In the fourth quarter, the economy grew at an annual rate of 3.2%, up from 2.6% in the third quarter, and up from the 1.7% pace in the second quarter of 2010. The growth rate was somewhat below consensus expectations, 3.5%, and frankly a bit lower than I was expecting. However, the quality of the growth was extremely high, so overall I would have to say that this was a very strong report.
So how did we get to the 3.2% overall growth? What parts of the economy were growing and thus adding to growth and which parts were acting as a drag on growth? 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 70.8% of the overall economy in the fourth quarter, and was the biggest growth driver. PCE contributed 3.04 growth points, up from 1.67 points in the fourth quarter and 1.54 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.
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 66.43% of PCE and 47.02% of overall GDP. It chipped in 0.78 growth points, up slightly from contributing 0.74 points in the third quarter and from a net contribution of 0.75 points in the second 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 (F) more easily than they can defer purchase of a box of corn flakes from Kellogg’s (K), durable goods demand is very volatile.
As a result, durable goods tend to “punch above their weight” in determining is the economy is booming or slumping. Durable goods consumption added 1.48 points to growth, up sharply from an addition of 0.54 points in the third quarter and 0.49 points in the second quarter.
The high and accelerating contribution from durable goods is exactly what we want to see at this stage of the recovery (well actually it would have been nice to see it earlier, but I’ll take it now). The sector is only 12.87% of PCE and 9.11% of overall GDP, yet it contributed 46.25% of the overall GDP growth in the quarter.
Non-durable goods are 22.78% of PCE and 16.12% of overall GDP. The sector’s contribution to growth rose to 0.78 points in the fourth quarter from 0.39 points in the third quarter and 0.31 points in the second 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.
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 s/he was in the fourth quarter.
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 12.08% of the overall economy. Overall GDPI subtracted 3.20 growth points in the fourth quarter, a sharp reversal from adding 1.80 points in the third quarter and 2.88 points in the second quarter.
The decline in contribution from GDPI is disconcerting, at least at first glance. Its shrinkage as a share of the economy was dramatic, in the third quarter it made up 12.93% of the overall economy. However, when one looks a bit deeper, the picture is much more encouraging. In fact, I would almost call it a reason for celebration, not despair. The operative word there is “almost.”
Investment is the key to future growth and 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 fourth 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 drawdown in inventories accounted for more than all the overall drag from GDPI. Inventory investment subtracted 3.70 points from growth in the fourth quarter. That is a sharp reversal from the third quarter, when higher inventories added 1.80% to overall growth and from the second quarter when it added 0.82 points to growth.
In other words, in the third quarter, 69.2% (1.80/2.6) 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.
The big negative contribution from inventories this time around is actually good news, and was the major reason that overall GDP growth came in lower than I (and most everyone else) was looking for. While as we have seen over the last few years a negative contribution in one quarter does not guarantee a positive contribution to the next quarter, getting a bit of inventory correction out of the way now is a good thing. It potentially sets us up for strong growth in the first quarter.
After all, if inventories had just been a non-factor, the economy would have been booming at a 6.9% growth rate (then again the growth rate in the third quarter would have been only 1.0% and in the second quarter only 0.9%, so it can cut both ways).
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 0.08 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.
Residential investment is now just 2.27% of the overall economy, down from well over 6% of the economy at the peak of the housing bubble. Residential investment has been a drag on GDP growth in 14 of the last 17 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 2 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.
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. Investment in structures added 0.02 points from growth in the fourth quarter, so it was sort of a non-factor, just as it was in the fourth quarter, when it subtracted 0.09 points and in the second quarter when it added 0.01 points.
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.
On balance, investment in non-residential structures is likely to be close to a non-factor again in the first quarter. If I have to guess, it will probably be on the positive side, but only slightly. Later in the year and into 2012, it is more likely to be a significant positive force for economic growth, but not yet.
Equipment & Software Investment
Investment in equipment and software (E&S) is what we really want to see to power future growth, and there the news continues to be good, but not quite as good as earlier in the year. E&S investment added 0.41 points to growth, which is not a bad showing since it is only 7.11% of the overall economy. It is down, however, from a 1.02 point contribution in the third quarter and a 1.52 point contribution in the second quarter.
