GDP, Macroeconomics, and Spinach

I admit it – I teach macroeconomics. If I was a botanist I probably would have taught Spinach 101. Hardly anyone really likes macro despite the fact the Department of Commerce feeds us a big heaping bowlful of GDP every quarter. We feed our kids spinach too and tell them they will grow up to be like Popeye but they hardly ever like it.

Through much of my teaching career the economy performed pretty well so announcements of quarterly GDP were much like weather announcement s in Arizona in February. EVERYONE knows that the weather forecast in February in Arizona will be sunny and warm. It gets boring. “Hi Fred did you hear that GDP rose 3.23496% last quarter?” Yes, Martha, I did. How lovely. Please pass the spinach will you?”

Luckily for macroeconomists there are times when all the wheels start coming off the economic wagon and people get VERY interested in GDP. While I won’t exaggerate and say that GDP information becomes more interesting than Donald Trump’s hair or high school basketball in Bedford IN, I do hear people talk about GDP at Kroger and the Crosstown Barber Shop.

Last week the US Department of Commerce announced the GDP number for the first quarter of 2011. Here is the link to the press release --  http://bea.gov/newsreleases/national/gdp/gdpnewsrelease.htm

It was not a good number. While 1.8% would be a good quarterly weight gain for me, apparently the world would have been happier if US GDP grew by more than 1.8%. The government press release was chocked full of information presented in black and white in words that only a chronic sleep-deprived owl could stay awake through. Luckily your favorite TV programs animated the information and provided graphs in full color with subliminal photos of Rush Limbaugh and Nancy Pelosi in Las Vegas.

After having several email interchanges with some of you, I decided that you guys needed a little review about GDP. Since I just taught a macro course in Italy (it is hard to type the words Italy without a giant smug multi-toothed grin overtaking my face – yes ITALY the one over there near Slovenia) this information is fresh in my mind and it reminds me of how the press release can be helpful but can sometimes be downright incomplete or misleading.  The general tone of the release and much of the following colorful interpretations was that 1.8% growth in Q1 2011 was low, disappointing, and proved beyond a shadow of a doubt that (1) the US economy either needs more stimulus or (2) needs less stimulus.  The slowdown, according to the reports, came from slower government spending and exports to the world.

Below I will try to explain two reasons why one should ignore most of what has been said about GDP Q1. First, one month’s reading – sort of like weighing yourself once a month on the 27^th, can be very misleading. To usefully understand what is going on in the economy and how it will behave in the future, we should integrate the information from the latest month into the experience of several. Additionally, keep in mind that this first publication will be revised several times before we land a number for Q1 2011 that gets written in indelible ink. Unfortunately the usual press releases don’t provide this kind of perspective and most talking heads don’t spend time trying to say reasonable things. “Ladies and Gentleman – GDP fell off the top of the Empire State Building nude and landed on top of a hotdog cart that was trying to parallel park in a space the size of a peanut. Next we turn to a commercial for soap.”

Second, most discussions of GDP assume that we know only one equation that describes GDP and nothing else. There are a few easy subtleties, however, we can discuss that help us better understand what is happening to our nation’s economy. 

Let’s start by defining this thing we call GDP. Some things to emphasize are:      

                GDP is a measure of output produced within the borders of the country, regardless of the nationality of the country of the companies producing it. So when GDP rises by 1.8% in Q1, imagine a huge pile of stuff* coming out of our companies being stacked on trucks, transported, and subsequently dumped in Dallas. The pile in Q1 2011 was about 1.8% higher than the pile in Q4 2010. *Stuff is a very technical term that includes all goods (autos, clothing, medical marijuana, vibrators, etc) and services (telecommunications, business assistance, Turkish steam baths, and medical marijuana consulting) produced.

                To measure the pile, we put it in dollars. Thus we say GDP was $13.4 trillion in Q1. To make sure it measures only volume changes – changes in the size of the pile – it keeps the prices constant. We all know that sales can increase because of prices or volume – but this $13.4 trillion number is based on only volume increasing. So the 1.8% was NOT CAUSED BY PRICES. The load of stuff produced gave us 1.8% more stuff than we had in Q4 2010. This volume measure is sometimes called REAL GDP or GDP in constant dollars.

So let’s put this 1.8% increase in perspective: The recession lasted six quarters and in those six quarters the percentage change in GDP was negative in all but one quarter. These recession quarters were followed by seven consecutive quarters of growth which have averaged about 3% annually. Through these seven quarters (and typical for any seven quarter time period), GDP changes fluctuated. The largest increase of 5% came in Q4 2009. The smallest of 1.6% was Q3 2009. I do not think that the 1.8% in Q1 2011 tells us much of anything except the economy continues to recover and expand.

