Thursday, November 29, 2012

Three under-appreciated GDP facts

Everyone knows that the economy is weak, and that this recovery has been the weakest ever. So weak that the Fed believes it is going to have to keep interest rates at zero and continue buying bonds by the bushel for the next several years. So it is rather surprising to look inside today's third quarter GDP revision and discover three under-appreciated areas of strength: nominal growth last quarter was the strongest in over 5 years, inflation is running above the Fed's target, and corporate profits are extremely strong.

As the above chart of quarterly GDP shows, in the third quarter the economy posted its fastest rate of nominal growth in over 5 years. The last time nominal GDP grew by more than Q3/12's 5.55% pace was the second quarter of 2007, when it registered 6.5% annualized growth. On a nominal basis, Q3/12 growth was a good deal better than the 4.0% average pace of quarterly growth since the current recovery started in mid-2009. And at 2.7%, real growth in the third quarter was comfortably better than the 2.2% average for the current recovery. Despite almost universal gloom, last quarter stands out as one of the best in the current recovery.

The above chart shows the quarterly annualized rate of inflation according to the GDP deflator, the broadest measure of inflation available. The latest reading for the third quarter was 2.8%, and that is above the Fed's professed inflation target of 1-2%. Taken together, both growth and inflation in the third quarter were non-threatening. So why is the Fed still panicked? 

What worries everyone, of course, is that the economy has fallen way behind where it could have been if this recovery had been a normal one, and if the economy's potential growth rate track were the same as it has been for most of the past 50 years. With an output gap (see above chart) of as much as 13%, there aren't enough jobs to bring the unemployment rate down to healthy levels. The Fed wants to close the actual/potential GDP gap since that will increase jobs and reduce the unemployment rate.

The question everyone should be asking is whether monetary policy is capable of accomplishing such a feat.  Is the economy struggling because there is a shortage of money? Can zero interest rates on cash convince small businesses to hire more people? No one really knows, but neither has anyone ever argued that monetary policy was an effective tool for generating real growth. The Fed is in uncharted territory, with regards to the magnitude of its quantitative easing efforts and the scope of its policy objective.

The chart above compares total after-tax corporate profits (as calculated by the Bureau of Economic Analysis) to the level of nominal GDP. The two y-axes are calibrated so that both show a similar range. Note how strong profits have been during this recovery, and over the past decade. The growth rate of profits appears to be tapering off, but profits are still up 4% over the past year.

As this next chart shows, corporate profits have displayed unprecedented strength in this recovery. Never before have profits been such a big percentage of GDP (with the exception of last year's fourth quarter). 

This chart of PE ratios is constructed using the S&P 500 index (normalized) as a proxy for the value of all corporate businesses (the P), and the after-tax corporate profits measure shown in the preceding two charts for the E. PE ratios by this measure have rarely been lower, even though profits have never been stronger.

For purposes of comparison, the chart above shows the traditional measure of the PE ratio of the S&P 500 index, using trailing 12-month reported earnings. Both this chart and the one above it tell the same story: PE ratios are substantially below their long-term average, despite record-setting profits. The only explanation for this anomaly is that the market apparently believes that the current level of profits is not sustainable, and that profits will likely revert to their mean (e.g., 6% of GDP) in coming years—which would entail a huge decline in nominal terms.

The chart above compares total corporate profits to nonfinancial domestic corporate profits. which make up about half of total profits. This shows that the strength of corporate profits is broad-based, since both measures have increased by a similar order of magnitude in the current recovery.

This last chart compares corporate profits to global GDP. Here we see that profits are not unusually high at all, and not much different from their long-term average. This casts doubt on the need for, or the likelihood of, a big, mean-reverting decline in profits in coming years, and that further suggests that the market may be much too pesssimistic about the outlook for profits. U.S. companies now make a much larger percentage of their profits from overseas, and that is to be expected since the world has become much more integrated and many foreign economies are experiencing exceptional growth (e.g., India, China). The global marketplace has expanded much more rapidly than the U.S. economy, and U.S. corporations are benefiting from that expansion. Over the past decade, U.S. exports have grown 40% more than U.S. GDP.

So two puzzles remain: if corporate profits are so strong and there is little reason to expect them to collapse, why are PE ratios so low, and why aren't corporations using those profits to boost GDP by investing in more plant, equipment, and personnel?

