Friday, January 27, 2012

The 13% GDP gap

This chart nicely illustrates just how weak the current recovery has been—it's actually unprecedented. According to my calculations, there is a 13% "gap" between the current size of the economy and where it would be if it were following its long-term trend growth rate (3.07% compound annual growth, which breaks down on average into 1% annual growth in the workforce and 2% annual increases in productivity). The current output gap is equivalent to lost income of $1.75 trillion, and that's inextricably bound up with the fact that there ought to be at least 10 million more jobs today if the economy were on its long-term trend growth track.

The precise cause of this huge output gap will be the subject of discussion among economists for years, but most of the evidence I see points to the highly unusual expansion of government spending (mostly in the form of transfer payments) over this same period as the leading culprit. Since 2008, federal payments to individuals as a % of GDP have increased by at least one-third, to their highest level ever. Income redistribution on a massive scale like this can not only fail to create growth, it can stymie growth by creating perverse incentives (e.g., rewarding the lack of work and punishing success).

One thing about today's fourth quarter GDP report that caught my eye was the relatively weak growth (3.2%) in nominal GDP, which was entirely due to sharply lower inflation. This can be traced to the same decline in inflation that shows up in the CPI and the PCE deflator over the same period, and which, in turn, was mostly a function of a decline in energy prices, which have since stabilized. As the chart above shows, real growth has been accelerating for the past three quarters, so it's not unreasonable to think that nominal GDP will accelerate in the current quarter, as I suspect it will. Faster nominal GDP growth would also be consistent with a decline in money demand, a phenomenon which I think will be driven by the lessening of concerns over the Eurozone financial crisis. Of course, even if we do get an acceleration in nominal GDP this year, the output gap will likely remain large. Faster nominal GDP is good for corporate cash flows and debtors, but it is not necessarily a big job-creator. For more jobs we need less government and better and permanent after-tax incentives to work and invest (e.g.,  a simpler and flatter tax code) for individuals as well as corporations.

Today's GDP report also amounted to one more shot across the bow of the Phillips Curve theory of inflation: an output gap this large and this persistent should have resulted in years of deflation, according to standard thinking. Instead, the GDP deflator (the broadest and arguably best measure of overall inflation) has risen a total of 6.5% since the peak of the last business cycle.

Brian Wesbury also makes an interesting point, which is that a reduction in public sector spending was one of the sources of weakness in Q4: "Excluding government, real GDP grew at a robust 4.5% annual rate in Q4 and was up 2.6% for 2011 as a whole." In other words, cutbacks in local, state, and federal spending reduced the growth in GDP last year by 1 percentage point. That's not surprising, since we know that public sector payrolls have been declining for the past three years, and we know that our military presence in the Middle East has been winding down of late. But it's not exactly bad news, since our public sector had grown like topsy in the years preceding. A smaller government footprint on the economy means more room for the more-efficient private sector to grow.

So even though today's GDP report was bit weaker than expected, it's not necessarily bad news at all.


brodero said...

" highly unusual expansion of government spending (mostly in the form of transfer payments) over this same period as the leading culprit."

What about Reagan?

Anonymous said...

Believe it or not, the weather may also be to blame, at least in part:

Modeled Behavior
"For example, personal consumption expenditures were weak at a 2.0% growth rate, but this is largely because Services came in a 0.2% which in turn is because Housing and Utilities Services declined by 13 Billion dollars. And, that is almost certainly due to a warm winter a lower than expected heating bills.

So, what does that tell us about the direction of the economy? Essentially nothing. We can say that Housing and Utilities will likely pop back in the spring meaning that Consumption expenditures could easily grow by 2.5 – 3.0%."

Scott Grannis said...

brodero: as the second chart shows, we've never before seen an expansion in transfer payments such as has occurred since 2008.

Anonymous said...

BTW, regarding jobs ...

I don't think anyone is going to be ready for this. My back-of-the-envelope calculation of jobs based on withholding tax receipts says we could get in the +350K range.

Bill said...