This is the seventh quarter in a row that E&S investment has made a positive contribution to growth. A year ago, investment in E&S was just 6.43% 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, and don’t like the declining trend, but a 0.41 point contribution is still not that bad.
Government spending subtracted 0.11 points to growth in the fourth quarter, down from a 0.79 point addition in the third quarter, and a 0.80 point addition in the second 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 slight drag from Government spending indicates that the private sector is now doing it on its own, and this is no longer a stimulus-fueled “sugar high” of growth.
The Federal Government was a non-factor in the fourth quarter, subtracting 0.01 points from growth. 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 8.33% of the economy in the fourth quarter. Of that, 67.09% was spent on Defense, and 32.91% was on Non-Defense spending. Put another way, just 2.74% of the overall economy is non-defense federal spending (excluding transfer payments) and 5.59% of GDP is spent on Defense.
Defense spending subtracted 0.11 points from growth, down from a contribution of 0.46 points in the third quarter and 0.40 points in the second quarter. The Non-Defense contribution was 0.10 points, down from a 0.25 in the third quarter and a contribution of 0.32 points in the second quarter.
Anyone who suggests that it is possible to cure the budget deficit by only cutting Non-Defense spending and 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 were a 0.10 point drag on the overall economy, down from a 0.09 contribution in the third quarter, and a 0.08 point contributor in the second 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 0.10 drag is a major positive surprise.
A big part (approx. 23%) of the ARRA has gone to helping State and Local Governments to help them avoid having to either cut spending drastically or rise 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 really slow down the overall economy.
Net Exports (X – M)
The biggest positive swing by far in the fourth quarter was net exports, adding 3.44 points to growth. In other words, if we had not had an improvement in the trade deficit, the economy would have actually fallen in the fourth quarter. That, is 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.
To some extent, this is a bit of the flip side of the inventory swing, since some imports go into inventories. Still, this is extremely good news, and represents very high quality growth.
Both sides of the net export equation helped out. The contribution from higher exports rose to 1.04 growth points from 0.82 points in the third quarter and was just slightly below the 1.08 point contribution in the second 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. 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 2.40 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.
Can that sort of contribution be sustained? That is a hard question to answer. 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, just less of a drag than they were. Our trade deficit is still unsustainably large.
Trade Deficit & Our “Addiction to Oil”
On the other hand, I would not count on a repeat of this sort of massive contribution again in the first quarter or for 2011 as a whole. About 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 — when the dollar weakens, the price of oil tends to rise.
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. However if we can move to ethanol made from things like saw grass, 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.
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 (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.
The Takeaway: Fair to Middling Report
Overall, this was an OK, but not great report. The headline number was clearly much lower than expected, but the quality of growth was extremely high. The change in inventories, the lowest quality part of growth has gone from being a big part of overall growth in the third, and especially second quarters, to being a big negative factor. One where we are showing significant growth despite the inventory change, not because of it.
I would expect that the change in inventories will be much less of a factor in the first quarter. All else being equal, that would mean a big acceleration in the rate of growth.
Of course, all else is not likely to be equal. Net exports are likely to be a contributor again in the first quarter, but a much smaller one. That should offset much of the better growth from inventories being less of a drag. The growth coming from the Consumer was impressive, and is probably sustainable, although it too might be a somewhat smaller contributor in the first quarter, but will still be a force for growth.
Building, both residential and non-residential, should be more or less a non-factor again in the fourth quarter, but that is better than being a big weight tied around the ankles of the economy. Historically, Residential Investment is what pulls the economy out of recessions. Investment in non-residential structures tends to come much later in the economic cycle.
The drag from State and Local Government spending is likely to accelerate it in the first quarter, and we do not need to compound that with a major drag from Federal government spending. Having the overall government being a non-factor at this stage of the economic cycle is probably about where we want to be.
Overall, a solid but not spectacular report, but one that lays the foundation for more growth ahead.