Friday, April 27, 2012

Thoughts on why real growth has been disappointingly slow

According to the government's first estimate of Q1/12 GDP growth, the U.S. economy grew at a 2.2% annualized rate, a bit less than the 2.5% expected. In numbers, that shortfall from expectations works out to about $10-12 billion, and that is essentially a rounding error. The government is going to revise its growth estimate several times in the future, and the final number could be a lot more—or a lot less—than what these charts show. One thing that won't change, however, is the fact that the U.S. economy is growing by much less than it should be, given the degree to which it suffered in the last recession. The top chart above is my attempt to quantify that underperformance, which I'm guessing is 12%, or about $1.8 trillion. That's a lot of income that should have been recovered by now.

This next chart shows that the the economy has been growing at a nominal rate of about 4% for the past seven quarters. Nominal growth has been fairly constant, but real growth has varied significantly over that same period. On balance, the economy has been muddling along, not doing anything very impressively.

Before the current recovery started, I thought the economy would post 3-4% growth, which at the time qualified as a "sub-par" or disappointing growth forecast given the depths of the recession. Instead, the economy has posted 2-3% growth on average (to be exact, real GDP has grown at a 2.4% annualized rate since the middle of 2009). My projection was relatively pessimistic at the time from an historical and theoretical perspective, but it turns out I was a bit too optimistic relative to the ensuing reality. Nevertheless, I have resisted the double-dip recession fears which have arisen a few times in recent years (most recently last Fall), and so far I've been right on that score. I still don't see signs of an impending recession, and I continue to expect sub-par growth. But in the end, whether growth is 2.5% or 3.5% makes little difference, I suspect, since my reading of the market tea leaves (notably the 2% yield on 10-yr Treasuries and the below-average PE ratio of the S&P 500) suggests that the market is not even priced to 2% growth.

The next two charts show inflation as measured by the GDP deflator, the broadest measure of inflation. The first chart shows the year over year growth of the deflator, whereas the second shows the quarterly annualized growth of the deflator. Inflation by this measure has averaged about 1.4% per year over the past three years. That's pretty tame, and about as low as we've seen for quite some time. But it is only slightly below the 2% upper range the Fed is targeting, and there are no signs that deflation is threatening.

Which brings me to the elephant in the room. The fact that we have not experienced any deflation (expect for the Q2/09 quarter, during which the deflator fell at a modest, 0.5% annualized rate), despite the magnitude of the recession and the huge 12% output gap which has prevailed for some time, is really big news. The prevailing theory of inflation (embodied in the Phillips Curve), which the Fed shares, is that it should vanish or turn negative if the economy were to experience a huge output gap for several years, such as we have experienced. Instead, inflation has been about the same in recent years as it has been for the past two decades. This probably should be a testament to the brilliance of Fed Chairman Bernanke, but the Fed's record of keeping inflation low on average has been marred by the relatively high degree of inflation volatility that we have seen in the past decade, as highlighted in the second chart: inflation has varied from a low of -0.5% to a high 4.7%. Given the nasty recession and painfully slow recovery we've been through, it's tempting to forgive the Fed this error, except for the fact that it's unsteady hand on the inflation tiller likely contributed to the 2008 recession.

In any event, the record of recent years is good evidence that the Phillips Curve theory of inflation has not done a good job at all of explaining or predicting the behavior of inflation. It's never made sense to me that inflation should be a function of the strength of the economy, or of the level of unemployment, or the degree to which resource slack exists. Inflation is a monetary phenomenon, pure and simple, and central banks therefore are the primary source of inflation.

As a corollary, while central banks have the ultimate control over our inflation destinies, they have very little ability to create real growth. Good monetary policy can contribute to growth by promoting the stability of a currency and thus bolstering the confidence of investors, but it can't just create growth out of thin air by artificially lowering interest rates or running the printing presses. In the end, real growth only occurs when the resources available to the economy (e.g., capital, labor, raw materials) are put to work in a manner which increases total output.

