Don’t Blame Households for First Quarter GDP

The first quarter GDP numbers were ugly. Real GDP grew by an anemic 0.2%. In this article I’ll explain why. The bad news is far worse than the single glimmer of hope. As always, my methods are transparent. Click here to download the Excel workbook containing all the data I used here (and a bit more).

One technical note: throughout this article you will see phrases like “a decrease of -0.2%.”  I know this is the arithmetic equivalent of a double negative.  Please just treat negative numbers as negative numbers and try not to worry about the issue.

Executive Summary

The worst news from this report is the collapse of gross private domestic investment. While the overall growth rate was +2.0%, that figure hides some very distressing data. Business fixed investment (nonresidential construction and equipment) fell by −2.5%. Structures (nonresidential construction) fell by −23.1%. Even worse, spending on computers and peripheral equipment fell by −29.2%.

The last time we saw numbers like this, bad things followed.

For those who have forgotten basic macroeconomics, business fixed investment is the engine of future economic growth. And it’s very difficult to blame these numbers on weather. This is business spending, not consumer spending. The last time we saw numbers like this, bad things followed.

Despite a 4% increase in disposable personal income, consumer spending grew by only 1.9%. Consumption was buoyed by increased spending on services (2.8% growth contributed 1.26 percentage points to the 1.9% total growth). The disparity between income growth and spending growth was caused by a whopping increase in the saving rate from 4.6% in 2014:IV to 5.5% in 2015:I.

And there was more bad news from the foreign sector. Exports fell by -7.2%, with exports of goods falling by −13.3%.

A Quick Digression

The graph below shows the growth rate of real GDP quarter-by-quarter since 2000.[1]

GDP Growth 2000-2015

GDP Growth 2000-2015

The U.S. economy is still sick. It will not be cured until (if and when) the current regulatory onslaught emanating from Washington, D.C. is not just slowed, but rolled back. The U.S. needs business climate change.

According to the NBER Business Cycles Committee, there have been two recessions since January 1, 2000. The first (the dot-com crash) began in March, 2001 and ended in November of that year. For convenience I’ll assume it lasted for the last three quarters of that year. The second began in December, 2007 and ended in June, 2009. Again, to make my life easier, I will assume the recession began in January, 2008. Luckily, June is the end of the second quarter, saving me one assumption. The average growth rate for the period between the end of the 2001 recession and the beginning of the 2008 recession was 2.8% per year. Since June, 2009 the growth rate has been 2.2%.

The U.S. economy is still sick. It will not be cured until (if and when) the current regulatory onslaught emanating from Washington, D.C. is not just slowed, but rolled back. The U.S. needs business climate change.

The Good[2]

Despite a 4% increase in disposable personal income. consumer spending grew by only 1.9%.[3] The contribution to total growth was 1.31 percentage points. But the news is not all good. Of those 1.31 percentage points, 1.26 came from growth in spending on services.[4]

The disparity between income growth and spending growth was caused by a whopping increase in the saving rate from 4.6% in 2014:IV to 5.5% in 2015:I. To see what this means, consider the following table (based on BEA Table 2.1[5]):

Personal Income and Its Disposition

Personal Income and Its Disposition (click the image for a larger version)

Personal income grew by $145.6 billion. Disposable personal income rose by $132.2 billion. But most of that — $124.4 billion — went into consumer saving (much of which was probably debt liquidation). Only $7.8 billion was spent. With that number, it’s surprising that consumption spending grew at all.

The Bureau of Economic Analysis publishes “expanded detail” GDP accounts. One disturbing fact: spending on “Motor Vehicles and Parts” fell by a whopping 3.0%. Fortunately, that category is a small part of overall consumer spending, only dragging down the total growth by 0.08 percentage points. Spending on groceries, clothing, and footwear fell by −2.5% and −2.9% respectively, combining for a drag of 0.19 percentage points on consumer nondurables spending.

The growth in services spending was 2.8%. Households contributed 1.48 percentage points to that total. The drag was from final consumption expenditures of non-profit institutions, amounting to −0.22 percentage points. That category’s growth rate was a phenomenal −10.8%.

Digging deeper into household services spending, housing and utilities grew by 4.9%, and transportation services by 3.4%. Contrary to what you may have read about healthcare spending being under control, the first quarter growth rate was 5.4% — and that in a quarter when income growth was anemic. There is a bit of good news in that food services and accommodations grew by only 1.6%. That’s good news because jobs in that sector typically pay pretty low wage rates.

The Bad

Net exports dragged growth down by a whopping −1.25 percentage points. Even worse, −0.96 percentage points of that decline were caused by a -7.2% decrease in exports. And, capping off a dreadful series of numbers, exports of goods fell by −13.3%, contributing −1.26 percentage points to the −0.96 percentage point overall contribution of exports to net exports.

Goods exports are important because they include manufacturing, agriculture, and other areas. Growing exports of goods encourages businesses to expand capacity. They do that by investment spending. Which brings us to the really bad news.

The Ugly

Gross private domestic investment grew by 2.0%. How can that possibly be bad news?

As always, the devil is in the details. Business fixed investment (nonresidential construction and equipment) fell by −2.5%, dragging down gross private domestic investment by 0.40 percentage points. Structures (nonresidential construction) fell by — take a deep breath — −23.1%. The drag on nonresidential investment was −0.75 percentage points. Even worse, spending on computers and peripheral equipment fell by −29.2%, dragging equipment spending down by −0.14 percentage points.

What bailed out investment? Transportation equipment spending grew by 23.7%, boosting nonresidential investment by 0.33 percentage points. And “intellectual property products” contributed 0.30 percentage points to that category, with 0.21 of those percentage points coming from research and development. (I’ve written about this squishy category before. While it’s not as bad as including illegal drugs and prostitution in GDP, it’s still subject to a lot of, um, interpretation.)

Finally, the change in private inventories contributed 0.74 percentage points to gross private domestic investment. Inventory change is always problematic because we don’t know how much is planned inventory change (good because it reflects business optimism) and unplanned inventory change (bad because it means domestic spending on domestically produced goods was less than domestic production). Given the terrible first quarter consumer spending numbers, it’s easy to believe that most of this increase is unplanned. Meaning businesses will cut production in future quarters to liquidate their excess inventory.

The last time we saw business fixed investment collapse like this was in the first quarter 2010. Over the period 2010:II through 2012:IV real GDP growth averaged 2.0%, including a decrease of −1.5% in 2011:I. Given the expected time lags in the impact of changes in investment, it’s a safe bet that the 2011:I drop was at least partly caused by the investment collapse in 2010:I.

A Note on the Income-Expenditure Multiplier

There has been quite a bit written about the government spending multiplier ever since the ARRA was passed. It has become clear that there is more to fiscal policy than government spending. What gets purchased by the spending and the timing both matter. Sorting out the impact of the actual purchases made under ARRA, the timing of the expenditures, and the effect of regulations will create jobs for hundreds of economists over the next decade.

But there is considerably less disagreement about the existence of a tax multiplier. Tax cuts, especially personal income tax cuts, that are viewed as permanent will cause spending and production to rise. The tax multiplier is probably greater than 1.0.