I'm compelled to note here that total after-tax profits of U.S. corporations have averaged about $1.3 trillion per year since the recovery began in mid-2009, and that this happens to be almost identical to the annual federal budget deficit over the same period. Think of it this way: corporations have generated over $4 trillion in profits during the recovery, and substantially all of those profits have been borrowed by the U.S. government to finance what for the most part has been a huge expansion of transfer payments and a shortfall of tax collections (due to the output gap and the reduced level of employment).  Corporations may not have directly funded the federal deficit, but the funds they have saved and supplied to the credit markets, being fungible, have in effect found their way into Treasury notes and bonds. Since the U.S. government is highly unlikely to be able to spend $4 trillion as productively as corporations could, much of the money has, in a sense, been squandered. Collectively, we have not spent those funds in a very productive manner, so it is not surprising at all that the recovery has proved to be unusually weak.

Of course, that still leaves unanswered the question: Why aren't corporations using their profits to expand? The only sensible answer to that is that there is still a great deal of uncertainty about the future, which in turn stems from 1) the possibility that taxes on capital could increase dramatically in coming years, 2) the fact that Obamacare imposes significant new taxes on many people and significantly higher costs on small businesses, 3) the strong likelihood that regulatory burdens will be increasing, especially with the implementation of Dodd-Frank, and 4) concerns over the ability of the Federal Reserve to reverse its massive quantitative easing program in time to avoid a significant increase in inflation. All of these represent uncertainties, higher costs, and headwinds that weigh on any business' decision to put capital at risk.

In the end, the story boils down to this: government spending is a tax, and too much of it can smother an economy's growth potential. Japan is the prime example. Having engaged in massive deficit-financed public sector spending over the past few decades (enough to make ours look tame by comparison), it is not surprising that Japan's economic growth has been much weaker than ours.

We must find ways to reduce projected federal spending, especially on entitlements, if this economy is going to regain its former luster.


Benjamin said...

Another very solid wrap-up of economic outlooks by Scott Grannis.

And we get this for free?

And what does the CPI say about that?

The ability of the private-sector to adapt even in the face of governmental headwinds is remarkable. BTW, governmental headwinds from the local, state and federal levels. It is awful what we do to business in the USA, at every level.

Try building seaside condo sky rises in Newport Beach, CA. You have to get voter approval. But they call Santa Monica the red city.

That said, I think there is more monetary policy can do. Every modern, developed nation has a mess of taxes and regulations, at local, state and federal levels. So does Commie China.

But China has an aggressive growth oriented central bank. Japan's Bank of Japan shoots for zero inflation, growth being secondary.

And how is that working out?

On inflation. Shooting for too-low inflation by a central bank seems to invite monetary suffocation---see Japan and the ECB. Both until recently, had zero inflation targets. It just does not work. Forget theory, forget morals. It doesn't work.

If inflation is theft, then zero inflation is economic suffocation.

Is the Fed aggressive enough now? Maybe. They have been flatfooted since 2008, and current troubles began. At long last, they have adopted a open-ended QE program, pegged at $40 billion a month. I would prefer a larger number, or a rising number, until more-solid nominal GDP growth figures come in.

On federal outlays, the news is bad. The GOP calls for entitlement cuts, but most entitlements go to old people (Medicare and Social Security) and old people vote. The GOP is never really going to cut those outlays, largely funded by payroll taxes.

On agency spending (largely funded by corporate and income taxes), the GOP is in favor of increased outlays, for defense, homeland security, the VA, the USDA---but that is the lion's share of federal agency spending. What happened under Bush jr, is instructional. Boom times in DC.

So, no cuts from the GOP, and none from the D-Party either (the D-party actually likes deficit spending---but then so did Reagan, Bush, Bush jr, so who doesn't like deficit spending?).

All we can hope for is an aggressive Fed, and that a boom economy contracts the federal deficit. The QE is paying down debt too. So far, the monetization of debt has resulted in little inflation, and inflation remains near historic postwar lows. Let us hope that even more QE works.

I wish I had another party to vote for.

Good luck everybody.

Joseph Constable said...

What a strange wonderful loop. Deficit spending is government negative savings which ends up as business profits less any household savings as the money travels to and through individuals ultimately ending up as profits. The spending also goes to businesses first which ultimately ends up going to and through people back into profits less personal savings, if any. The MMTers gotta love this.