The federal government is also very limited in its ability to generate real growth, since spending money on more bureaucrats or more transfer payments doesn't do anything to create more output, and more likely results in greater inefficiency and thus less output. Generating more output from scarce resources is where the private sector excels. It's hard for an entrepreneur to figure out get more out of a given amount of resources, and working more hours is hard too. Working hard or harder generally requires giving people an incentive to do so, and the profit motive operating in free markets is what has proven to work best.

So if we're looking for a reason why the economy is 12% smaller than it otherwise should be, we shouldn't be looking at the Fed. I think one obvious source of the shortfall is the huge increase in government spending in recent years, most of which has been in the form of transfer payments. Instead of allowing the private sector to utilize the trillions of dollars the federal government has borrowed to fund this increased spending, the government has effectively just taken the money from the pockets of those who have been productive and put it into the pockets of those who have been unproductive or less productive. That doesn't create growth, it just wastes our scarce resources, because—as Milton Friedman taught us—nobody spends other people's money as wisely as they spend their own money. It's as if the government simply directed all of us to pour some of our hard-earned money down the toilet by buying things we don't need.

Here's another way of appreciating what has happened in recent years. The private sector has been working very hard to increase its efficiency and its output, and that shows up in the record level of corporate profits, both in nominal terms and relative to GDP (see charts above). But instead of allowing or encouraging the private sector to plow those profits back into the economy in the form of new plant and equipment, new jobs, and new technologies, the federal government has effectively borrowed all the corporate profits generated since 2009 and distributed the money to the unemployed, to the poor, to favored "green" industries, to unions, to state and local governments, and to "make-work projects," among other things. There's been a lot of money thrown around, but lots of it has been wasted in the process that could have been put to better use; we simply don't have much to show for the $1.25 trillion of after-tax profits generated per year on average by U.S. businesses since 2009. (I'm referring here to the fact that federal deficits in recent years have been roughly equivalent to after-tax corporate profits—actually a bit higher. So on a "sources and uses of funds" basis, the government has effectively used all corporate profits to fund its spending.)


Unknown said...

Maybe because nothing much has been done about the 5,591,000 mortgaged properties that are in arrears.

You like to allude that a bottom is forming in housing. I really don't think so.

How can this not drag on the economy for another 5-10 years?

Hans said...

Fantastic reading, Mr Grannis..

But please remember, that in the past thirty years how much we have advanced American Social Justice, which as we all know, is much more important than economic values!

Unknown said...

What you see as a bottom forming in housing, I see as collusion among the banking cartel to hold REO's off the MLS and clear excess supply.

They have to do this, otherwise they are insolvent.

We have a long and bumpy road ahead of us.

brodero said...

The postponable purchases components
of GDP grew at an annualized rate of 9.5% last recession

Hans said...

Let's extrapolate from what was said in this OP...

Mr Grannis, mentions the impediments caused because of government spending, which I may suggest has become more and more evident in the past thirty or twenty years...

If one examines the trend line starting, in 1947, you will see a graduated declining growth in GNP...The same is true, if one uses 1955...

It is my contention, that as all forms of governmental units grow, in scope and funding, there must be a general impact on economic growth...It is beyond debate nor are you able to escape, this cruel and unfortunate fate..

The other part of this equation, are the 100's of thousands of regulations which is build into the cost and results again in lost economic opportunities...

I suspect as these two factors continue to grow, their causalities will be the health and welfare of the economy..

For an example or two, just look over the pond.

Hans said...

" I see as collusion among the banking cartel to hold REO's off the MLS and clear excess supply."

That "collusion" if there even is one, comes at a cost of holding and maintaining assets which are still likely to sell for less...

Anonymous said...

Table 1.5.2.

"Housing and utilities" subtracted 0.41% from Q4 GDP, and 0.23% from Q1 GDP.