And there is no research I know of that disputes the existence of an investment multiplier. My guess is that the investment multiplier for business fixed investment is larger than the multiplier for intellectual property and inventory change.

Conclusion

Economics is often called “the dismal science.” The subject would be a lot less dismal if policymakers would stop making foolish choices.

[1] U.S. Bureau of Economic Analysis, “Table 1.1.1. Percent Change From Preceding Period in Real Gross Domestic Product” http://bea.gov/national/index.htm#gdp (accessed May 2, 2015).

[2] Material from this point forward is from one of the sources cited in footnotes 3, 4, and 5.

[3] U.S. Bureau of Economic Analysis, “Table 1.5.1. Percent Change From Preceding Period in Real Gross Domestic Product, Expanded Detail” http://bea.gov/national/index.htm#gdp (accessed May 2, 2015).

[4] U.S. Bureau of Economic Analysis, “Table 1.5.2. Contributions to Percent Change in Real Gross Domestic Product, Expanded Detail” http://bea.gov/national/index.htm#gdp (accessed May 2, 2015).

[5] U.S. Bureau of Economic Analysis, “Table 2.1. Personal Income and Its Disposition” http://bea.gov/national/index.htm#personal (accessed May 2, 2015).

 




The Mystery of Third Quarter GDP

Executive Summary

There has been speculation that a substantial part of the growth in third quarter GDP was caused by subprime auto loans. According to the third estimate, real GDP grew 5.0% at an annual rate. In this article, I use data from the Bureau of Economic Analysis, Experian Automotive, and Equifax to estimate the actual impact. Using Experian’s estimates for leases, loans, and risky lending I conclude that the contribution to third quarter GDP growth from subprime lending was about 0.05 percentage points. I also note that there are subprime loans for recreational vehicles. However, I could not find any data. I assumed the automobile percentages applied to the RV market as well.

A second source is a speech given by Joy Wilder Lybeer, a senior vice president at Equifax. Ms. Lybeer claims that one-third of auto loans are subprime. This is in stark contrast to Experian’s estimate of 10.57%. Using Ms. Lybeer’s estimate, the contribution to third quarter growth from subprime lending was 0.13%. Using BEA standard rounding technique, third quarter growth would have been 4.9% instead of 5.0%. That’s a noticeable difference. But 4.9% is nothing to sneeze at.

There are two areas that pose far greater problems. The first is the persistent growth of inventories. Whether that reflects business optimism about the future or lower than expected spending today is a topic for debate.

The second is the burst of growth in intellectual property investment. This is a fairly new addition to GDP and, as many have noted, a category that is fraught with estimation difficulties. Let me just say that between inventory and IP growth, the 5.0% overall growth rate looks a bit shaky. But it’s not because of subprime vehicle loans.

The Mystery of Third Quarter GDP

Introduction

The third (“final”) estimate for U.S. real GDP growth in the third quarter was a whopping 5 percent. There have been various reasons cited for this astonishing performance. One explanation is the sluggish economic performance in the first quarter created pent-up demand that exploded over the summer months. Another is the boost from sub-prime auto lending. I’m going to once again violate my promise to not use government data to dive into the GDP numbers and see if there’s anything there. Except as noted, all data is from the U.S. Department of Commerce, Bureau of Economic Analysis. [1]

As always, my methods are transparent. Click here to download the Excel workbook with my calculations.

Gross Gross Domestic Product

At the gross level, let’s first look at the growth rate compared to the second quarter. Overall growth was 4.97%. The components with the largest quarter-to-quarter growth were:

  • Consumption spending on durable goods.
  • All components of gross private domestic investment except business structures, residential construction, and the inventory change.
  • Federal government defense spending.

GDP Growth The Mystery of Third Quarter GDP

(Click image for larger version)

 

The growth of durable goods spending bears further examination because that’s where automobile sales are buried. I’ll look at the details in the following section.

Gross Gross Domestic Product: Component Growth

The robust growth of business investment is a welcome improvement from the first quarter’s anemic levels. However, the change in business inventories was +$82.2 billion dollars, down slightly from the second quarter’s +$84.8 billion. This is somewhat worrisome because inventory change has been above +$80 billion for four of the past five quarters:

IP Investment The Mystery of Third Quarter GDP

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As Keynes noted, the real issue is the extent to which this inventory growth is intentional (“planned inventory change”). Part of the growth is undoubtedly planned by businesses expecting sales to grow. The rest is unplanned, caused by current sales falling short of production. Planned inventory increases are good because they reflect business confidence. Unplanned inventory increases are bad because businesses are likely to cut production to reduce unwanted inventories. But inventory change fluctuates quite a bit from quarter to quarter, so this is probably not much of a concern.

Inventory change The Mystery of Third Quarter GDP

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Ever since intellectual property investment was added to U.S. GDP, some economists have worried about the difficulty of obtaining reliable numbers — and therefore the temptation to use this category to fudge the results. The figures for 2014 do nothing to quell those suspicions. In the third quarter IP growth was 8.83% (annualized). And this continues a trend that began in 2o13:III.

IP Investment The Mystery of Third Quarter GDP

(click image for a larger version)

Ironically, the final major contributor to quarter-to-quarter growth was federal defense spending which grew by 16.01%. Tomahawk missiles at $1 million each probably accounted for quite a bit of this growth, followed by drones and their armaments.

Gross Gross Domestic Product: Contributions to Growth

A second way of disassembling GDP growth is by looking at the contributions to the current quarter’s growth. Luckily, the BEA produces this breakdown in their Table 1.1.2. Once again, consumption spending leads the way with non-residential private investment in second place. At the detail level, consumption of durable goods, investment in equipment, and government defense spending were big contributors.

Contributions to GDP growth The Mystery of Third Quarter GDP

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Fine Gross Domestic Product

What we’ve seen so far gives us guidance about where to explore further. Specifically, what drove that increase in consumer durables spending? The BEA has the answers once again. Tables 1.5.1, 1.5.2, and 1.5.6 have the data we want. Let’s start by looking at the components of consumer durable spending.

Consumer Durable Spending Details

First, let’s look at the quarter-to-quarter growth rate (annualized). Sure enough, motor vehicles and parts grew 11.3% with “recreational goods and vehicles” contributing a whopping 15.7%. An immediate question comes to mind: how much of that growth was caused by subprime lending? (We’re verging on some sort of risk-adjusted GDP here, but I’ll put that exercise off for another day.)

Growth of consumer durables spending The Mystery of Third Quarter GDP

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Naturally we also need to look at the contributions to that 5 percent GDP growth:

Contributions to GDP growth The Mystery of Third Quarter GDP

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We’ll come back to car and RV sales in the next section. But now I want to look at gross private domestic investment.

