Read ‘Em & Weep: GDP In Depth, pt. 2 (SPX)

(EDITOR’S NOTE: This article is a continuation of our recently-published "Read ‘Em & Weep: GDP In Depth, pt. 1.")

Government Spending

Government spending subtracted 0.23 points to growth in the second quarter, down from a 1.23 (1.20) point drag in the first quarter, and a 0.58 (0.34) point drag in the fourth 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 from Boeing (BA). 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 actually added 0.18 points to growth, a big swing from the subtraction of 0.82 (0.69) points in the first quarter, and a 0.26 (0.02) drag in the second quarter. All of the change came from the Defense side, which added 0.39 points to growth.

Defense Spending

In the first quarter, it was a 0.74 (0.74 point) drag, and in the fourth quarter it was a 0.34 (0.34) point drag. In the GDP accounts (again, with transfer payments not included), Defense makes up 67.14% of overall government 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. The sharp drop in the first and fourth quarters is a bit of an aberration. It is thus not that surprising that it was a major positive contributor this time. We are still involved in three wars (OK, 2½, but Libya is still costing real money).

Non-Defense Government Spending

The non-defense side of the federal government was a 0.21 point drag in the second quarter. In the first quarter it was a 0.08 point drag and it was a 0.09 point contributor in the fourth quarter (both unrevised). 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. For all of 2010, it was a 0.19 (0.17) point contributor to growth. Given the obsession with cutting spending going on in D.C. right now, it’s clear that the federal government is going to turn into a much larger drag on growth in the second half.

If the debt ceiling circus is not resolved, it is going to be a massive drag. If it is resolved the way the Tea Party wants it resolved, it will still be a huge drag on growth.

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.

That spending is only 32.9% of government spending, and a mere 2.71% of GDP. 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 0.41 point drag on the overall economy. That matches the revised 0.41 (0.51) point drag in the first quarter, but is up from the 0.33 (0.31) point drag in the fourth quarter. Frankly, given the severe fiscal problems that most 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 rise taxes. The ARRA funding has dried up. I would expect that S&L government spending will be a drag on growth in third 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. Over the last year, 305,000 state and local jobs have been lost, creating a very substantial headwind to overall job creation.

Net Exports

The biggest positive swing in the second quarter was net exports, adding 0.58 points to growth. That is up from being a 0.34 point drag (0.14 point contributor) in the first quarter. There was a huge revision to the fourth-quarter numbers, where net exports are now only seen adding 1.37 points to growth, down from the previous 3.27 point addition.

This is sort of the flip side of the revisions to inventories for the quarter. When goods are imported, they often first go into inventories before they are sold.

The contribution from higher exports fell to 0.81 points from 1.01 (0.97) points in the first quarter and the 0.98 (1.06) point contribution in the fourth 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.

Better exports have been a very big part of the recovery. The downward movement the export contribution is a bit discouraging, but the overall level is still quite strong. The weakness in the dollar seems to be having a beneficial effect.

This is all 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 dollar subtraction from GDP, so falling imports is a very good thing from a GDP accounting point of view. Rising imports were a 0.23 point drag on growth in the second quarter. In the first quarter they were a 1.35 (0.84) point drag. The really big revision was to the fourth quarter, where falling imports are now seen as only a 0.39 point contributor to growth, down from the previous 2.21 point contribution.

The fall in oil prices since the end of April is the primary reason that the drag from imports was so much lower in the second quarter than in the first. There is a bit of a lag between the oil prices you see quoted each day in the financial press, and what shows up in the GDP accounts, so we might see a bit more positive news from the import side in the third quarter.

If we exclude the effects of international trade, growth would have been only 0.7% in the second quarter, matching a 0.7% growth rate in the first quarter, and down from 0.9% growth in the fourth quarter.

Can net exports continue 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 & Oil Addiction

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.

The Fed recently reduced its growth forecasts for 2011 to 2.8%. Clearly those estimates are going to have to be revised down again, and sharply. With growth in the first half of just 0.85%, that means that second half growth will have to average 4.75% to get the whole year to 2.8%.

I see no possible way that we will get growth of anything like that in the second half. Given the drag from fiscal austerity and the Fed now sitting on the sidelines, I suspect that second half growth is more likely to be around 2.0% than 4.75%. Yes, some of the temporary negative factors will abate, but so too will some positive temporary factors, such as the Fed’s QE2 program. We will still need a very solid contribution from net exports even to get to that level of growth.

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, but it is a huge problem for the rest of the world. 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. However commercialization of non-food based ethanol is still several years away.

Deposing King Dollar

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.

Report Card: F

This was a disastrous report. Not only was growth far below consensus expectations, it was even below what most of the pessimists on growth (like me) were looking for. Keep in mind that the 1.7% consensus expectation was after the estimates had fallen sharply in recent weeks. Not that long ago, people were looking for a substantial acceleration in growth in the second quarter relative to the first.

Well, if you want a silver lining, we got it. But that was only due to a massive downward revision to the first quarter. The solid growth we thought we had in the fourth quarter turned out to be mostly a mirage as well.

The overall level of GDP is now much lower than we thought it was, mostly because the recession was far worse than earlier thought (and who didn’t think the original numbers were awful). The recovery has been a bit weaker overall than we thought, but there were quarters that were revised substantially higher as well as lower, so most of the downward adjustment is due to the worse-than-thought downturn.

Looking forward, spending cuts at all levels of government are slowing down the economy, and the amount of the drag was higher than we thought after the last look at the data. We did get a pick-up from the federal side, but that was all from Defense spending. That growth was also not very surprising given it came after two quarters of sharp declines. The already substantial drag from state and local government cutbacks will probably increase as well as the year goes on.

Growing at 1.3% is nothing to get excited about, even if it is up from 0.4% growth in the first quarter. Better than falling back into recession, but it is not the sort of growth that is going to seriously reduce unemployment. The general rule of thumb is that we need at least 2.0% growth to see the unemployment rate fall.

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 encouraging, the downward revision to it is certainly not. Nor is the fact that its contribution is falling.

The Consumer, which represents the overwhelming bulk of the economy, simply went AWOL this quarter. A sector of the economy makes up 71% of overall GDP needs to be adding more than 0.07 points if the economy has any hope of growing enough to bring down unemployment. While both of the previous quarters were revised down for PCE, the bigger concern is the more straight forward slowdown from quarter to quarter, even after the revisions.

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. Government spending is going to be an even bigger drag going forward. The drag from the non-defense side is going to be big in the second half, even if the debt ceiling is raised.

If it isn’t, the drag will be massive (and the Defense side too, with the very real danger of weakening national security). 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.

No Forward Momentum

The economy has no real forward momentum, and none of the recent economic reports seem to be pointing to any sort of big pick-up in the economy in the third quarter. It is time for Congress to stop fixating on cutting spending now. That is simply a debate over how fast we can undertake measures to slow the economy. With unemployment at 9.2% and rising, that is insane.

The slower growth is going to depress tax revenues even more, so I doubt we will see the deficit fall anywhere close to what is advertised in the spending cuts. Even if by some miracle we were to see growth accelerate to say 2.5% in the second half, it is not going to bring down unemployment to normal levels for a very long, long time.

The lack of jobs is a real crisis. The debt ceiling is an entirely made-up crisis, manufactured for political reasons. It actually has nothing to do with the deficit. The deficit is a long-term problem, not an immediate one.

The final graph (again from this source) shows the historical relationship between growth of GDP and the change in the unemployment rate. If the 1.3% growth rate were to persist, we would be looking at rising (apx. 0.8% over a year) not falling unemployment rates. The data on this graph, though, is only through the third quarter of 2010.

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