by Dirk van Dijk
In the first quarter, the economy grew at an annual rate of 1.8%, down from 3.1% in the fourth quarter, and from the 2.6% pace in the third quarter. The growth rate was slightly above consensus expectations of 1.7%. Also, the quality of the growth was weaker than in the fourth quarter, but not awful. The first graph (from this source) shows the history of GDP growth.
So how did we get to the 1.8% overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag? Since the different parts of the economy are of very different sizes, and some tend to be relatively stable while others can be very volatile, I will focus on the contributions to growth. In other words, growth points, not the percentage growth rates.
After all, a small percentage change in a very big part of the economy can have more impact than a big percentage change in a small part of the economy. To do this I will follow the familiar Y = C + I + G + (X – M) framework, where Y = GDP, C= Consumption, I = Investment, G= Government, X = exports and M = imports.
Personal Consumption Expenditures
The biggest part of the economy by far is the Consumer, or consumption, or to be more specific, Personal Consumption Expenditures (PCE). It represented 71.2% of the overall economy in the fourth quarter, and was the biggest growth driver. PCE contributed 1.91 growth points, down from 2.79 points in the fourth quarter but up from 1.67 points in the third quarter.
The increasing contribution to growth from C is generally a good thing, at least in the short term. Over the long term, our economy is already weighted far too much towards C, and that contribution has been rising over the years. Back in the 1960’s it represented more like 64% of the overall economy.
Our consumption share is also far higher than most other economies in the world. Still, we need consumers to be opening their wallets for the economy to grow, at least in the short term. This is high-quality growth, and is very welcome in the current environment.
Goods vs. Services
Consumption can be broken down into two main categories, goods and services. Goods can be further broken down into durable goods, which tend to be big ticket items that will last more than 3 years and Non-Durable goods, which tend to be consumed right away. (For some reason clothing is categorized as a non-durable good. Clearly the people making those decisions have never looked into my closet.)
Services are by far the biggest part of consumption, at 65.96% of PCE and 46.96% of overall GDP. It chipped in 0.70 growth points, up slightly from contributing 0.70 points in the fourth quarter and from a net contribution of 0.74 points in the third quarter.
This solid increase is very encouraging. Services tend to be “produced” domestically, not in China, and also tend to be more labor intensive than goods producing jobs. Normally, demand for services is more stable than demand for goods, especially durable goods.
Durable vs. Non-Durable Goods
Within the consumption of goods, consumption of non-durable goods is about twice as large as the consumption of durable goods. However, since people can defer purchase of durable goods like an auto from Ford (NYSE:F) more easily than they can defer purchase of a box of Corn Flakes from Kellogg’s (NYSE:K), durable goods demand is very volatile. As a result, durable goods tend to “punch above their weight” in determining if the economy is booming or slumping.
Durable goods consumption added 0.78 points to growth, down sharply from an addition of 1.45 points in the fourth quarter but up from 0.54 points in the third quarter. While that contribution is not bad, the sharp slowdown is a bit disheartening. The sector is only 10.88% of PCE and 7.75% of overall GDP, yet it contributed 43.33% of the overall GDP growth in the quarter. Early in recoveries it tends to have a bigger positive impact, but it also has a big negative impact when the economy falls into recession.
Non-durable goods are 23.15% of PCE and 16.48% of overall GDP. The sector's contribution to growth fell to 0.34 points in the first quarter from 0.65 points in the fourth quarter and 0.39 points in the third quarter. For a “Steady Eddie” part of the economy, this is nice solid, and importantly, sustainable level of contribution to growth.
Overall, the Consumer is doing his and her part in getting the economy rolling again. The strong contribution from the consumer service sector is encouraging. All three parts made solid contributions to growth, though goods much less so than in the fourth quarter.
While over the long term we can worry that far too much of the overall U.S. economy is dedicated to consumption and not enough to investment and exports, for right now we want to see the Consumer alive and kicking. Without a doubt he was in the first quarter, but not kicking as hard as at the end of last year.