Gross Private Domestic Investment Details

First, here are the annualized quarter-to-quarter growth rates:

Growth of gross private domestic investment, detailed The Mystery of Third Quarter GDP

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And the contributions to that 5 percent growth:

Contributions to growth, gross private domestic investment The Mystery of Third Quarter GDP

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Industrial equipment, transportation equipment, and IP were the main contributors from this category. Transportation equipment? Most likely railroad cars to carry the oil that won’t fit through existing pipelines. I’ve already expressed some doubt about the veracity of the IP numbers so I won’t repeat that argument. Also note that despite a large quarter-to-quarter growth rate, computers and peripheral equipment was a small contributor to the overall growth rate. That is probably because this category was only 0.44% of third quarter nominal GDP.[2]

Automobiles, Recreational Vehicles, and Subprime Loans

Experian follows automobile financing quite closely. There are two sources of financing for new vehicles: loans for purchasing and leasing. Experian has broken the data into five risk groups: Super prime, prime, nonprime, subprime, and deep subprime.[3] Here’s the breakdown:[4]

Experian loan quality data (new cars only) The Mystery of Third Quarter GDP

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Leasing by risk segment (new cars, Experian data) The Mystery of Third Quarter GDP

Leasing by risk segment (new cars, Experian data)

Loan volume by risk category (new cars only, Experian data) The Mystery of Third Quarter GDP

Loan volume by risk category (new cars only, Experian data)

Experian also notes that 84.8% of new car sales are financed.[5] Of that, 29.14% are leased.[6] It’s easy to calculate the percentage of overall sales that were financed by loans versus leasing:

 

Sources of financing, new car sales The Mystery of Third Quarter GDP

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Now we can get some work done. Assume that these percentages apply to both auto and recreational vehicle financing. Those two categories contributed 0.59% to the 5.0% third quarter growth. Of that 0.59%, 0.15% was leasing and 0.35% was loan financed. (The remaining 0.09% of sales were not financed, presumably cash purchases.) Multiplying by the percentage of leases and loans made to subprime and deep subprime borrowers and adding leases and loans gives an overall contribution to GDP growth of about 0.05%.

Experian results The Mystery of Third Quarter GDP

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However, there is another estimate from Equifax. In an interview, Ms. Joy Wilder Lybeer said,

“Don’t take the bait on claims that there will be a bubble,” says Joy Wilder Lybeer, a senior vice president at Equifax, a credit-reporting firm. “Subprime is as healthy as it’s ever been.”

“One in every three cars sold goes to a subprime borrower, and those loans are performing well,” she says, citing historically low delinquencies, defaults and repossessions as a percentage of outstanding loans.[7]

Well, that’s quite a difference. One third compared to 10.57% is not insignificant. Fortunately, it’s easy to calculate the new numbers. I‘ll assume the lease percentages are those estimated by Experian.

Equinox results The Mystery of Third Quarter GDP

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So without subprime lending, third quarter growth would have been 4.9% instead of 5.0% (using BEA rounding conventions). That’s a bit of a difference, but 4.9% growth is nothing to sneeze at.

Conclusion

While subprime vehicle loans contributed to third quarter growth, the total contribution was minor. Far more concerning is the continuing growth of inventories and the apparent burst of growth in IP investment.

Endnotes

[1] All BEA data is from the NIPA Interactive Data site at http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1. Accessed late December, 2014 and early January, 2015.

[2] I used nominal GDP because no estimate is available for chained real GDP. See Excel worksheet RealGDPdetailChained especially footnote 4: “4. The quantity index for computers can be used to accurately measure the real growth of this component. However, because computers exhibit rapid changes in prices relative to other prices in the economy, the chained-dollar estimates should not be used to measure the component’s relative importance or its contribution to the growth rate of more aggregate series; accurate estimates of these contributions are shown in table 1.5.2 and real growth rates are shown in table 1.5.1.”

[3] Melinda Zabritski, Sr. Director Experian Automotive, ” State of the Automotive Finance Market, Third Quarter 2014.” http://www.experian.com/assets/automotive/white-papers/experian-auto-2014-q3-presentation.pdf?WT.srch=Auto_Q22014FinanceTrends_PDF Accessed December 31, 2014.

[4] Ibid., slides 17 and 28. Note that deep subprime leases are calculated by me to make the sum 100%.

[5] Ibid., Slide 14.

[6] Ibid., Slide 16.

[7] http://wardsauto.com/finance-insurance/subprime-just-fine-dire-predictions-aside. Accessed January 3, 2015.




Second Quarter GDP

The second quarter GDP numbers are a puzzle for several different reasons:

  1. The growth rate of 4.0% (actually 3.95%) is remarkably high, especially given the anemic performance of business investment in the first quarter. I don’t pretend to understand this completely, but I wouldn’t be writing this if I didn’t have a few ideas.
  2. Comparisons between the first and second quarter, 2014, GDP estimates are clouded by the revision of the previous four quarters of GDP that occur during July each year. Which means there was a fourth estimate of first quarter GDP.
  3. The behavior of inventories has been problematic (to put it politely).

Before going into the gruesome details, I’d like to thank Lisa Mataloni of the BEA for advising me about the “fourth estimate” of first quarter GDP. She also pointed me to this BEA document that describes the revision process. Here’s what she e-mailed:

Each summer, typically in July, we revised our estimates during our annual revision process. Additionally, every five years or so, we perform comprehensive revisions of our full history to benchmark to the quinquennial Economic Census.  Estimates are always subject to further revision as we obtain better source data or update or methodologies.

This is one of the many details I used to know. Sadly, it fell through the ever-expanding cracks in my ancient brain.

Methodology

As I noted in my earlier article, the BEA’s News Release Archive is a treasure trove for macroeconomic data geeks. After my current exercise, I think I can claim membership in that elite group.[1]

I retrieved four sets of data for the first quarter of 2014: the advance, second, and third estimates plus the “fourth” estimate created by the annual revision. Next I calculated the growth rates of second quarter GDP using each of the four first quarter estimates. I then broke the overall growth rate into “contributions to GDP growth.” This is a BEA measure that is included in every GDP report (Table 2 in the press release dataset, Table 1.1.2 in the interactive database). It’s easy to calculate. Take the change in the component and divide it by the base GDP.

Let’s consider the contribution to GDP growth of personal consumption expenditures. We’re going to compare the advance estimate for 2014:Q2 with the annual revision for 2014:Q1. Let’s let dC be the contribution of consumption to the change in GDP, GDP2014:Q1Rev4 be the annual revision for the first quarter, C2014:Q2Adv be the advance estimate for consumption spending for 2014:Q2 and C2014:Q1Rev4 be the annual revision for consumption spending for 2014:Q1 Here’s the calculation:
Equation

Thanks to our pal Mr. Excel, these calculations are fairly straightforward (but tedious). As always, I’ve uploaded the Excel workbook which you can get by clicking here. If you’d like a pdf version of the main worksheet click here. Or if you’d like all my Excel workbooks and the pdf file and, probably, a few other things, click here.

Analyzing the numbers

I split the pdf file into four pages. Let’s look at them one at a time.  (As always, click the image to see a larger version.)

PDF page 1

First, note the pattern of GDP growth. Using the 2014:Q1 advance estimate, second-quarter growth would have been a measly 0.98%. But thanks to the downward revisions in first quarter GDP, the second quarter growth rate improves. (In fact, if we used the third estimate for 2014:Q1, second quarter growth would have been 4.15%!)

