(This is Part 2 of the "How We Got to 1.3% Growth" article. Part 1 can be found here.)
Government Spending
Government spending subtracted 0.16 (0.18, 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 and Medicare, 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 0.16 (0.16, 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 fourth quarter. All of the change came from the defense side, which added 0.37 (0.38, 0.39) points to growth. 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.
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, 2 ½, but Libya is still costing real money — though with the liberation of Tripoli, that cost should diminish very rapidly).
Non-Defense Government Spending
The non-defense side of the federal government was a 0.22 (0.21, 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.
Therefore, 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.
Looking further out, if the Super Committee is deadlocked — or what they propose is not passed by Congress and signed by the President — then massive, meat-cleaver cuts will kick in for 2013, which will make Federal Government spending a huge drag on GDP growth. I think the chances that the Super Committee will come up with the $1.5 Trillion in cuts it is supposed to be looking for that can actually become law are extremely small.
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 is quite simply not dealing with reality. 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
State and local governments were a 0.34 (0.34, 0.41) point drag on the overall economy. That was lower than 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 of the states are facing, and since they cannot borrow legally to cover operating deficits, the 0.34 (0.34, 0.41) drag is about what one would expect.
A big part (apx. 23%) of the ARRA has gone to helping state and local (S&L) 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, and then increase still further in the fourth quarter and into 2012.
The drag just might be enough to put the economy back into recession. The odds of a new recession have been rising, and now stand at about 40% or so. Still not the most likely scenario, but far from a long shot, either. Private sector job creation is going to have to be extra strong to also absorb all the jobs lost at the S&L level. Over the last year, 340,000 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 0.24 (0.09, 0.58) points to growth. The downward revision in the second look was deeply discouraging, but we regained some of it this time around. If we are going to climb out of the current economic morass, we are going to have to do a much better job on net exports, particularly if residential investment is not going to be playing its normal role of pulling the economy out of a slump.
Still, relative to the first quarter they are 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 (as of the first release) 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 0.48 (0.41, 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, and the growth of exports in this recovery has been better than it was in any of the previous three recoveries. The downward movement the export contribution is a bit discouraging, but the overall level is still OK.
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.
Imports & Oil
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 0.24 (0.33, 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.
Also, the price of oil imports tends to track Brent, not WTI, and Brent has been far more expensive over the last year than WTI (not always, or even usually the case). The price of Brent crude has not fallen as much as that of WTI since late April. If we exclude the effects of international trade, growth would have been only 1.06 (0.91, 0.7%) in the second quarter, up only slightly a 0.7% growth rate in the first 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
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 on 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.
Given the drag from fiscal austerity, I suspect that second-half growth is more likely to be around 1.0% than 4.85%.
The Fed seems to be grasping at straws. Operation Twist is likely to have very little effect on raising the growth rate. While I don’t think it is a bad thing to do, I just don’t think it will really accomplish much. Sort of like rearranging the deck chairs. 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, about a quarter of our exports go to Europe, and they are seeing even weaker growth than we are — most notably in the PIIGS, but increasingly in the core countries of Germany, France and the U.K.
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.
Overall: Positive Report
This was a positive report. Growth was slightly above consensus expectations, and the quality of growth improved. Still the absolute level of growth is very anemic.
Looking forward, spending cuts at all levels of government are slowing down the economy. Relative to the first quarter, we did get a pick up from the federal side, but that was all from defense spending, and as Eisenhower said, “Every gun that is made, every warship launched, every rocket fired, signifies in the final sense a theft from those who hunger and are not fed, those who are cold and are not clothed.” Thus it is hard to get excited about growth that comes from higher defense spending.
That growth was also not very surprising given it came after two quarters of sharp declines. The already substantial drag from S&L cutbacks will probably increase as well as the year goes on.
If the American Jobs Act (AJA) is not passed, there will also be a massive negative effect on PCE starting in 2012. The payroll tax on the personal side will revert back to its 6.3% level from its current 4.3% level.
In other words, the after-tax income of everyone earning less than $106,800 will fall by 2%. If it is passed, they will rise by 1% from where they are in 2011. For the median household, that means a drop of about $1,000 in their paychecks. That alone could be enough to send the economy back into recession.
Plenty of Room for Improvement
Growing at 1.3% (1.0%, 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 in the quarter. A sector of the economy makes up 71% of overall GDP needs to be adding more than 0.49 (0.30, 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. 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, and most likely much longer than that.
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. 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 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% (1.0%, 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, but starts back in 1980, so a few new data points would not change the overall picture.
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