Investment tends to be the most volatile part of the economy, and thus is the major reason why the economy either booms or busts, even though it is a relatively small part of the overall economic picture. Overall Gross Domestic Private Investment (GDPI) is just 12.42% of the overall economy. Overall GDPI added 1.01 growth points in the fourth quarter, a sharp reversal from subtracting 2.61 points in the fourth quarter but down from the 1.80 point contribution in the third quarter.
Investment is the key to future growth, but as a share of the economy it is much lower than most other economies. However, not all investment is of the same quality. Fixed investment, particularly investment in equipment and software, is investment that tends to have a positive return on investment and which then drives future growth.
But not all investment is fixed. If companies build up their inventories, that too is counted as investment, and it tends to be of very low quality. If companies are simply adding to store shelves, and those goods just sit there, then the investment in inventories will be reversed in later quarters.
This is exactly the dynamic we are seeing in the first quarter numbers. The inventory cycle is a powerful driver of booms and busts; recessions from 1946 through the early 1980’s were mostly due to the inventory cycle, or at least had the inventory cycle as one of the major components.
The increase in inventories accounted for most than all the overall increase from GDPI. Inventory investment added 0.93 points from growth in the fourth quarter. That is a sharp reversal from the fourth quarter, when lower inventories subtracted 3.42% from the overall growth.
In the third quarter, inventories added 1.61 points to growth. In other words, in the first quarter, 51.7% (0.93/1.8) of the total growth came from adding goods to the shelves, not from people actually buying the stuff on the shelves. This is very low quality growth, especially when it happens for several quarters in a row, and we had five of them where inventories were a big positive player in providing growth. Then again, those came after eight quarters in a row where inventories were a drag on overall growth.
Clearly inventories can have a big influence on overall growth, but it tends to be very low quality growth. There does, however, seem to be somewhat of an inverse correlation with net exports, which I discuss below. The contribution from inventories was large relative to overall growth, but not particularly big in absolute terms. In other words, not so big as it is likely to turn negative in the second quarter.
If inventories had just been a non-factor, the economy would have been crawling along at a 0.9% growth rate -- down from an awesome 6.5% growth rate in thr fourth quarter. The pace of growth ex-inventories is roughly similar to what we were running in the third quarter (1.0%) and in the second quarter of last year (0.9%).
Residential vs. Non-Residential Investment
Fixed investment can be broken down into Residential Investment (mostly homebuilding) and non-residential (or business) investment. Residential investment has been the major thorn in the side of the economy for a long time now. That changed a bit in the fourth quarter, and we appear to be slowly forming a bottom in residential investment, it being up in two of the last three quarters.
In the fourth quarter, residential investment added just 0.07 points to growth, but that is a big swing from the 0.75 point drag in the third quarter. In the second quarter, fueled by the first-time buyer tax credit, Residential Investment added 0.55 points to growth, but that was a big exception to the recent trend. The first quarter was back to more “normal” form, subtracting 0.07% from overall growth.
Residential investment is now just 2.21% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble. Normal is about 4.4% of the economy. While the levels are still just plain awful, they have shrunk so much that it is hard for it to have that much of an effect on the overall rate of growth.
Residential investment has been a drag on GDP growth in 15 of the last 18 quarters. We still have a massive overhang of existing homes for sale (including those in foreclosure, and those which are likely to be foreclosed on). Most estimates of the amount of excess housing available today put it at about 1.6 million housing units.
With that much excess supply, building more houses is at one level simply a massive misallocation of resources. On the other hand, residential investment has always been historically one of the most important locomotives pulling the economy out of recessions. That locomotive is derailed this time around.
Residential investment is extremely volatile, and as such tends to “punch far above its weight” when it comes to the overall growth rate of the economy. The lack of residential investment is one of the key reasons that the recovery so far has been so anemic. Eventually population growth and new household formation will absorb the inventory overhang, and residential investment will pick up. That, however, it not going to happen right away.
Still, starting from such a low level, it seems likely that Residential Investment is likely to be a positive contributor to growth in 2011. Not a very big one -- that is more likely a 2012 story -- but simply by not being a major drag on the economy will be a major turn for the better. That bump is almost entirely a function of just how small residential investment has become as a share of the overall economy.