It is worth pointing out that despite the average 3% growth the entire seven quarter period tells us that this is a VERY lackluster recovery. GDP had attained a high value of $13.4 trillion in Q2 2008 and it subsequently fell to $12.8 trillion within a year.  It took six quarters to dig out of that hole and today we find ourselves just back to where we started from in 2008. In other words, the 3% average real GDP growth since the recession only got us back to ground zero. If we had not had a recession and GDP had grown by 3% through the last 13 quarters, GDP would have reached $14.5 trillion in Q1 2011. So we might say that we are about $1 trillion behind now. 

                To me – that’s the story that should be written. It is one thing to say that GDP grew by 1.8% last quarter – it is another to focus on the fact that seven quarters of recovery leaves us $1 trillion behind normal!

Let’s change gears to my second point. EVERYONE who has ever taken a macro course and actually went to the class and stayed awake during the first hour of the first day knows that

GDP = C + I + G + NX

Hidden in this highly complicated equation that only advanced physics and physical education students would know is that this equation says that only two things can be done with a nation’s output:

 (1) Output that is finished goes to sales to the final user or into unsold inventories of finished goods or

 (2) Output that is not finished goes into inventories of materials or intermediate goods

The usual explanations of the ups and downs of GDP focus on sales to final users – households, business firms, and the foreign sector (including interplanetary visitors and Justin Bieber). The logic is that if GDP grows slowly, then it must be because one or more of these groups of buyers decided to take a pause from buying and mediate or save or punish their really bad kids by not yet caving in to buying them an Ipad. In Q1 2011 the main culprits seemed to be state, local, and federal governments and foreigners.

What was mentioned but perhaps not really explained very well in the press release was that about half of the 1.8% increase was accounted for by increases in inventories. That is, if you decompose the GDP change – you find that half of the increase was because of sales to final users and the other half went to sitting on shelves. More precisely what we call Final Sales of Domestic Product rose by 0.8% in Q1 2011. You may be kicking your pet turtle right now, but the one quarter figure is not the one to focus on. If you look at final sales for the last seven quarters you may want to move to China or Rio. In the past seven quarters final sales increased an average of 1.8% -- implying that much of the increased GDP we have seen in this recovery has simply been goods going to restore inventory levels. In the recovery, final sales have grown by a mere 1.8% per year – much lower than the 3% increase in output.

Let me add one more wrinkle. The Commerce Department reported that consumer spending increased by 6.7% during the last two quarters and that gives the impression of relative strength coming from the household sector. But this is misleading because the C component of GDP includes goods that are sold but not produced in the USA. Something called Final Sales to Domestic Purchasers measures what is happening to sales of US produced goods and services to domestic buyers. In the last two quarters that figure increased by about 4.1%. That’s considerably less than the 6.7% growth in consumer spending.

To summarize, the US economy cooled to about 1.8% growth in GDP in Q1 2011. A closer look at the data suggests that while that creates a pause for concern, even worse is that the seven quarter recovery has been slow, averaging about 3% per year for almost two years. Our economy is today barely producing the amount we sold two years ago and is a trillion dollars off where it might have been without the recession. This slow recovery is the result of a very weak rebound in the demand by US buyers for goods produced in the US with much of the production simply boosting inventory levels and much of the sales coming from goods that were produced abroad.  So while the US household seems to be driving the recovery, the actual numbers reported for consumer spending overstate how much of that spending goes for US output. About the only parts of the GDP final equation that look good for now and the near future are exports and business spending on equipment.  But even export growth has slowed. After a rapid pickup of US exports in the first year of the recovery (14% annual rate) export sales slowed to about half that rate, or a 7% annual pace in the last three quarters ).

This longer term picture is not good. Households are not moving quickly to buy US goods. Governments are stressed and reducing their demands for goods and services. Foreigners continue to buy US products but despite a falling dollar have their own concerns that may limit how much they buy from us.  Real estate is still in the toilet and a rebound in business spending on equipment can only take us so far.

It is no wonder that our Keynesian friends want to continue to stimulate demand. But it isn’t that easy. We are beyond the day when we can sustain skyrocketing government debt and monetary explosion. We tried that and it didn’t get the job done. Now we are in a pickle. It seems odd that in the this time when spending is so fragile and clearly related to business hiring that our administration is so prone to finding enemies and relishing punishment to the corporate world. Let’s tax those rich oil producers. Let blame those speculators. Let’s take those profits away from bankers. The vicious cycle of jobs and spending will only end when business firms judge the future optimistically. We need rhetoric and a policy stance that recognize jobs are created by entrepreneurs and investors who take risks and expect commensurate returns.