So where did the decline in first quarter GDP come from? Part of it was a decline in the estimates of personal consumption spending. While consumption declined, it decreased less than GDP. C decreased by 2.47% while GDP fell by 2.85% meaning C became a larger proportion of GDP between the advance and fourth estimates of first quarter national income.

Much of the growth in consumption’s share of GDP was caused by spending on goods. These are items you can touch. Some people have suggested that subprime auto loans drove an increase in spending on cars. Not according to the data which shows spending on motor vehicles and parts contributed a fairly stable 0.4% to GDP growth.

But the real item of concern is the change in business inventories (page 2 of the pdf file).

PDF page 2

Based on the advance estimate for 2014:Q1, inventory change contributed about 0.15%. But the fourth revision raised this estimate to a whopping 1.48%. BEA really needs to get their survey methodology together. For comparison, let’s look at GDP growth minus the inventory change contribution for each of the four releases (row 75 in the Excel workbook):

GDP minus Inventories

Boosting the estimated increase in the change in inventories contributed mightily to second quarter GDP. And 2.47% growth is quite a bit below 4%. As always, the central issue is how much of the growth in inventories was intentional and how much was unintentional. I don’t know, but consumer spending grew by 2.46% (using the fourth estimate for the first quarter). This is consistent with the average growth rate from 2000 – 2013 of 2.31%.

Inventories rose sharply but consumer spending was about average. My conclusion is that about half that inventory increase was unplanned. That means my best estimate of a realistic growth rate for 2014:Q2 is 3.21%.

Consumption Growth

Foreign Trade

Some economists hyped the increase in exports. First, the highest level of exports in 2014:Q1 was the second estimate ($2.03 trillion). The advance estimate for 2014:Q2 is indeed higher, $2.07 trillion. But imports increased even more, from $2.47 to $2.54 trillion. Net exports, in fact, reduced GDP growth by 0.58 percentage points.

Conclusion

First quarter GDP was pretty good. I’ll only add that there are two more estimates to be released. BEA’s revisions have been pretty substantial in recent years. My guess — and it’s only a guess — is that the 4% growth rate will be revised downward over the next two months.

[1] My BEA sources include interactive tables: http://www.bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=1&isuri=1 and the news release archive: http://www.bea.gov/newsreleases/release_archive.htm?link=http://www.bea.gov/bea/newsrelarchive/relsarchive.htm. Both were accessed repeatedly during the week of July 28, 2014.




The Invisible Economy is Not the Hidden Economy

The Climbing Wall at Google's Boulder, CO Campus

The Climbing Wall at Google’s Boulder, CO Campus

Our techniques for measuring economic performance are obsolete, obscuring a complete picture of how we’re faring.

On July 9, an article titled “The Invisible Economy” was published on The Atlantic website. The author, Bill Davidow, makes this claim →

Mr. Davidow, unfortunately does not understand how GDP is calculated — or the reasons many internet services are “free.”  The invisible economy is not the hidden economy (also called the underground economy).  Mr. Davidow’s “invisible economy” is entirely visible and included in GDP

Start with a basic premise: there ain’t no such thing as a free lunch. When goods or services are produced, real resources must be used to produce them. This is the basic premise of both economics and national income accounting.

A Primer on National Income Accounting

Gross domestic product is the money value of all final goods and services produced in a country during a calendar year. This definition is so standardized that it does not warrant a citation. Here are the salient points of this definition:

  1. GDP measures production of new goods and services during a year. The act of production creates income (wages and salaries, interest, profits, and a few other items).
  2. These products are valued at current market prices. Simplistically, if an economy produces 1 billion oranges during the year and the market price of those oranges is $1.50 each, orange production will add $1.5 billion to GDP. Each country’s GDP is measured in that country’s official currency. (Note my careful avoidance of referring to “sales” of oranges. GDP measures production, not spending or sales.)
  3. A final good is either something produced for current consumption, items produced for business investment (buildings, machines, residential construction), and government spending by all levels of government.
  4. All production within a country is counted regardless of the home country of the firm engaged in production. Honda, a Japanese firm, has a number of assembly lines in Ohio. The production from each of those plants is added to U.S. GDP. (A related measure, gross national product, measures the value of goods and services based on the home country of the firm that produces the output.)
  5. At midnight December 31, the GDP counter is reset to zero. This counter then begins adding up the money value of all goods and services. The counter is stopped at 11:59:59 the following December 31. The value on the counter is that country’s GDP for that year.

Many people believe GDP measures spending. This is incorrect. GDP measures production. Production creates income. Fundamentally this is why national income must equal national product. (See, for example, Karl Case, Ray Fair, and Sharon Oster, Principles of Macroeconomics 11e (2014). Pearson Publishing.  pages 116-117.)

Those who hold the incorrect belief arrive at this conclusion by noticing that the first approximation to GDP adds up three spending items:

  1. Consumption spending by households,
  2. Business fixed investment by, um, businesses,[1] and
  3. Government spending by all levels of government.

What these folks fail to notice is that there are a few other items added to total spending. These three items convert total spending into total production. The three items are:

  1. The net change in business inventories. Inventory change measures the difference between domestic spending on domestically produced products and domestic production. If production exceeds spending, inventories rise. The amount by which inventories rise is added to total spending as the first step in converting to production. (Inventory change is included in total business investment, but is not part of business fixed investment.)
  2. Exports are products that are produced in a country but sold in another country. Exports, by definition, are not part of domestic spending. But they are part of domestic production. Adding exports to total spending is the second step in converting to production.
  3. Imports are products produced in another country but sold to domestic purchasers. Since imports are included in domestic spending, they must be subtracted to arrive at production.

A Digression on Value Added

Another way GDP can be added up is by summing all the value added in the economy. It’s helpful to understand value added to see how intermediate goods fit into the GDP framework. After all, if national income equals national product, what happens to the income earned by all those workers who produce goods that are not final goods?

Value added is the difference between a firm’s total revenue and (roughly) what it pays other businesses for products it uses to produce its output. Let’s consider a simple loaf of bread. While this presentation is simplified (to say the least), it will help you understand value added. The production chain for a loaf of bread is straightforward:

  1. A farmer grows wheat. The farmer uses seeds from last year’s crop. Therefore the farmer does not purchase any products from other firms. The farmer sells enough wheat for a loaf of bread to a miller for $0.20.
  2. The miller pays the farmer $0.20 for wheat, which is then ground into flour. The miller sells the flour to a baker for $0.80. The miller’s value added is $0.80 – $0.20 = $0.60.
  3. The baker adds a few minor items to the flour (yeast, water). We will ignore the costs of those items. The baker produces a delicious loaf of bread which is sold to a grocer for $1.50. The baker’s value added is $1.50 – $0.80 = $0.70.
  4. The grocer puts the loaf of bread on the shelf. At that point it becomes a final good.[2] The price of the loaf of bread is $2.00. The grocer’s value added is $2.00 – $1.50 = $0.50.

