(This blog is a continuation of "Growth Quality Revised Lower.")
Structures vs. Equipment & Software
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 subtracted 0.48 (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. The revised number is more like what I was expecting in the first place.
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 (50 is flat on this index) 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. The reduced drag from investment in structures is the one area where the quality of growth actually significantly improved with the revisions.
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. E&S investment added 0.81 (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 of 2010.
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 0.81 (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. (Unfortunately, this graph is not updated with the revised numbers.)
Government
Government spending subtracted 1.07 (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 (unrevised) 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
Defense spending subtracted 0.68 (unrevised) 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.
While making and dropping bombs does add to the economy in the national income statistics, it does not exactly build the economy or make most 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 (unrevised), 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 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
State and local governments were a 0.39 (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 0.39 (0.41) drag is about what one would expect.
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. But 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.
Net Exports
The biggest negative swing by far in the first quarter was net exports, subtracting 0.06 (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 nonfactor 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 rose to 1.16 (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 Obama’s goal of doubling our exports from 2009 to 2014.
Better exports have been a very big part of the recovery. The big upward adjustment to the export contribution is very encouraging. The weakness in the dollar seems to be having a beneficial effect. 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 1.12 (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. I suspect that much of the increased drag from higher imports was due to higher oil prices. They may also have had an effect in the lower contribution from consumer spending as well.
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 in Dire Shape
Our trade deficit is unsustainably large. It is the reason why we are so in debt to the rest of the world, not the budget deficit. 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 ion 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, 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 (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.
Disappointing Report
Overall this was a disappointing report, and not just because it fell two ticks shy of the consensus expectations. Much more significantly, the growth that we got was simply low-quality inventory additions. The Consumer is still doing his part, but not very energetically. Construction, both residential and non-residential, should be playing a major positive role in driving the economy at this point in the cycle, but both remain drags.
The good news on exports was offset by bad news on imports. Spending cuts at all levels of government are slowing down the economy, although the amount of the drag was just slightly lower than first estimated. 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.
In Summation
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 1.53 (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. While over the long term I would like to see the consumer become a smaller share of the overall economy, at this point of the cycle it is imperative that the consumer play a big role.
The big downward revision to the consumer contribution is probably the most significant disappointment in this report. 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 & 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 2.87% 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 int eh unemployment rate. If the 1.8% growth rate were to persist, we would be looking at rising (approx. 0.5% over a year) not falling unemployment rates.
The table below, also from (http://www.calculatedriskblog.com/) summarizes the changes in contributions.
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