The overall bottoming process in residential investment is not over, and it will be a long time before it returns to its historical norm of about 4.4% of the overall economy. However, as it does, it will set off some very strong economic growth. We are now at an all-time low for residential investment as a share of the economy, as shown in the next graph (also from this source).
Note how at the end of every previous recession, residential investment increased sharply as a share of GDP, in effect leading the economy out of the recession, but how it has persistently declined this time around. That is THE key reason that this recovery seems so sluggish.
Structures vs. E&S
Non-residential or business investment can also be broken into two major parts: investment in structures, such as new office buildings and strip malls, and investment in equipment and software (E&S). Investment in structures subtracted 0.63 points from growth in the first quarter. That is a very big negative swing from a contribution of 0.19 points in the fourth quarter.
I have to say the magnitude of the drop this quarter was a bit of a surprise, but not the direction. Vacancy rates are still extremely high in almost all areas of the country, and in almost all major types of non-residential real estate. We simply don’t need to be putting up a lot of new commercial buildings right now.
On the other hand, as the economy improves, we are starting to see some signs of those vacancies being absorbed, and prices for commercial real estate seem to be starting to firm up. The best leading indicator of future investment in non-residential structures is the amount of activity among architects.
That index has come back to being around flat in recent months after being deeply negative for most of 2009 and 2010. Later in the year and into 2012, it is more likely to be a significant positive force for economic growth, but not yet.
Investment in E&S is what we really want to see to power future growth, and there the news continues to be good. E&S investment added 0.80 points to growth, which is not a bad showing since it is only 7.38% of the overall economy. That is a nice improvement over the 0.54 contribution in the fourth quarter but down from the 1.02 point boost in the third quarter, and a 1.52 point contribution in the second quarter.
This is the eighth quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.71% of the overall economy. That increase is highly encouraging, but we need to see it continue it climb as a share of the overall economy. This is probably the highest quality form of growth out there, as it is growth that feeds future growth. I would prefer to see even more growth coming from this front, but a 0.80 point contribution is still extremely strong.
The next graph (also from this source) shows the contributions to growth from the three components of fixed investment on a rolling four quarter average basis. Note the very sharp rebound in E&S spending, back up to the levels of the late 1990’s, relative to the persistent drag from investment in structures, both residential and non residential.
Government spending subtracted 1.09 points to growth in the fourth quarter, down from a 0.34 point drag in the fourth quarter, and a 0.79 point addition in the third quarter. I should point out that in the GDP accounts it is only government consumption and investment that is counted as part of "G." Transfer payments such as Social Security are not included -- they tend to show up as part of PCE when Grandma spends her check.
What is counted is what the government pays in salaries to its employees (both civilian and military) and its spending on goods, from highways to fighter aircraft. The negative contribution from government this quarter just goes to show that a concretionary fiscal policy is, well concretionary. There is no such thing as growth-inducing austerity. The zeal to cut government spending NOW -- and hard -- is having an adverse effect on the economy, and as the budget cuts go further, the drag from "G" is only going to get bigger.
The Federal government was big factor in the first quarter growth slowdown, subtracting 0.68 points from growth. It was essentially a non-factor in the fourth quarter, being just a 0.02% drag. That is down from adding 0.71 points to growth in the third quarter and from the 0.72 point contribution in the second quarter.
Overall Federal Government spending, as defined in the national income statistics, was 8.15% of the economy in the first quarter, down from 8.33% in the fourth quarter. Of that, 66.5% was spent on Defense, and 33.5% was on Non-Defense spending. Put another way, just 2.73% of the overall economy is non-defense federal spending (excluding transfer payments) and 5.42% of GDP is spent on Defense.
Defense spending subtracted 0.68 points from growth, a much bigger drag than the 0.12 point drag in the fourth quarter. It contributed of 0.46 points in the third quarter and 0.40 points in the second quarter. All things considered, if I had to pick one area to be a drag on growth it would be military spending. While making and dropping bombs does add to the economy in the national income statistics, it does not exactly build the economy or make people better off. That is not saying that it is not needed, but the "less needed" the better.