The sum of the value added at each of the four stages of production is $0.20 + $0.60 + $0.70 + $0.50 = $2.00. Because of the way value added is calculated, total value added from all the stages of production must equal the price of the final good. Thus, by adding up the money value of all final products, we have implicitly added up the value added that went into making them. This table summarizes value added for this example:

Producer Price of Output Payment to other firm Value Added
Farmer $0.20 $0.00 $0.20
Miller $0.80 $0.20 $0.60
Baker $1.50 $0.80 $0.70
Grocer $2.00 $1.50 $0.50
TOTAL $2.00

We need to look a little more closely at what, exactly, makes up value added.

What is the difference between a firm’s total revenue and what it pays other firms for intermediate goods? Well, the cost of any input the firm pays for that it doesn’t buy from other firms is part of value added. Those items include labor (wages and salaries), capital[3] (interest and rent), and entrepreneurship (profit). Those are also the major components of national income.

Who Owns What?

“But,” you may say, “I don’t get any interest, rent, or profits. Who does that income flow to?”

Actually, you may be receiving some of each of those items. Do you have a retirement account? The wealth in that account owns assets (hopefully well-diversified, low cost mutual funds). Those assets earn interest, rent, and/or profits. Vast quantities of stocks and bonds in the U.S. are owned by mutual funds directly — and by households indirectly. Directly or indirectly households own all the factors of production.

Wasn’t that fun? Now let’s see how advertising fits into the GDP framework. Because, after all, it’s advertising that actually pays the bills for “free” internet services. To do this I’ll use Google as an example. Google derives about 90% of its annual revenue from advertising, making them an excellent case study.

Google, Advertising, and GDP

Advertising creates revenue for Google. This is their gross income before deducting any business costs. Since this article is not yet mind-numbingly dull, let’s take a look at Google’s income statement and balance sheet. In 2013 Google earned net profits of $12.9 billion on total revenue of $59.8 billion. Of that revenue, $50.5 billion was from advertising (84.5%). There is a mysterious “other” revenue entry of $5 billion. Assuming that is advertising-related, the percentage rises to 92.8%. Google makes money by selling advertising. Period.

And that advertising is part of GDP. Essentially, to calculate Google’s contribution to GDP we need to calculate the company’s gross value added. Luckily for us, the Bureau of Economic Analysis has a nifty paper titled “An Introduction to the National Income and Product Accounts.” Part II of this excellent work shows how to convert business financial statements into NIPA accounts. Following the BEA methodology to the best of my ability, Google’s gross value added for 2013 was $43.5 billion. (The Excel workbook, based on Google’s 10-K filing with the SEC, is available for downloading by clicking here.)

U.S. GDP for 2013 was $16.8 trillion. Google’s contribution to that total was 0.26%. The U.S. economy is very, very large indeed. But saying that the internet is “free” implies Google’s gross value added is zero. That’s very far from the truth.

This Guy Lives at Google's Mountain View, CA Campus

This Guy Lives at Google’s Mountain View, CA Campus

Confusion by Mr. Davidow

From the article:

There are no accurate numbers for the aggregate value of those services but a proxy for them would be the money advertisers spend to invade our privacy and capture our attention. Sales of digital ads are projected to be $114 billion in 2014, about twice what Americans spend on pets.

The forecasted GDP growth in 2014 is 2.8 percent and the annual historical growth rate of middle quintile incomes has averaged around 0.4 percent for the past 40 years. So if the government counted our virtual salaries based on the sale of our privacy and attention, it would have a big effect on the numbers.

First, note that Google’s advertising revenue is about half of the total cited by Mr. Davidow. But what is the point of the second paragraph? Comparing the dollar amount of advertising with the growth rate of GDP makes no sense at all. Instead let’s look at the dollar amount of GDP. Given the sharp drop in GDP in the first quarter, a safe forecast for 2014 nominal GDP is 2013 GDP, $16.8 trillion. Digital advertising is therefore likely to be about 0.68% of the total. Again, not much, but well above zero.

Conclusion

National income accounting is not particularly easy or interesting. But those who try to use GDP should know what they’re talking about. Mr. Davidow has sadly failed this test.

 

[1] “Investment” as used by economists means the construction of physical capital: buildings, machines, and residential construction. Similarly, “capital” refers to the total quantity of buildings, machines, and residential construction ever produced minus depreciation.

[2] Technically the loaf of bread is added to the store’s inventory, causing inventory to increase. This is actually when the bread is added to GDP. The offsetting transaction will be an increase in consumer spending when the bread is sold.

[3] Remember, “capital” means physical capital: buildings, machines, and residential construction.




Healthcare Spending and First Quarter GDP

[First revision July 30, 2014, 1:00 pm noted that the link to the Excel workbook was broken.  Second revision July 30, 2014, 5:30 pm uploaded and linked the correct Excel workbook.]

Once more into the breach, I’ll take a final look at the first quarter GDP. (At least, I sure hope it’s the final look.) Many pundits have noted that healthcare spending actually fell in the first quarter. Their hypothesis seems to be that healthcare spending and first quarter GDP are cause and effect. Zerohedge (Tyler Durden) has the best stories about this (http://www.zerohedge.com/news/2014-06-25/gdp-disaster-final-q1-gdp-crashes-29-worst-2009-far-below-worst-expectations and http://www.zerohedge.com/news/2014-06-25/here-reason-total-collapse-q1-gdp). Mr. Durden cynically believes that this is a deliberate fudge, with the spending being pushed forward into the second quarter. Normally I’d debate that point, but in view of other information I’ll simply wait and see. Here’s a key chart from Mr. Durden’s excellent website:

Zerohedge Graph Healthcare Spending and First Quarter GDP

Meanwhile, California’s Medicaid Expansion Is Going As Expected — Very Badly

Why did healthcare spending fall? A clue is found in the June 29 San Jose Mercury-News. Apparently California’s Medicaid expansion is not going well. (This program is called MediCal, of course.) The Mercury-News reported that some 900,000 applications were waiting to be processed. The backlog was 800,000 in April. Another 100,000 were added in May. The backlog has not changed since then meaning the state is processing new applications as fast as they arrive. But this keeps the stock of unprocessed applications constant. Without more resources, the backlog is unlikely to be reduced.

Those 800,000 unprocessed applications accumulated during the first four months of the year. During that period, many people were left in limbo about healthcare coverage. And remember, this is Medicaid. These people are likely to be relatively poor. They probably did what most poor people have done for several decades: ignore minor health issues and visit an emergency room if they really need healthcare. But, of course, those emergency room visits are “free” in that the consumer does not pay for the visit. Those visits will show up as higher healthcare premiums in the future.

My guess is that healthcare spending fell precisely because the same story applies to most of the country.  Obamacare is like watching a slow-motion train wreck.  Just when you think things can’t get any worse, they get worse.

Was Healthcare Spending That Important?

Yes, healthcare spending fell in the first quarter — by 1.42% to be precise. The table below is based on Table 1.5.6 from the Bureau of Economic Analysis. Red highlighting and percentage change calculations by your faithful author. (Normally this is the place where you could download the Excel workbook including the original BEA data. I uploaded the wrong file and have misplaced the original.  My apologies.  If I can retrieve the file I’ll post it.) (The Excel workbook has returned.  Click here to download.)

U.S. GDP Consumption Healthcare Spending and First Quarter GDP

But why worry so much about healthcare? Recreation services fell by 2.5%. Spending on clothing and footwear was down 4.17%. And, the worst news of all, consumer durables, furnishings and durable household equipment decreased by 1.51%.