What's also unprecedented is the total collapse of the housing market since 2007 and barely any recovery there as well as commercial construction. It's easy to say that housing itself is a smaller % of GDP but there are so many industries affected by it that I don't think you can underestimate how much it has to do with the weak recovery. Atlanta has recovered only 19% of its pre-recession job losses and it's because its economy is/was so tied to construction and related industries.

Benjamin Cole said...

Excellent commentary, as always, by Scott Grannis.

As Scott somewhat points out, although energy prices are up 10 percent or so y-o-y, we are seeing no general inflation, and minor deflation. Commodities do not reflect US inflation or monetary policy, and there is a ceiling on commodity prices, and we are about there now.

This strongly suggests the Fed's new job is not inflation-fighting, but deflation-fighting and stimulus.

For years now we have heard intense, even hysterical or strident concerns about inflation--one gets the impression some believe the purpose of macroeconomic policy is not prosperity but price control.

Others say prosperity is dangerous as it will lead to inflation.

Give to me such dangers everyday of my life.

The Fed has to think about Japan in 2012, long and hard. We are into our third or fourth year of real estate depression, and the DJIA is below 1999 levels.

We know US monetary policy is nearly insignificant in regards to commodities prices.

We are hiding from spooks, afraid to chart a course towards growth. Like Japan.

John said...

"The precise cause of this huge output gap will be the subject of discussion among economists for years"

The Bondad Blog already offers a data-supported explanation: austerity. Specifically cuts in the government expenditures.

Junkyard_hawg1985 said...

Great Post Scott! said...

Virtually no growth in recent 'recovery' as compared to the median post WW II recoveries (by quarter) after recession(s) ended since 1949.

Weakest Recovery

Hans said...

I agree with Sgt., that this is a rather pathetic growth rate, considering that we are three past the recession...

brodero said...

Postponable Purchases to GDP is
now 17.67%.The 65 year average is
20.58%. The 9 year average is 20.04%. No recession has occurred
unless first this average has gone
above 20%. With Residential Investment at 2.26% (a component of
Postponable Purchases) there is a lot more room to run.

L.A. said...

Scott, can you comment on some of the negativity out there that says that 1.9% of the 2.8% gdp was inventory replenishment and that it should be discounted. Some are saying there is indeed a recessionary trend in gdp currently.

Benjamin Cole said...

From David Glasner, evidently the GDP deflator ran of 0.4 percent annual rate for the fourth quarter.

"The other striking result of the GDP report is that NGDP growth actually fell in the fourth quarter to a 3.2% annual rate, implying that inflation as measured by the GDP price deflator was only at a 0.4% annual rate, a sharp decline from the 2.6-2.7% rates of the previous three quarters. The decline reflects a possible tightening of monetary policy after QE2 was allowed to expire (though as long as the Fed is paying 0.25% interest on reserves, it is difficult to assess the stance of monetary policy) as well as the passing of the supply-side disturbances of last winter that fueled a rise in energy and commodity prices. So we now seem to be back at our new trend inflation rate, a rate clearly well under the 2% target that the FOMC has nominally adopted."

Why all the hysteria about inflation? Has this become a peevish fixation on the American right?

Scott Grannis said...

Note that the decline in government spending that weakened Q4 GDP is not the same as money the government sends out in the form of transfer payments. Government spending only counts for GDP if it involves the actual purchase of goods or services.

Mark Gerber said...

I wouldn't suppose it has anything to do with the fact that in 2008 the biggest age cohort, namely the baby boomers, crossed over the prime age of 50 and started their decent into what we call retirement? Naw ... that's too simple minded of an explanation. Why look at the people that make up the economy when we have hundreds of stats and economic theories to consider.

Bill said...

I think Gerber is right. You've got to consider demographics when looking at the decline in spending. The baby boomers hit their prime in the '80s and '90s and are now in decline. However, I have seen some encouraging data that suggests we might have another boom by 2015 when the baby boomlets start their peak spending.

Anonymous said...

Any thoughts on the Baltic Dry Index? Specifically, what the steep drop portends?

JGW said...

What do people think about the possibility/probability that the GDP deflator gets revised upwards?