted that the second quarter GDP figures would show an improvement over the miserable performance of the last six months. That much was not hard to do, after all businesses will eventually run out of stuff to cut, slash, burn or otherwise eliminate. Once we reach that point even the most radical cost cutter has to turn his or her attention to growth. Rebuilding inventories, replacing worn out machinery, and generally fixing things then becomes the norm and GDP consequently sinks no further.

So this morning’s report that GDP fell only 1% during the second quarter came as a surprise only so far as the decline was so small. After having dropped by 5.9% over the past six months the economy’s free fall has finally started to slow down a bit. And after four straight quarters of contraction we can look forward, tentatively, to a slight upturn in the third quarter. Those four quarters of decline make this the longest recession since the Great Depression, although between then and now we have seen some sharper, but much shorter, declines.

The story within the numbers supports the notion that businesses are past the deepest part of retrenchment. Business investment declined ‘only’ 8.9% during the second quarter, which is a sad state of affairs until we realize it dropped at a 39.2% rate in the first quarter. After that appalling decline earlier in the year it was not too difficult to forecast an improvement!

The change in business spending – or rather the slowing down of the reduction in spending – contrasts with personal consumption: in the first quarter it grew very slightly – by 0.6% – while in the second it dropped by 1.2%. This turn for the worse was driven mainly by a sharp reduction in durable goods spending – stuff like cars and refrigerators – which fell 7.1% in the second quarter after having grown well, by 3.9% earlier in the year.

For those of you who need more evidence of the stimulus working: government spending kicked into gear nicely – it grew buy a heady 10.9% during the quarter; and even our beleaguered state governments managed to grow their spending 2.4 %.

Finally trade also contributed to the turn about. Both exports and imports declined less rapidly than before, with exports declining ‘only’ 7.0% and imports by 15.1%, compared with 29.9% and 36.4% respectively in the first quarter.

What do we make of this?

Obviously things are turning around. As I mentioned, this was inevitable given the depth of the retrenchment that businesses went through. The much harder question concerns the next few quarters and the shape of the recovery. There, I think, is not much evidence of enduring strength. At least not yet. That drop in consumption last quarter concerns me somewhat, especially when we couple it with the downturn in consumer sentiment of recent months. The other aspect of today’ report that suggests a sluggish recovery is, ironically the savings rate, which perked up some more from 4.0% in the first quarter to 5.2% in the second.

It is this steady accumulation of savings by American consumers that will turn out to be the most important single issue for the entire world economy over the next year or so.

Here’s why:

1. It was ‘over spending’ by Americans that enabled growth in the exporting countries like China, Japan, and Germany over the past few years. Americans lived way beyond their mean and went deeply into debt.
2. That indebtedness led America into a very fragile position where a collapse in banking became inevitable. Sloppy credit standards became the norm, which led to an accumulation of bad debts.
3. That is now being unwound.
4. This unwinding or ‘de-leveraging’ implies less consumption – by definition – and thus much more sluggish growth here in America, but also in countries who relied on selling goods here.
5. It also affects the world’s capital markets: because some countries, notably China, Japan, and Germany saved rather than consumed the world became awash with spare capital for investment: these countries ‘saved too much’. That capital found its way to America via our trade imbalance, and fueled our binge of debt.
6. So a slower US economy means that those countries either grow more slowly or they increase consumption/investment at home.
7. The other hidden story here is that the US dependence on foreigners for money is decreasing, so the proportion of the Federal Deficit that we finance by borrowing from China etc will drop sharply – in fact it already has. We know this because our trade deficit has dropped sharply during the recession and the trade deficit is a measure of how much foreign capital we are importing to support our indebtedness.

So, for all these reason the US drop in consumption is about to be the big story.

It means we will see much slower growth than we are used to for a while. It will mean the recovery in employment will be slow. And it will mean that our dependence on foreign debt will diminish.

In other words we will start to deal with our underlying economic imbalances at last. It’s about time the illusion of the Reagan/Bush era was stripped away and we got back to basics rather than living in a pretend world where we imagined that our competitive position was that of the 1950’s.

Adjusting to the new reality and then rebuilding will be difficult and will require a great deal of discipline across the board – our Federal deficit will have to be reduced significantly and that means extra taxes, or painful cuts in things like defense spending – but reality is preferable to silly illusions like shining cities built in the clouds.

And it is also why things like health care reform and banking reform should be seen as part of an overall economic strategy: we need to re-allocate our resources towards future sources of wealth and away from either frivolous or ephemeral short term things.

But all that lies ahead. Right now all we can say is that we are not falling as badly as before.

And that’s really good news.