To understand the importance of that last figure, consider the gross private domestic investment part of the table:

U.S. GDP Investment Healthcare Spending and First Quarter GDP

The key point is that spending on construction (both residential and nonresidential structures) fell sharply, by 4.25% and 7.97%. Less housing construction fits with lower spending on stuff that goes in houses. And less nonresidential construction fits nicely with reduced spending on equipment. It appears that this decrease was demand-driven, not caused by supply issues.

What About Winter?

Well, it happens that there’s a country just north of us that had about as bad a winter as the U.S. That’s Canada, where first quarter GDP grew 2.2%. This growth occurred despite a contraction in gross investment (-1.6%) and a huge drawdown in business inventories of -$495 million (Canadian dollars, of course). Somehow, even faced with harsh winter conditions, those intrepid Canadian consumers managed to increase spending by 2.6%. Perhaps Amazon.com and Google shopping are easier to use north of the border.

Canada GDP Healthcare Spending and First Quarter GDP

Was the Weather Really That Bad?

Not really.  Here are some summary statements and maps from Environment Canada:

The national average temperature for the winter of 2013-2014 was 0.4°C [0.72°F] below the baseline average (defined as the mean over the 1961-1990 reference period), based on preliminary data, which is the 24th coldest observed since nationwide recording began in 1948.

Canada Temperature Deviation Map

Canada Temperature Deviation From Trend

We can also look at precipitation for Canada:

Canada Precipitation Deviation Map

Environment Canada has a comment and a caveat for those interpreting the precipitation map:

The national average precipitation for the winter of 2013-2014 was 9% below the baseline average, based on preliminary data, making it the 15th driest winter since nationwide recording began in 1948.

It should be noted that “average” precipitation in northern Canada is generally much less than it is in southern Canada, and hence a percent departure in the north represents much less difference in actual precipitation than the same percentage in the south. The national precipitation rankings are therefore often skewed by the northern departures and do not necessarily represent rankings for the volume of water falling on the country.

Here are the state by state maps for the U.S. for the winter of 2013-2014 (from the NOAA website):

U.S. State Temperature Map December, 2013 to May, 2014

US_StatePrecipitationMapDec2013toMay2014

Conclusion

The winter of 2013-2014 was not as bad as the headlines would have you believe, especially in the western U.S. and Canada.  Naturally, the east coast media bias tends to focus on what reporters and editors are seeing outside their windows rather than actual data.  In any case, those who blame the bad winter for the U.S. economic performance should perhaps take a lesson from our neighbor to the north.

 




What Happened to GDP in the First Quarter

What happened to GDP in the first quarter? The short answer is that I don’t know and neither does anyone else. I’ve done a bit of number-crunching and am left scratching my head.

The Excel workbook shown below is some very simple analysis. It compares the second estimate released around the end of May with the third estimate released June 25. Column E shows the second estimate change between 2014:I and 2013:IV. Column F is the third estimate for 2014:I. Column G is the third estimate change between 2014:I and 2013:IV. Finally, Column H equals Column G minus Column E. Column H is the difference between the two changes.

Simple Analysis of GDP What Happened in the First Quarter

Simple Analysis of GDP (click the picture for a larger image)

And Column H is where my confusion begins. How is it possible that personal consumption expenditures fell by $55.2 billion between the second and third estimate? These figures should be relatively stable because estimates of consumer spending are based on data that is available relatively early in the estimation process. And most of this decrease is made up of consumer spending on services ($49.8 billion). This makes no sense at all.

And it gets worse. There are huge changes in gross private domestic fixed investment and nonresidential construction. Exports decreased by an additional $15.9 billion, about half the original change (Column E). Imports increased by 150% of the second estimate.

As always, the Excel workbook I used is available for downloading by clicking here.

Earlier this year I posted an article stating that I would not use government data until at least after the 2016 election. I’ve now violated that promise several times. But this data makes me suspect that even the Bureau of Economic Analysis is just making up numbers.




What Really Happened in the First Quarter

Percent Change in U.S. Real GDP

The Bureau of Economic Analysis announced that, according to the second estimate, real GDP fell by one full percentage point in the first quarter. That was revised down from the first estimate of -0.1%. Many in the media are having trouble reconciling these numbers with, say, the falling unemployment rate. In the interest of education, I offer my take on what really happened in the first quarter — and what did not happen. (And, in the pursuit of education, I am violating my rule against using government data. This is, hopefully, a rare exception.)

When I started writing this, I thought I knew why real GDP fell in the first quarter. It turns out my guess was wrong — but, believe me, that’s not good news at all. I’m going to walk you through my hypothesis, then point out why it’s wrong. Then I’ll deliver the really, really bad news.

Definitions: GDP, Real GDP, Inflation, Oh My!

Gross domestic product is the dollar value of all goods and services produced in a country during a year. Since GDP uses current prices to value the goods and services, we would like to know how much of a change in GDP was caused by increases in actual output (Y) and how much was the result of a higher price level (inflation, P). This rule must hold at all times:

GDP equals real GDP times the average price level

Economists usually focus on real GDP because it’s changes in output that cause employment to change. For convenience, let’s use a simple model that I’ve used in my classes over the years. Real GDP is still Y but we now break it into two parts: the number of workers (L) and the productivity of each worker (W). Productivity is simply output per worker (Y/L) so this equation must also hold at all times:

Real GDP equals the number of workers times productivity

From this perspective, there are two ways real GDP can increase. We can use more workers with the same productivity. Or we can use the same number of workers with more productivity.

What Causes the Unemployment Rate to Fall?

This is the key. The unemployment rate measures the percentage of the labor force that is looking for work but can’t find it. The unemployment rate can fall because there are fewer unemployed and more employed. But there is a second possibility. Suppose the previously unemployed workers do not find jobs, but instead give up looking for work. Since they’re not looking for work, they are not in the labor force. The number unemployed and the number in the labor force decrease by the same amount. But the unemployment rate will fall because the proportional reduction in the number unemployed will be far greater than the proportional reduction in the labor force.

An example will help. In the first quarter of 2000 there were 5.766 million unemployed in the U.S. The labor force was 142.386 million. The unemployment rate was 5.766/142.386 = 4.05%. In the fourth quarter of 2009, the depths of the Great Recession, there were 15.223 million unemployed and the labor force was 153.591 million, giving an unemployment rate of 9.91%. So far so good. The labor force increased by about 11 million people and the number of unemployed went up by about 10 million.

Consider, now, the second and third quarters of 2013. Here’s some data:

Description 2013:2 2013:3 Change % change
Unemployed (millions) 11.289 10.777 −0.512 −4.5%
Employed (millions) 144.245 144.172 −0.428 −0.1%
Labor Force (millions) 155.534 154.949 −0.585 −0.4%
Unemployment Rate 7.26% 6.96%

The point is that the percentage change in the unemployment rate is far larger than the percentage change in the labor force. In reality, the number of people employed fell during these two quarters. The decrease in the unemployment rate was caused entirely by people leaving the labor force.

