GDI vs. GDP - Which One's a Better Recession Indicator?

by: James Hamilton

The "final" values for 2008:Q2 GDP released by the Bureau of Economic Analysis on Friday were more disappointing than the earlier estimates. Still, the 2.8% annual growth rate for real GDP that we're now told characterized the second quarter doesn't sound like a recession. Or does it?

As we teach in any introductory macroeconomics course, it is possible to think of GDP in two different ways. One is as the dollar value of all final sales of goods and services produced by factors of production located within the United States. The second is as the dollar value of all the income generated by that production. The two measures are equal to each other by definition. But in practice, one can try to calculate GDP either using production data or using income data. If we obtain the production and income numbers from different sources, we're certain to end up with different numbers for what is supposed to be the nation's GDP. The difference between "gross domestic product" (NYSEMKT:GDP) and "gross domestic income" (NYSE:GDI) is simply reported by the BEA as a "statistical discrepancy."

Annual growth rates of real GDP and real GDI
Quarter GDP GDI
2007:Q4 -0.2% -0.8%
2008:Q1 +0.9% -0.5%
2008:Q2 +2.8% +1.8%

Federal Reserve economist Jeremy Nalewaik has several research papers ([1], [2]) arguing that GDI may be a more helpful series for recognizing recessions than is GDP. It is interesting that while GDP indicates sluggish growth over the last 3 quarters, GDI looks much more like a recession, with 2007:Q4-2008:Q1 satisfying the traditional rule of thumb of two quarters of falling real output.

Real GDP and real GDI, 2005:Q1 to 2008:Q2 (quarterly growth reported at annual percentage rates). Real GDI calculated by deflating nominal GDI by the GDP deflator. Data from BEA Tables 1.1.1, 1.1.9, and 1.10.

Jeremy has calculated recession probabilities similar to our Econbrowser recession indicator index using GDI in place of GDP. He has a slightly different approach to real-time versus revised data from the one we use, and bases parameter estimates on a sample beginning in 1959 rather than the 1947 starting point that we use. Using the later starting point causes his parameter estimates to imply slightly milder recessions on average than one would infer on the basis of the full data set, so his algorithm is a little more likely to indicate a recession for given slow or negative growth rates than would ours. But the biggest difference is the more sluggish recent behavior of GDI relative to GDP.

Jeremy was kind enough to prepare for me a plot of his recession probabilities calculated on the basis of GDI, displayed in the figure below. Note that this diagram follows the same rule as our index (plotted here) -- the value of the index for any given date is calculated on the basis of the data as it was actually reported at the time. Jeremy's index unambiguously signals that the U.S. economy is now in recession.

Red line: Nalewaik's recession indicator index based on GDI growth rates. Shaded regions: NBER recession dates.

I'm not convinced that there's a compelling basis for claiming that GDI is a better measure than GDP. But in this case, there's another very important consideration. Measures of employment growth and the unemployment rate seem to be signaling pretty strongly that the U.S. is already in a recession, whereas the GDP numbers do not. Which should we believe? Given that one can reconcile the employment and GDP inferences entirely on the basis of the known numerical value for the statistical discrepancy in the GDP numbers, it seems like a pretty clear call to me -- the U.S. economy is currently in a recession which likely began in the fourth quarter of last year.

There's an important implication of this for the ongoing discussion of the current financial turmoil. The U.S. is currently in a recession, and events of the last two weeks are sure to make things worse for the next few months, even if we had some policy to bring immediate stability to financial markets. That is water under the bridge at this point.

The purpose of the Paulson-Dodd proposals is thus not to prevent the economy from going into recession. The purpose is to prevent the recession from turning into a severe contraction.