Weekly Update: GDP and More

Well the economic news seems to have been dwarfed by the ongoing oil spill in the Gulf and the extraordinary events in the Middle East. But there is some news to go over, especially the release last week of the GDP figures for the first quarter.

The good news is that the economy is clearly growing. The government’s news release shows GDP growing at a 3.0% pace for the first three months this year, which is decent, but is also slightly less than the first estimate issued in April. These numbers are notoriously bumpy and are subject to significant revisions as the government sifts through more recently received data. My guess is that this 3.0% will stick though and so we can take a close look at it to see whether it portends well for the rest of the year.

Here’s the broad breakdown:

Personal Consumption [‘PCE’] contributed +2.4%

Private Investment contributed +1.7%

Trade [Exports minus Imports] contributed -0.7%

Government Expenditures [both Federal and State] contributed -0.4%

So what does this say?

First: consumption is obviously picking up. That seems to fit well with all the anecdotal evidence we have received and is in line with rising consumer confidence. This is good news. PCE constitutes about 70% of the total GDP so anything positive in consumption is a huge lift for the economy as a whole. Even better: the growth was fairly well spread across all categories of expenditure, so this was not a case of pent up demand for big ticket items – ‘durable goods’ – but encompassed pretty much everything. Of particular note was the long awaited turn in dining and restaurant expenditures, which posted it first positive contribution since mid 2008. Since dining out is seen as a luxury item the fact that it seems to have turned the corner is a strong supportive factor suggesting that the economy’s growth is now sustainable.

Second: The investment numbers are a little deceiving. The record was very mixed. A steady, but not great, increase in non-residential investment was almost completely offset by a continued decline in residential construction. This is not exactly a surprise given the stupidity and excesses of the bubble, but it demonstrates the continuing drag on the economy of the over-construction of the last decade. As we unwind that lunacy it will tend to press down on the GDP numbers, and I expect this negative effect to be with us for a while.

With these two categories of investment offsetting each other, the big impetus to growth came form inventory investment. This is the third quarter in a row that has been bolstered by this trend, and is something we need to be acutely aware of as we project the rest of the year. Inventories always follow a volatile and exaggerated trajectory during any business cycle. This one is no different. The boost to growth in the first quarter attributable to inventories was about half that of the fourth quarter, so I think it is fair to say we should not expect much more support during the rest of this year. To put this in perspective: about half of all GDP growth in the first quarter came from inventories. take that away, as I think we should, and the next few quarters will see a drop in overall growth unless consumption keeps on rising.

Third: the negative drag from trade is no surprise. Imports were bound to rise once consumption kicked in, and even though exports have also grown, the old pattern of persistent trade deficits as America sucks in oil and consumer goods will be dominant for the foreseeable future. In the medium term this should put pressure on the dollar, but luckily for the US that trend is being swamped by the shorter term chaos that the Euro is stirring up. As long as the European economies muddle around and go through difficult adjustments the dollar will remain stronger than its ‘fundamentals’ justify. I see no way that trade will improve over the near term, so imports will continue to drag down GDP for the rest of the year.

Fourth: government spending exerted a negative impact. This may surprise many you, especially given the hyperbole about the Federal deficit. The really important factor to bear in mind is that the US consists of a bunch of governments and only one has the ability to provide help. That’s at the Federal level. Practically all the rest – predominantly the States – are working to make the economy worse. They are all under immense pressure to balance their budgets which is about the worst thing they could do at the moment. Every cut in expenditure by a State government withdraws purchasing power from the economy. This withdrawal cuts into final demand and slows the economy down. Continued severe contraction at the state level is reducing the impact that the Federal stimulus is having. In fact as these numbers testify, the states are more than offsetting that stimulus. If this trend continues the local contractions could cause us to fall back into recession. This is the basis for my suggestion that we need more, not less, stimulus at the Federal level.

What do we make of all this?

The economy has come out of recession. It is now growing. Too much of that growth is attributable to inventories, but there is plenty of evidence that consumption can allow overall GDP growth to continue even after the boost from inventories subsides.

There are plenty of dangers: the biggest being the drag caused by anti-growth cutbacks at the state level of government. We urgently need more Federal spending to mitigate those anti-growth cuts, otherwise GDP will start to sputter somewhat later this year, and we will not see sufficient activity to generate the jobs we are all looking for.

One last comment before I head back to the mountains of Vermont:

There is a rising swell of demand for conservative fiscal and monetary action. Reports are popping up everywhere calling for government tightening at the budget level, and for a hike in interest rates to ‘head off’ inflation.

Such calls are foolish, and could be disastrous.

The economy is growing, but it is nowhere near robust enough to be taken off life support. Cutting Federal spending would have terrible consequences. We are not yet stable enough to do anything so radical. I agree that the deficit needs attention: especially working out how to overcome the damage done by the Bush tax cuts which are the primary budgetary problem we have, but dabbling around with cuts at the moment would be akin to turning off the medication with the patient not yet cured. It is simply not credible policy to trim the deficit until 2011 or even 2012. Until then we should keep our foot firmly on the gas and allow the cyclical forces that will rein in some of the deficit to do their work before we attack the underlying Bush regime issues.

Remember, even though GDP grew 3.0%, that figure is quite low for this point of a recovery. Typically we expect more than quarter of much higher growth before we settle back down to the long term trend of between 3.0% and 3.5%. The fourth quarter last year saw growth of 5.6%, and already we are slowing down from the peak.

Let me repeat myself: history tells us that economies whose recessions were caused by a financial crisis, as ours just was, take much longer to recover fully and are extremely vulnerable to ‘after shocks’. We seem to be a model case of the historical trend. The after shocks are plentiful – another round of banking write downs caused by the commercial real estate market; the ongoing turmoil in Europe; the impending real estate bubble in China [although they are working hard to prevent too much damage]; and the cost cutting efforts of our states, are the most obvious. What else lurks under the surface is unknown, but the risks are all on the downside. Which means we have no room for error.

In that context I remain on the cautious side and expect growth to slow down as the year progresses. We won’t fall into another recession, but this will not be a very robust recovery. We may well have seen its high point already.

There’s a lot of work to do before we have shrugged off the massive damage we inflicted on ourselves between 2000 and 2007.