What’s dragging the economy down?

This recent observation by Dean Baker got me thinking:

‘As noted in today’s lesson on accounting identities, the share of GDP devoted to investment in equipment and software is almost back to its pre-crisis level. And, the saving rate is still below its post-war average, meaning that consumption is high, not low.’

The point about investment is particularly notable. All through this Little Depression we’ve been hearing that companies are reluctant to invest, whether because of pessimism about future sales (me, for example) or because of uncertainty about future taxes and regulations (conservatives). A bit less than half of  investment is in equipment and software, so it’s good news that that’s largely come back. The larger part of investment, structural investment (both commercial and residential), is still hurting, however; I’d think the reasons are related to the post-2007 woes in the housing and real estate sector in general.

The Commerce Department’s quarterly GDP reports are a godsend for trying to pinpoint what areas of the economy are strong and which are week. The reports have three one-page tables: Table 1 gives the annualized real percent change for the various GDP components, broken down into a couple dozen sub-components; Table 2 gives the contribution of each one to real GDP growth (e.g., if increased investment caused GDP growth to be 1.0% instead of 0.0%, its contribution is listed as 1.0%); Table 3 gives the dollar value of each component and sub-component. Yesterday’s report contains revised figures for the second quarter of this year, and quarterly figures dating back to 2007. What do they tell us?

First, looking at the yearly figures, in 2008 and 2009, the two years when real GDP actually fell, investment fell even more sharply, and consumption fell somewhat, with positive contributions from net exports and (secondarily) government purchases making up some of the difference. Okay, that’s not news, but it’s worth keeping in mind.

Turning to the quarterly figures, we’ve now had two full years of rising real GDP dating back to the third quarter of 2009, but from 2010:I to 2011:I that growth slowed in every single quarter: 3.9, 3.8, 2.5, 2.3, 0.4%. It rebounded to a still-anemic 1.0% in 2011:II. Those last few growth rates are not enough to keep the unemployment rate from rising, which is the definition of a “growth recession.”

The economy had three consecutive strong quarters in 2010:IV-2011:II, with real GDP growth of almost 4%. What drove that little spurt? In the first two cases, investment, especially inventory investment (which means companies were optimistically producing in expectation of higher sales and/or failed to sell much of what they produced). Equipment and software investment made a modest contribution, and structural investment again made a negative contribution. In the third quarter, investment again led the way (this time sparked by equipment and software), with consumption closely behind. Notably, despite the federal stimulus, the total government contribution to GDP growth was slightly negative in those first two quarters (state and local retrenchment more than offset the federal stimulus) and modest in the third quarter (of note: the modest federal contribution of 0.71% was actually the second-highest since the stimulus began, with the highest being 1.09% in 2009:II. Draw your own conclusion. Mine is that the stimulus was way too small.)

What caused growth to be so slow in the first two quarters of 2011? Government retrenchment led the way, with respective contributions of -1.23% and -0.18%. In the first quarter, most of the retrenchment was at the federal level (-0.81%), which probably represents the winding down of the stimulus. In the second quarter, state and local government retrenchment shaved 0.34% off GDP, while the federal contribution was slightly positive. Also in the first quarter, a surge in imports mostly negated the contribution of increased consumption (1.47%-1.35%).

If we want to look for positives, here are the components of real GDP that grew by at least 3% (annualized, and 3% is about the historic norm for GDP growth) in both quarters of 2011:

• investment in equipment and structures: 8.7%, 7.9%
• exports: 7.9%, 3.1%

Not bad, but too small in relation to the economy to lead economic growth. Investment in structures was still poor (with a combined contribution to GDP growth in the two quarters of about zero), and rising imports more than offset the improvement in exports. Perhaps the key thing that sticks out is that even without the drags on the economy from government retrenchment and negative net exports, the positive parts of the economy were themselves fairly weak. Consumption contributed just 1.47% and 0.30% respectively; investment just 0.47% and 0.78%. Even without the drags from government and net exports, that’s total growth of just 1.94% and 1.08%. This is still a very slowly recovering economy, still a Little Depression. It also looks like there’s way too much vacant housing and physical plant out there for many people to want to build.

Autarchy in the US

(No, this is not a call for protectionism.)

The third-quarter GDP growth numbers are better than originally reported, as today the Commerce Department revised them from their 2.0% initial estimate up to 2.5%.  As many commentators have no doubt noted, that’s still short of the 3.0% thought to be necessary to reduce the unemployment rates.  But we should not stop there.  The more I look at the quarterly GDP figures, especially in the Commerce Department’s full report, which includes a table that breaks down the contribution to percent change in real GDP from each of the main components, i.e., consumption, business investment, government purchases, and net exports, the more it looks like a real recovery is underway.

Looking over those GDP breakdowns over time, a couple patterns emerge.  First, as is often noted, fluctuations in business investment tend to be the key to recessions and recoveries.  Investment is highly volatile, more so than consumption, and it tends to lead the business cycle.  Second, net exports are even more volatile and, unlike investment, don’t have much of a cyclical pattern. They seem to be mildly countercyclical (in a recession that hits the whole world evenly, our imports would fall more than our exports would, simply because we our imports are much larger than our exports to begin with), but whatever cyclical pattern exists seems to be swamped by other fluctuations: just eyeballing the numbers, the GDP contribution of net exports looks like one of those “random walks.”  Consider net exports’ percent contribution to real GDP over the past five quarters (i.e., since recovery officially began, or 2009:III-2010:III):

-1.37

1.90

-0.31

-3.50

-1.76

Not much of a trend there –close to -1.5% in the first quarter of the recovery, sharply positive in the second, near zero in the third, huge and negative in the fourth, back around -1.5% in the fifth.  These big fluctuations can drive the quarterly real GDP changes, masking what’s happening in the domestic economy.  Officially, real GDP over the past five quarters grew by the following amounts (seasonally adjusted at an annual rate:)

1.6

5.0

3.7

1.7

2.5

Again a lot of fluctuation, with the strongest readings coming the two times when net exports’ contribution was either positive or near zero. If we omit net exports to get a closer look at actual domestic spending (i.e., C+I+G, or “domestic absorption,” as development economists call it), the growth of the rest of real GDP over the same span looks like this:

3.0

3.1

4.0

5.2

4.3

A much clearer picture:  GDP grew slowly in the first two quarters of the recovery, and thereafter at a much faster clip, about 4%-5%.  It looks to me like the domestic U.S. economy has been recovering a respectable pace in 2010.  While net exports may continue to be a drag on the economy in the future, especially as our European trading partners opt for the bloodletting approach to their economies, their extreme fluctuation makes me leery of making a definite prediction about net exports. I feel safer in saying that consumption and investment seem to be leading the U.S. recovery and that investment will hopefully pick up further as more businesses come to believe that a genuine recovery is underway.