GDP: less growth, more inflation

As this chart from Calculated Risk shows, today's historical revisions to GDP subtracted a lot—a little more than $200 billion—from real GDP. The recession now looks worse than before, and the recovery looks weaker. Real GDP has still not recovered to its 2007 high. Although growth in 2010 was revised upwards, growth this year has proved to be much weaker than previously thought. On a minor note, my original forecast in late 2009 that GDP would grow by 3-4% in 2010 has now been vindicated, since according to today's revisions, GDP expanded by 3.1% in 2010. But so far, first-half 2011 growth (0.8%) is much slower than the 3-4% I expected last December.

Much of what was subtracted from real GDP was added to inflation (i.e., nominal GDP didn't change very much, but its composition did). The first of the above two charts shows quarterly annualized changes in the GDP deflator before today's revision, and the second shows them after the revision, including the second quarter number. Previously, we had two quarters of deflation, with six quarters of inflation that was either very close to zero or negative. Now we see only one quarter of deflation, and only two that were close to zero or negative. For the first half of this year the GDP deflator has risen at a 2.6% annualized rate. The CPI rose at a 3.8% rate over the same period, so between the two we have clear signs of accelerating inflation.

This has to be a very surprising and even shocking result for establishment economists as well as for the Fed. As the above chart shows, real GDP is now over 12% below its long-term trend. This huge "output gap" should have been extremely deflationary, according to traditional Keynesian analysis, but that hasn't been the case at all. The Fed has been in a near-panic for the past three years, believing that the extreme weakness (aka "resource slack") of the economy posed the very real threat of a debilitating deflation, but deflation has proved to be only a fleeting phenomenon. If current trends continue, the Fed is soon going to be worrying about too much inflation, not too little. 

Once again these developments underscore supply-siders' belief that growth can only come from hard work and risk-taking. Monetary policy can't create growth out of thin air, and neither can fiscal "stimulus" spending. The swimming pool analogy is very apt: fiscal spending "stimulus" is akin to taking water out of the deep end of a pool and pouring it into the shallow end—it achieves nothing and is simply a waste of effort. Real growth only occurs when people work more and/or someone figures out how to make the same amount of work produce more output.

If there is a silver lining to this gloomy GDP cloud, it is that fiscal and monetary policy "stimulus" have now been soundly discredited. Congress does not have the power to pull spending levers in order to speed up the economy, and the Fed can't speed up the economy by keeping interest rates at artificially low levels. In fact, fiscal and monetary policy errors of the sort we have lived with in recent years only serve to weaken the economy. Too much debt-financed spending only wastes the economy's scarce resources, while simultaneously boosting expected tax burdens. This in turn reduces the after-tax rewards to hard work and risk-taking, which explains why corporations have been so slow to invest their growing stockpiles of cash. Too much easy money only boosts speculative activity (which shows up as higher commodity and gold prices) while undermining the dollar and reducing investment.