If we get a heat wave in the spring and summer, the economy will appear to be booming!

Sameer said...

Is it clear that the government has "used corporate profits to fund spending"? Perhaps it is completely the opposite way with "the stand-out engine of corporate profits of late having been the fiscal deficit".

That is the view that James Montier of GMO takes. You can read more here

What do your readers think?

Isaac said...

The James Montier piece is excellent. Government deficits, mostly in the form of transfer payments, increased household income feeding into corporate income.

Actual government spending on goods and services (not transfers) has been declining since 2010.

marmico said...

So on a "sources and uses of funds" basis, the government has effectively used all corporate profits to fund its spending.

Do you have any empirics to support that ridiculous statement?

Back out the ARRA stimpack, and federal government expenditures have been historically quite tame since Obama was elected.

Total (federal, state and local) government expenditures show a similar pattern.

What you really meant to say and what is demonstrable in the empirics is that the corporate share of national income has risen and the labor share has declined.

Benjamin Cole said...

Milton Friedman, in similar conditions, advised Japan to print a lot of money---yes, money cannot create growth. It can breath life into an economy asphyxiating from lack of same.

If you read this, obviously the Reaganauts thought Volcker, and thus monetary policy, was retarding growth---so much so, they wanted to get Fed policy under the control of the White House. They actually wanted to strip away Volcker's powers and put it in the Oval Office:,8412282&hl=en

Obviously, monetary policy was once perceived by right-wingers as retarding growth. It is now by many conservative economists---but they are hiding from the newly emergent, strident right-wing of the GOP.

It would be nice to cut federal, state and local government down to size (the latter two actually often the most antigrowth).

Below is list of largest federal agencies, by employees, financed by income and capital gains taxes. Where should we cut?

Defense 3,200,000
Veterans Affairs 240,000 

Homeland Security 200,000
Treasury 162,119 

Justice 124,870 

USDA 100,000 

DOT 100,000
Health and Human Services 62,999 

Interior 57,232 

Commerce 41,711 

NASA 19,198 

EPA 18,879
State 18,000 

Labor 16,818 

Energy 14,000 

GSA 14,000 

Somehow I doubt the GOP will really effect deep cuts in federal employment/

Hans said...

Ben Jamin, seriously what matters most, a department's total budget or it's employment roster?

John said...

"So on a "sources and uses of funds" basis, the government has effectively used all corporate profits to fund its spending."

I think you need to explain that one.

Benjamin Cole said...


Interesting question.

Social Security has a small staff, but a huge budget---but mostly it collects money and disburses it. Not a true parasite, just a structural impediment.

Department of Defense sucks money into its black hole---eating up employees, resources, taxes. Produces nothing of value, economically.

So, I would answer the size of payroll, and resources consumed, will roughly equal the damage any federal agency does to our productive private sector.

Donny Baseball said...

Marmico and John-
Money is fungible so you are being too cute by half in demanding empirics to question SG's "sources and uses" contention the the government has spend in advance all corporate profits. Nobel economist William Vickery advocated massive deficit spending - even more that we are seeing at the hands of the Lightworker - in order to "recycle savings" of the private sector that can be peskily inaccessible. This is well understood by big deficit-spending pols, and exactly what is going on now. Yes, technically the money is not directly traceable to the corporate sector, but that is the sector with the excess capital these days, so it is accurate to say that the govt's massive spending is an attempt to recycle savings is coming from the corporate sector.

brodero said...

The durable goods component of GDP is
as of the 1q 2012 at 8% of GDP. Of the 11 recessions that have occured in the last 65 years all except 1 had
this number above 9% first...we are still in the early stages of an upswing in the business cycle.

brodero said...

The ratio of postponable purchases to government consumption is .925%...
this is ratio is well below the excess point...The GDP report had a good composition of rising postponable purchases with flat government consumption expenditures...this is not a recessionary trajectory

William said...