Profits are good because they are the basis for investment. Investment is the best way to produce more business profits instantaneously in the macro view. The micro expenditure is capitalized on the balance sheet with no expense associated with it. Over time consumption allowances expense the asset but at first spend the money goes into the economy and lands as business profits less household savings without any expense booked on the income statement. What a great system.

But government efficiency can’t be the only downside to doing deficit spending as much as I appreciate how extreme the inefficiency is. Saying government is inefficient doesn’t do it justice. Still, it looks like a free lunch to do deficit spending. There must be more downside than extreme inefficiency. I want to expand my understanding of what is damaging from deficit spending. I want to be able to explain it to my liberal (former) friends. And after all, the market monetarists think deficit spending is a good thing to do. (see previous comment). “We’re all Keynesians now”.

steve said...

fascinating stuff scott. excellent job. oh that govt could be run by business leaders! oh wait, we tried. to your point about why the market is cheap; FEAR! to your point about why biz isn't spending; why should they? they're raking in profits without spending much. common sense really.

B Terramorse said...

Yes growth is nice, and yes profits have been huge for years. The real economic is low wages and high unemployment. 30 years of corporate revenue growth that has been largely based on cutting staff, lowering wages and shedding benefits has taken their toll. Seriously Wal-Mart is the largest retailer in the world and their average employee is a part-timer on poverty wages. What the hell kind of future for the average worker is that?

Where is the economic theory that will seek to cure that? Certainly not Austerity. Look at Europe!

We really can't give any more tax cuts to the job-makers, can we.

And why do these conversations never seem to recall that there was a surplus very recently under Clinton. And that the first thing that the Very Responsible Republicans did was to flush it down the toilet to create another crisis in governance to further the goals of the Republicans.

Dr William J McKibbin said...
This comment has been removed by the author.
Dr William J McKibbin said...

I regret that serious spending cuts by the US government are unlikely -- moreover, I suspect that tax increases are imminent -- however, neither cuts to government spending or tax increases (or even a balanced approach that includes both) have any chance of "fixing" the US economy -- said another way, austerity in the form of spending cuts and/or tax increases has failed and would be "too little too late" to change America's economy regardless -- austerity is now irrelevant.

If we take austerity off the table as a way forward (for whatever reason), that leaves only two remaining paths forward: a) monetary expansion (resulting in inflation, which is a form of default); or b) outright default on some or all of the national debt.

Again, austerity has failed, leaving only two remaining economic paths forward. I wonder which path Scott would prefer: a or b...?

Dr William J McKibbin said...

PS: What everyone should try to understand is that the profits being enjoyed by our nation's largest companies will never be seen by Main Street USA -- the reality of the top 1% will soon have 99% of the nation's wealth, while the rest of America endures ever deeper declines in real working wages, home values, and the employment to population ratio is going to be the rule for the rest of the 21st century -- we need to give up on the 99% club of Americans who are marginalizing themselves from the global economy due to lack of skills and capital -- the regression of working wages to global norms is unstoppable at this point -- what people need to ponder is how to get out of the 99% club, and how to get into the 1% club -- my view is that acquiring dividend and rent-earning equities over a lifetime, together with world-class skills that convert into premium wages and more equities, is the only way for most Americans to join the 1% club -- I am very optimistic for those who accept that challenge and get started with building their estates -- let's face it, most Americans do not have a plan beyond living on entitlements -- I caution everyone to avoid that plan, especially young people -- just my thoughts...

Erne Lewis said...

The author failed to mention an issue that deserves much more effort. GDP includes warfare expenditures vastly beyond what is needed for National Defense. Warfare spending is not a profit producing enterprise except to the corporations who engage in it. It does nothing for building national wealth (except in salaries) without first taking every cent spent in the form of taxes to be paid now or in the future.
If we want to judge the annual production of wealth that can be enjoyed by the public this issue must be addressed.

Public Library said...

"Public austerity is a necessary condition for private flourishing and a rapid recovery. The problem of Europe (and the United States) is not too much but too little austerity — or its complete absence. A fall of GDP can be an indicator that the necessary and healthy restructuring of the economy is underway."

Gloeschi said...

