October 31, 2014
There was much celebration in the business press over the better than expected third quarter GDP growth. (See, for example, this WaPo piece touting the U.S. recovery as the “envy of the world.”) Many were quick to say that the 3.5 percent growth for the quarter implies that the economy is now on a higher growth path, possibly in excess of 3.0 percent. Mr. Arithmetic begs to differ.
First, if we can look all the way back to the beginning of 2014 we see that the average growth for the first three quarters so far this year is just 2.0 percent, the same as the average for the prior three years. And, just to remind folks, we had a really bad recession back in 2008-2009. This has left us at a level of output way below the economy’s potential. To make up the ground lost the economy has to be growing faster than its 2.2-2.4 percent potential growth rate. At the 2.0 percent growth rate we have seen so far in 2014, we are making up none of the lost ground.
The second point that should have featured prominently in all discussion of the GDP report is that the major drivers of growth in the quarter, net exports and military spending, will almost certainly not be adding to growth in the same way in future quarters and will most likely be in part reversed. In other words, the strong growth in these components is reason for believing future growth will be weaker, not stronger.
Net exports added 1.32 percentage points to growth in the quarter, while military spending added 0.66 percentage points. If the contribution of these sectors to growth had been zero, GDP growth would have been 1.5 percent rather than 3.5 percent.
If the folks who expound on the economy had access to data from the Commerce Department they would know that both of these sectors are very erratic, sharp movements in either direction tend to go in the other direction in the following quarter. (There is a logic to this. Imagine that the true path for both sectors is a constant growth path, but we have random error in either direction. If our error is on the high side one quarter, then if we get an accurate measure the next quarter, it would imply a decline from the erroneously measured number the previous quarter.)
The last time next exports added more than a percentage point to growth was the fourth quarter of 2013 when it added 1.08 percentage points. The following quarter it subtracted 1.66 percentage points from growth. Net exports added 1.12 percentage points to growth in fourth quarter of 2010. It subtracted 0.24 percentage points from growth in the following quarter.
The reversal of the surge in military spending is even more certain. Military spending added 0.58 percentage points to growth in the third quarter of 2012, it subtracted 1.12 percentage points in the fourth quarter. Unless Congress votes some large supplemental military appropriation (@$100 billion a year), we will not see a substantially higher level of military spending on a sustained basis.
But let’s be optimistic and assume that neither net exports or military spending are a drag on growth in the fourth quarter, this leaves us with a 1.5 percent growth rate. Of course, there were also some anomalies on the low side. A slower pace of inventory accumulation (second quarter accumulation was unusually fast), subtracted 0.57 percentage points from growth. This drag will likely not be there in the fourth quarter, pushing growth up to a 2.1 percent annual rate.
The category of housing and utilities subtracted 0.21 percentage points from growth in the quarter. This was almost certainly due to less demand for utilities due to milder than normal weather. It will be reversed in the fourth quarter, with this sector likely adding somewhere around 0.2 percentage points to growth. That would put us around 2.6 percent growth. You would have to do some serious stretching to get to 3.0 percent growth for the fourth quarter, and that assumes that there is no drag on growth from reversals of the spurts in net exports and military spending in the fourth quarter.
In short, Mr. Arithmetic thinks the celebrations of third quarter GDP were premature. The economy is likely still on the slow growth path of the last three years. We’ll see whether or not he is right when the fourth quarter data are released in January.
There are a couple of other points in the Post’s celebration that are worth comment. The piece notes the slowing of growth in China and then asks whether the U.S. economy can still be the engine of world growth as it ostensibly was before the downturn. Since the U.S. economy and Chinese economy are now roughly equal in size, even if China’s growth slows to 5 percent it will still be providing far more of a boost to the world economy than any plausible growth rate for the U.S. With the Chinese economy growing much larger than the U.S. economy over the next decade, the days of the U.S. economy as the primary engine of world growth are history.
The other point is that the piece wrongly touts the prospect of improved consumer confidence leading to a surge in consumer spending. The implication is that consumer spending has been depressed. That is not true. The saving rate out of disposable income was 5.5 percent in the third quarter. This is higher than the 2.5 percent rate at the peak of the housing bubble, but well below the 8.0 percent average for pre-bubble years. In other words, there is little reason to expect consumption spending to rise much relative to income, even if consumers are more confident.
The key issue remains that there is no plausible way to offset the drag of GDP created by the trade deficit in the absence of either large-scale deficit spending or another bubble. The trade deficit did fall sharply in the third quarter, driven largely by reduced oil imports, but this pace of decline is unlikely to continue. Therefore we are likely to be stuck with an economy that is operating well below its capacity for quite some time. This means millions of people will be unemployed or under-employed for no good reason.
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