OECD: Composite Leading Indicators Point to Potential Turning Point

Organisation for Economic Co-operation and Development ( OECD ) composite leading indicators point to potential turning point in economic activity in the Euro area and regained momentum in other major economies

04/10/2012 - Composite leading indicators (CLIs) designed to anticipate turning points in economic activity relative to trend, continue to point to a positive change in momentum in the OECD as a whole but with some divergence between major economies. The CLIs for Japan and the United States continue to show strong signs of regained momentum in economic activity. The CLI for the Euro area indicates a potential turning point but with diverging assessments for the four major European economies. The CLIs for Italy and France point to continued sluggish economic activity. In Germany and the United Kingdom the CLIs continue to show signs of a positive change in momentum but these are weaker than in last month's assessment. The assessment for Brazil, India, Russia and, in particular China, shows stronger positive signals compared to last month's assessment.,3746,en_2649_33715_50091056_1_1_1_1,00.html

Steve K said...

Great post Scott, really enjoy all the posts.

Over on Mish's blog he concludes last 10yrs GDP growth has been 1.7%. I think your point of the crowding out effect of the Fed. Govt. has caused this. Not to mention the associated increase in compliance costs.

To bring it local, we had a little cottage business here in SoCal, and over the years the increase in fees, compliance costs, etc. sucked the profit right out of the business. Likewise to my customers. This is the opposite of a "virtuous cycle".

I recall the investment/supply curve, raise the costs of doing business and there are less business opportunities. Then extrapolate this nationally and you have a declining economy. Just this week we see an EPA official that likes to "crucify" companies to get them in-line with EPA guidlines. Who wants to build a power generating plant under those circumstances.

William said...

Lipper US Funds Flows Date

Q1 Equity Fund Inflows $33.5 Bil; Taxable Bond Fund Inflows $105.2 Bil

xETFs - Equity Fund Outflows -$2.1 Bil; Taxable Bond Fund Inflows $90.8 Bil

March Equity Fund Inflows $7 Bil; Taxable Bond Fund Inflows $34.7 Bil

xETFs - Equity Fund Outflows -$2 Bil; Taxable Bond Fund Inflows $31.9 Bil

Without including ETF data, there would have been outflows in both periods.

Thus far in April, there have been total outflows of $9 Billion

William said...
This comment has been removed by the author.
William said...

Schaeffer's Investor Intelligence



Hans said...
This comment has been removed by the author.
Hans said...

Ben Jamin, I realize the point you are making.

The effects of salaries as a percent of spending is highest at the paroch ial level... Score 1/2 point for, Sir Ben Jamin.

On the Federal level, it is the opposite, accounting for a minority of the department spending budget.

Score 1/2 point for me and a declared draw!

Hear is my source:

Hans said...

This chart demonstrates ever declining GNP rates since 1950 or 1959 for that matter...

The Great War on Free Enterprise:

Hans said...

Look at three states which have openly embraced the socialist order and in the past, where leaders in GNP Growth and employment.

The past decade has yielded the following, in terms of job growth.

Calif +300,000, 11% unemployment
NY +102,000, 8.5% unemployment
Ill. -4,000 8.8% unemployment

In the meanwhile, Texas has added more jobs than all three states combined.

Hans said...
This comment has been removed by the author.
Hans said...

Those that tax and spend, will find themselves at an end.

Public Library said...

Fiat money originates from CB's. Governments spend more money than recouped via taxation. Where do you think this ability comes from? If the United States had a metal based monetary system, we could eliminate this problem altogether.

Additionally, not only can the Fed NOT create real wealth, they can destroy it which is what I believe is the problem. If you reduce the quality of price signals such that every project looks profitable, we end up with a misallocation of resources and more unemployment than what would occur otherwise. Welcome to 2012.

NormanB said...

I think most people look at CorpProfits/GDP and are worried that CP will drop to be more like normal. But maybe this is a reverse indicator, that it shows how much GDP can expand, the CP is showing the true story.