Unfortunately this does not account for what happened in the first quarter of 2014. Employment rose by a respectable 1.238 million and the number unemployed fell by about 600 thousand. The labor force also increased by about 900 thousand. (All data is contained in the Excel 2007 workbook. Before you change anything in that workbook, be sure to read the NotesSources tab as it describes the relationships among the worksheets.

What About the Weather?

Many economists (who should know better) blame the bad weather in the first quarter.  As is often the case, there was snow, ice, storms, and sundry other weather-related events.  Here in the greater Silicon Valley area we had two months of freezing temperatures overnight.  For better or worse, those two months were from mid-October to mid-December, 2013.  Except for a serious drought, the weather has been very nice so far in 2014.

Here’s the problem.  The weather gets bad every winter in most of the U.S.  At least the continental U.S.  (Hawai’i, as far as I can tell, never has bad weather.  And Alaska speaks for itself.)  GDP data are seasonally adjusted.  That means the reported figures already assume a bad winter and are corrected to compensate for it.  The only way weather could cause a drop in GDP is if the weather was worse than usual.  I’m skeptical about that, but would love to hear from meteorologists.

The Bad News: What Really Happened in the First Quarter

Better sit down. This is bad. The reason GDP fell in the first quarter was a precipitous decline in business investment and exports. You don’t have to believe in the neo-Keynesian multiplier to realize that this is very, very bad. (If you do believe in the multiplier, you will recognize investment and exports as two of the elements of autonomous spending. That means a change in either has a multiplied impact on the economy. And that multiplied effect will impact real GDP over the next few quarters. Those hoping for a rebound will be disappointed. This is the beginning of a new recession. (For some of us, it’s a continuation of the Great Recession.)

“But,” the pundits say, “wasn’t that all caused by a decrease in inventories?” If only. The change in gross private domestic investment was −$80.9 billion. Inventories were −$62.7 billion. But business fixed investment — plant, equipment, office buildings, warehouses, and other hardware — fell by $14.8 billion. In fact, the only category of gross private domestic investment that rose was “Intellectual property products,” a category recently added to U.S. national income accounts to make the GDP numbers larger more adequately account for this important segment of the U.S. economy. Excluding that increase, the decline in physical capital investment was −$88.8 billion.

Exports fared no better. Total exports declined by $36.1 billion. A decrease in exports of goods of $36.5 billion was slightly offset by a $5.1 billion increase in services exports.

Real GDP 2013:4, 2014:1 and the Change

Real GDP 2013:4, 2014:1 and the Change

What Is Gross Private Domestic Investment?

When economists talk about “investment” we usually mean physical capital: factories, machines, office buildings, warehouses, and other stuff you can touch and feel. The sole exception is intellectual property products.

The net change in business inventories is literally goods that have been produced but not yet sold. Naturally, only companies producing goods can worry about inventories. A decrease in inventories can be caused by two factors.

We need to divide inventory change into two parts: planned and unplanned. Businesses often change inventory levels to accommodate expected future changes in sales. The best example is Christmas. Starting in August, many companies begin to “fill the pipeline” with goods they expect to sell during the Christmas shopping season. These are planned inventory changes that are usually not very important. (One exception to this rule is businesses reducing inventories because they expect future demand to fall. This can lead to a self-fulfilling prophecy as businesses reduce inventories and cut production. The outcome is sometimes a lower growth rate in income and (possibly) a recession.

Unplanned inventory changes are caused by unexpected changes in demand. Consider a shoe manufacturer that I will call Brown Shoes. In July, Brown’s economist forecasts that the company will sell 12,000,000 pairs of shoes in August. Brown is currently producing 10,000,000 pairs per month, so they ramp up production.

But, unfortunately, the forecast was wrong. Actual sales were only 8,000,000. Brown produced 12,000,000 pairs but only sold 8,000,000. The difference — 4,000,000 pairs — is an unplanned increase in Brown’s inventory.

This is the core point about inventories. Unplanned inventory changes are caused by incorrect forecasts. At the GDP level, an unplanned inventory change means many businesses are forecasting incorrectly.

So the question is whether the $62.7 billion decrease in inventories in 2014:1 is planned or unplanned. Consulting entrails, my astrologer, and (important) looking at the actual GDP numbers, my guess is that about $45 billion of that was unplanned. Demand was less than businesses were forecasting. Therefore they reduced investment and inventories. But the actual decrease in inventories was more than businesses had intended. Ergo, businesses will continue to reduce output.

A Digression on National Income Accounting

Inventory change is added to total spending as one of the three elements that converts spending into production. (Remember, GDP measures production, not spending.) The other two elements are exports and imports. Exports are produced here but sold outside the country. They are not included in domestic spending, but they need to be included in domestic production. We need to add them to total spending to get to production.

In brief, when adding up GDP the first step is to add total spending in the economy: consumer spending, business fixed investment spending (including IP), and government spending. We then add the net change in business inventories to account for the difference between domestic spending and domestic production. We add exports because those products are produced here but sold in other countries. Since they are not included in domestic spending, we must add exports because they are part of domestic production.

What about products produced in other countries but sold here? That BMW was made in Germany and, therefore, is part of Germany’s GDP. But it’s included in U.S. consumer spending. We need to subtract imports because they are included in domestic spending but are not part of domestic production.

Conclusion

The U.S. economy is in for a rough time in 2014. In large part this has been caused by the implementation of Obamacare, the Dodd-Frank financial reform act, and the flood of new regulations emanating from a plethora of U.S. government agencies. I’ll just mention the de facto war on coal being waged by the EPA and the broad use of “disparate impact analysis” in the Department of Labor.

The economy will not begin to improve until some of these anchors are lifted. The earliest that will happen is 2017. The outcome of the next presidential election will determine whether the U.S. economy continues to stagger along or it is freed from some of the onerous chains are removed.

Sources

U.S. Bureau of Economic Analysis, “Table 1.1.1. Percent Change From Preceding Period In Real Gross Domestic Product,” second estimates for the first quarter of 2014, (accessed May 29, 2014). http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&904=2012&903=1&906=q&905=2000&910=x&911=0

U.S. Bureau of Economic Analysis, “Table 1.1.6. Real Gross Domestic Product, Chained Dollars,” second estimates for the first quarter of 2014, (accessed May 29, 2014). http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1#reqid=9&step=3&isuri=1&904=2012&903=6&906=q&905=2000&910=x&911=0

U.S. Bureau of Labor Statistics, Labor Force Data accessed through the FRED database at the Federal Reserve Bank of St. Louis on May 29, 2014.




National Income Accounting and the Most Recent NPR Fail

Sometimes a self-appointed economist gets it so wrong that their statement fails the laugh-out-loud test.  Today’s subject is the fascinating world of national income accounting and the most recent NPR fail. Along the way we’ll learn how gross domestic product is measured.  Even if you’re a real economist, I suspect you can learn a thing or two from this.

Why is this important?  Because gross domestic product is equal to national income.[1]  When GDP rises, so does national income.  Even if you don’t think GDP is important, I’m pretty sure national income matters to you.

Writer Dave Barry once famously said, “gross domestic product would be an excellent name for a band.”  While that may be true, we’re going in a different direction today.