I suspect that the sharp drop in the first quarter is a bit of an aberration though, and much of the spending will be made up in the second and third quarters. We are still involved in three wars (ok, 2 ½, but Libya is still costing real money). The non-defense contribution was nothing, down from a 0.10 point contribution in the fourth quarter and a contribution of 0.25 points in the second quarter.
Last year we were still feeling the effects of the ARRA, but that spending is mostly over and now all of DC is looking to slash spending. Look for the contribution from the Federal Government, particularly the non-defense side, to turn negative over the rest of the year and probably into 2012.
Anyone who suggests that it is possible to cure the budget deficit by only cutting non-defense spending excluding transfer payments like Medicaid and Social Security is someone who quite simply should stay off of Jeff Foxworthy’s show, since they clearly are not smarter than a fifth grader. Social Security has its own dedicated revenue source, and has been running a surplus every year since 1983, and has thus been subsidizing the rest of the Federal Government.
State & Local Governments
State and local governments (S&L) were a 0.41 point drag on the overall economy, down from a 0.31 drag in the fourth quarter, and a 0.09 point contributor in the third quarter. Frankly, given the severe fiscal problems that most of the States are facing, and since they cannot borrow legally to cover operating deficits, the 0.41 drag is about what one would expect.
A big part (apx. 23%) of the ARRA has gone to helping state and local governments to help them avoid having to either cut spending drastically or raise taxes. The ARRA funding is starting to dry up. I would expect that S&L government spending will be a drag on growth in first quarter GDP and that the size of the drag will increase, but it will not be enough to put the economy back into recession. However, private sector job creation is going to have to be extra strong to also absorb all the jobs lost at the state and local government level.
The biggest negative swing by far in the first quarter was net exports, subtracting 0.08 points to growth. That does not sound that bad, but in the fourth quarter, net exports added 3.27 points to growth. In other words, if we had not had an improvement in the trade deficit in the fourth quarter, the economy would have actually fallen in the fourth quarter. That was a huge improvement over the 1.70 point drag in the third quarter and the massive 3.50 point drag net exports were in the second quarter.
Net exports being sort of a non-factor in overall growth is a bit of an anomaly. To some extent, this is a bit of the flip side of the inventory swing, since some imports go into inventories. As net exports tend to be very high quality growth, the fall from being a huge contributor to a minor drag is very bad news.
The contribution from higher exports fell to 0.64 growth points from 1.06 points in the fourth quarter and below the 0.82 point contribution in the third quarter. The U.S. has actually been doing quite well on the export front, and we are well on our way to meeting President Obama’s goal of doubling our exports from 2009 to 2014.
While I would have preferred to see the same sort of contribution we saw in the fourth quarter continue, a 0.64 positive contribution is not all bad, and better exports have been a very big part of the recovery. That is very nice, but when it comes to GDP growth, it is net exports that count, not just exports alone.
If our exports double but our imports also double, we will be in a deeper hole than if both had remained unchanged. It is the import side that was the massive swing factor. Each dollar of imports is a subtraction from GDP, so falling imports is a very good thing from a GDP accounting point of view.
Falling imports added a stunning 2.21 points to growth in the fourth quarter, a massive turnaround from being a 2.53 point drag in the fourth quarter, and a 4.58 point drag in the second quarter. In the first quarter they were a 0.72 point drag. While clearly we have seen worse, it is also the key reason why overall growth was so much lower in the first quarter than in the fourth quarter. If we exclude the effects of international trade, growth would have been negative in the fourth quarter by 0.2%, not a positive 3.1%. In the first quarter it would have been a positive 1.9%.
Can net exports go back to being a positive contributor? A weaker dollar would sure help the cause, and there is plenty of room for further improvement. Net exports are still a huge drag on the economy. Remember we are looking at changes here in the contributions to growth, not levels.
Trade Deficit Remains a Big Problem
Our trade deficit is unsustainably large. It -- not the budget deficit -- is the reason why we are so in debt to the rest of the world. The budget deficit feeds into our overseas indebtedness only indirectly. Over half of our overall trade deficit comes from our addiction to imported oil.