Oh, those bad poor people. Their entitlements are ruining our economy!
What about the "entitlements" of the defense industry?
The US is soooo vulnerable, with arch enemies to the north and south - not. But as long as certain bloggers manage to put the blame on food stamps normally thoughtful people will continue believing in the FOX narrative. Sadly.

Gloeschi said...

btw - CBO revised it's estimate of the "output gap" downwards by 7%. Two more revisions, and the gap is gone.

Seriously - do you really think any idle manufacturing capacities are left over from the 2007/9 recession, 4-6 years later?

Gloeschi said...

Scott, where do you get your 13% output gap from? CBO and FRED both have it at roughly $1trn or 6%. Please refer to "CBO: The budget and economic outlook: fiscal years 2012 to 2022", page 28. The bars show quarterly value at an ANNUAL RATE.

Dr William J McKibbin said...

I anticipate that both defense spending and entitlement spending will continue to grow exponentially in the US -- that's what the big government Democrats and military-industrial Republicans want more than anything, including liberty -- we the people need to find other ways to get ahead that does not include relying upon the government -- but again, I expect government spending for entitlements and defense will climb exponentially over the rest of the 21st century -- watch California for the future of the American way -- the good news is that Americans with scarce skills are also seeing their salaries rise exponentially -- for example:

Getting into the top 1% requires world-class skills, which required commitment to world-class excellence -- everyone else should be under cover...

Joseph Constable said...

Cutting defense spending frees up money to be squandered on life style transfer payments. Gloeschi personalizes it by telling us that if we think entitlement spending is a problem then we are blaming those bad poor people. If we don’t protect Southeast Asia with the Navy then we will lose our ability to do business there as China will take them over like Tibet. Spend the money and do business with SE Asia. Don’t spend the money and don’t do business with SE Asia. It nets out the same, probably.

In 2011 Social Security and Medicare increased their unfunded liabilities by $3 trillion dollars ($5.4 T to cover increased benefits net the projected revenue). This is 20% of GDP. Doesn’t that scare you? See if for yourself read pages 46 to 48 of the financials. The real deficit is $4.3 trillion in 2011. This isn’t going to work out. > Reports - Financial Report of the US Government > By Category – Financial Statements > go to pages 46 through 48. This is a pdf file.

The amount of money we should have in the bank for entitlements is between $58 trillion and $100 trillion. How much do we have? ZERO. This isn’t going to work out. The Federal Government gives new meaning to the term “unfunded liabilities”. We will definitely have to cut defense spending also and put those laid off on unemployment, welfare, and into low paying jobs. I just hope we can keep the technology spending going.

It really would have helped if we got the economy rolling again. The 51% voted against that in favor of more equalitarianism and cronyism the likes of which we have never seen before.

PD Dennison said...


This is and OUTSTANDING work.

Will you please consider turning this work into an OpEd for the Wall Street Journal or IBD?

I believe this is an important analysis that needs a wide readership and a benefit to all that read it.


PD Dennison said...

Erne Lewis,

Defense has dropped from 70% of Federal spending to 18% today, going to 15% soon.

During the same timeframe, transfer payments to individuals have gone from 15% of Federal spending to 70% today.

The US Military is the best job training program in government.

WAKE-UP and smell the loon droppings.

netbacker said...

why aren't corporations using those profits to boost GDP by investing in more plant, equipment, and personnel?

Wouldn't this be because the consumers are tapped out due to excessive private debt resulting in no aggregate demand?

If we can safely cut taxes on those that we think will be most likely to go out and spend, and that spending leads to the sales that then leads to investment in more plant, equipment, and job creation.
So whether the additional spending comes because we get a payroll tax holiday and millions of Americans have more take-home pay and more money to eat or pay down debt or to go out and buy something new, or whether it comes from direct government spending, cash registers don’t discriminate.

Gloeschi said...

"The US Military is the best job training program in government."

If the job is to "drone" American Citizens, then I guess, yes, mission accomplished.

Maybe YOU will be woken up by a drone hovering over your head one day?

Gloeschi said...

Let's hear Ron Paul on entitlements: "When I first came here in 1976 I was under the impression that if you talk about welfare you talk about those people who won't work and get food stamps. But have a completely different opinion now: that exists and it's not healthy, but that's minor compared to the "food stamps" the wealthy get. The wealthy get the contracts and the special deals and that's where the biggest turmoil is." (11/28/2012)