Background: NPR Strikes Again

Today’s egregious error is from Public Radio International’s The World.  The segment was titled “How Should We Judge Our Economy.” And the guest clown pseudo-economist was “Eric Zencey, a political economist with the Gund Institute for Ecological Economics at the University of Vermont.”  Forthwith, Mr. Zencey’s argument (lifted straight from the PRI page for this story).

“I think GDP should re-named, so that we don’t mistake it for a measure of well-being. I think we should call it gross domestic transactions,” said Zencey. “That’s all it is, it totes up the monetary value of all the transactions. And if it had that name that would help break the association people have with the idea that more GDP is better. It’s like hmmm, more transactions are better? Well it depends on what you’re transacting.” [All quotation marks and other punctuation unchanged from original story.]

The easy criticism is that, even if GDP equaled spending, it would not equal the total volume of transactions in the economy.  For starters, GDP excludes transactions involving assets.  If you buy or sell shares in a mutual fund, that is not included in GDP.  Also excluded are transactions involving previously-owned items.  That antique pepper mill you bought at a garage sale? Not in GDP.  That car you bought from a soon-to-be-ex-friend?  Also not included.  So the total volume of transactions in any economy would be a huge multiple of GDP.

The more subtle issue is a complete misunderstanding of what GDP measures.  Most principles of economics texts get this pretty much: gross domestic product is the market value of all goods and services produced in a country during a calendar year.  Read that again and see if you can find the words “spending” or “transactions.”  You can’t because GDP measures neither of those.  GDP measures production, not spending.

“Wait,” says the knowledgeable reader. “In macroeconomics I learned that GDP was the sum of consumption spending, investment spending, and government spending.  Why isn’t GDP the same as total spending? What about C + I + G?”

Read on.  The answer is far simpler than you can imagine.

GDP and Spending

Think carefully about what you learned in that economics course.  In the definition of GDP wasn’t there something about exports and imports?  And if you memory is better than mine, you may recall something about the net change in business inventories being part of gross private domestic investment (“investment spending”).  Each of these three items is important in its own way.  Let’s begin with a basic fact: C + I + G measures total domestic spending on newly-produced goods and services.  Asset transactions and purchases of previously-owned goods are still excluded.[2]

GDP, Domestic Spending, and Domestic Production

Let’s first discuss a country that operates in complete autarky.  This lovely word autarky describes a country that does not interact economically with the rest of the world.[3]  In such a country, total domestic spending on domestically produced goods is, in fact, total spending.[4]  What happens if there is a difference between spending and production in such an economy?

This is actually pretty simple.  John Maynard Keynes discussed it at length in his General Theory of Employment, Interest, and Money.  When spending is less than production, business inventories rise.  The unsold goods flow into inventories.  And when spending is greater than production, business inventories fall.  The only way businesses can sell goods they have not produced is to draw them from inventory.

A simple example may help. Consider a company that makes ordinary wooden pencils.  They try to produce to meet demand.  When thinking about how many pencils to produce in July (for example), they consult their economist who assures them that there will be demand for 5 million pencils in July.  The company produces 5 million pencils in July.  But the forecast was incorrect.  Only 4.8 million pencils were actually sold.  What happens to the remaining 200,000 pencils?  They end up in inventory for the beginning of August.

Note the relationship here:  output – sales = inventory change.  We can rewrite this simply as output = sales + inventory change.

But wait – we’re trying to measure output (GDP).  We start by adding up total spending: consumption plus government plus business fixed investment.  We then correct for any output that was not sold by adding the net change in business inventories.  Adding inventory change converts total spending into total output.

That was pretty easy.  Believe it or not, the next section is even easier.

GDP, Domestic Spending, and Domestic Production in an Open Economy

Now let’s open our economy to international trade.  Our GDP equation now becomes C + I + G + (X − M).  Exports are X, imports are M.  Together, X − M is called net exports.

If you read several principles textbooks you will find many convoluted explanations of why exports are added and imports are subtracted.  That’s unfortunate because the explanation is very easy.  Exports are goods and services produced in our country and sold elsewhere.  We add exports to domestic spending because those goods and services are not included in domestic spending but they are included in domestic production. Workers producing those exports earn income even though the products they are producing are not sold within the country where they are produced.

What about imports?  Goods and services that are produced in other countries but sold in our country fall into this category.  Therefore, those goods and services are part of domestic spending.  But they are not part of domestic production.  Imports are subtracted to correct domestic spending into domestic production.

Consider a couple of examples.  Suppose you buy a new BMW for $50,000.  The car was produced in Germany.  But it’s sold here, which means domestic spending rises by $50,000. But domestic production has not changed.  We need to subtract that $50,000 from domestic spending to move the total in the direction of domestic production.

Similarly, consider German tourists visiting the U.S.  They are buying tourism services from the U.S. which count as exports.  The services are produced here but sold (in effect) in another country.  Therefore we must add the value of those exported services to total spending to move the total in the direction of domestic production.

Conclusion

So here’s the story.  We begin with domestic spending (roughly C + I + G ignoring the fact that inventory change is included in I).  We then add the net change in business inventories to this total to correct for any difference between domestic spending on domestically produced goods and domestically produced goods sold within the country.  Next we add exports, products that are produced here but sold in other countries.  Finally we subtract imports, products that are produced in other countries but sold here.  Remember, the central idea is to convert domestic spending into domestic production.

At its most basic, this stuff is not difficult.  It’s always been a mystery to me why economists insist on making it difficult.  I hope this explanation has been helpful.  Please feel free to ask questions in the comments.


[1] Please don’t quibble.  I know there are differences between GDP and national income.  This is a blog, not the American Economic Review.

[2] No one has yet figured out how to sell previously-owned services, so we don’t have to worry about that.

[3] From the ancient Greek autarkeia: self-sufficiency, or nonattachment. See this page from Britannica online for more details.

[4] Consistent with national income accounting assumptions, I continue to exclude spending on assets and previously-owned goods.




GDP Growth Was Revised Down

The second estimate is in for the third quarter and — no surprise — GDP growth was revised down.  The preliminary estimate had been 2.5 percent, but the revised estimate is 2.0 percent.  Remember, you read it here first.




It’s the Advance GDP Estimate, Stupid!

Happy talk media today are whooping it up because real GDP grew by 2.5% in the third quarter.  News flash: it’s the advance GDP estimate, stupid!

Don’t take my word for it.  Read the first two paragraphs of the press release from the Bureau of Economic Analysis:

“Real gross domestic product — the output of goods and services produced by labor and property located in the United States — increased at an annual rate of 2.5 percent in the third quarter of 2011 (that is, from the second quarter to the third quarter) according to the “advance” estimate released by the Bureau of Economic Analysis. In the second quarter, real GDP increased 1.3 percent.

The Bureau emphasized that the third-quarter advance estimate released today is based on source data that are incomplete or subject to further revision by the source agency (see the box on page 3). The “second” estimate for the third quarter, based on more complete data, will be released on November 22, 2011.”

Prediction: this estimate will be revised downward twice — once at the end of November and a second time just as we’re about to welcome in 2012.