Unfortunately, a weaker dollar is not likely to help significantly on this front, as when the dollar weakens, the price of oil tends to rise. However, a weaker dollar is very useful in reducing the non-oil part of the deficit. It makes imported goods more expensive, and therefore less competitive with domestically made substitutes. It also makes our exports more competitive.
However, if we can start to replace imported oil with domestically produced energy we could substantially boost the overall rate of economic growth. While ultimately we would want to do that with renewable sources, such as wind and solar, they mostly produce electricity, and oil is mostly used as a transportation fuel. We do, however, have very abundant supplies of natural gas, and the technology for using natural gas as a transportation fuel is already very well established.
We need to take steps NOW to transition to the use of more natural gas as a transportation fuel to replace oil. Ethanol really is not that good of an answer since the production of corn to be made into ethanol for fuel requires using a lot of oil. The use of a huge portion of our corn crop to make fuel is a big part of the reason that food prices are rising so quickly. That is a bit of a problem here, and it is a huge problem for the rest of the world.
However if we can move to ethanol made from things like sawgrass or the corn stalks that are left over from the corn harvests, that would be a major step forward. Bio-fuels based on algae are also another promising area. However, commercialization of non-food based ethanol is several years away.
A weaker dollar would help significantly on the other half of the trade deficit, the part that is made up of all the stuff lining the shelves at Wal-Mart (NYSE:WMT). King Dollar is a tyrant and needs to be deposed. It will help on reducing imports as foreign goods become relatively more expensive and producers fill demand from domestic production. That does not happen overnight, however.
The trade deficit is a far bigger economic problem than is the budget deficit, particularly over the short and intermediate term. The fact that we are making significant progress in bringing it down is extremely welcome news.
Report Card: C
Overall, this was an OK, but not great report. The headline number was about as expected. The quality of growth was just OK, and much worse than in the fourth quarter when it was unusually high. The change in inventories, the lowest quality part of growth, represented more than half the overall growth, after being a massive drag on overall growth in the fourth quarter.
The overall feel of this report is much more like that of the third quarter than of the fourth quarter. Just as in the third quarter, inventories added more than half the growth and net exports, especially higher imports were a big drag on growth. I suspect that inventory growth will be sort of a non-factor in the second quarter. It is hard to say which direction net exports will go, but the higher price of oil is not going to help matters.
Growing at 1.8% is nothing to get excited about. Better than falling back into recession, but it is not the sort of growth that is going to seriously reduce unemployment.
We need to see more of a positive contribution from residential investment if we are really going to get the economy back on track. Eventually that is going to happen, but "eventually" can be a long time from now.
The continued high contribution from business investment in equipment and software is very encouraging. The big negative contribution from non-residential structures looks to me like an anomaly, and should probably turn slightly positive in the second quarter and more positive in the second half of the year. Even so, by the end of the year it will still be very low in absolute terms.
The Consumer, which represents the overwhelming bulk of the economy, is doing OK, but not great. While the 1.91 contribution is down from the fourth quarter, it is also at a level that looks very sustainable, and we will probably get a similar contribution in the second quarter.
Government spending is going to be an even bigger drag going forward, although it seems likely that in the second quarter, it will be the non-defense side that is the big drag, not the defense side as was the case this quarter. The anti-stimulus coming from the state and local level is likely to continue if not get worse, and that will be a significant anchor on the economy for at least the rest of the year.
The private sector is going to have to grow much faster to offset the drag from government. Overall private sector growth of 2.9% is not all that bad, although in the early stages of a recovery you would want to see it higher. It would be a very solid showing if averaged over a complete economic cycle. However with the economy operating well below potential, we need to grow much faster than that to get back up to potential.
I am not thrilled with this report, but neither am I despondent about it. However, if growth does not start to rebound again in the second quarter it will be time to get worried. This sort of growth is not going to bring down unemployment and if it persists we may well start to see unemployment creep up again.
The final graph (again from this source) shows the historical relationship between growth of GDP and the change in the unemployment rate. If the 1.8% growth rate were to persist, we would be looking at rising (apx. 0.5% over a year) not falling unemployment rates.