The second quarter gross domestic product numbers showed overall growth of 3 percent. The cause shopped by most pundits was imports, contributing an eye-popping 5.18 percentage points to the growth. That was partially offset by a contribution of −3.09 points in gross private domestic investment. What’s going on? The answer lies in expectations and the mismanagement of information from the Trump administration. I’m going to discuss fixing GDP problems created in Washington DC.
Here’s the summary of contributions to the overall 3 percent growth rate. (Add the numbers in black boldface to get 3 percent. Ignore the 5.18.)
Fig01 Contributions to Percent Change in Real GDP Q 2023-2025 (click for larger image)
It’s pretty straightforward to correct the reported figures for this distortion. The first step is to simply average first and second quarter import and inventory numbers. Then add those averages to gross domestic spending plus exports. (There are a few other tweaks described later.) The result: second quarter GDP growth would have been 0.8% (annual rates) instead of 3.0%. Call the 0.8% the counterfactual GDP.
Background: How We Got Here
Here’s the short version. President Trump threatened massive tariffs on, well, just about every country. Businesses promptly began hoarding imported products, building inventories in anticipation of higher post-tariff prices. Then the president backed off from his tariff threats. Businesses breathed a sigh of release and proceeded to sell off their inventories. Since they were selling goods they already owned, their imports fell. Economists will immediately recognize this as a cycle induced by changing expectations. One mystery I’ll look at later is why first quarter inventories did not rise commensurately with imports.
Regular readers will recall the tariff on penguins (here and here). At least the most recent announcement was limited to putting tariffs only on countries that have actual human populations. Believe it or not, the penguin tariffs were proposed in April of this year. I had to look at the date twice to be sure. It seems like it happened last year.
The Source of the Problem
The problem arises because imports are subtracted during the calculation of gross domestic product. Remember, GDP measures production. To add up GDP, start by adding up gross domestic spending: consumption plus gross private fixed investment plus government spending. Then add products made here but sold in other countries (exports). Since part of spending is used to buy imports (not produced here), subtract imports. Finally, add the change in inventories to correct for products being held for future sales. If a good is produced, but not sold, it ends up in inventories.
An increase in imports reduces reported GDP. Conversely, a decrease in imports boosts GDP. This is all because GDP measures domestic production.
During the first quarter, both imports and business inventories rose sharply. During the second quarter, they both dropped sharply. The media has focused on imports. But businesses also build inventories in anticipation of tariffs. The increase in inventories did not match the increase in imports. During the first quarter, imports grew by $309.1 billion. But inventories only increased by $160.5 billion.
But that’s a topic for later. Today we need to crunch a few numbers. (Those allergic to math are invited to stop reading here.)
Correcting Imports and Inventories
The most direct way to create a counterfactual is to simply average the first and second quarter figures. I have taken the liberty of adjusting the two figures for growth in real gross domestic spending (C + Ifixed + G). I did this by reducing first quarter growth by half the growth in domestic spending and increasing second quarter growth by the same percentage. Here’s the result:
Fig02 Counterfactual and Actual GDP (click for larger image)
Pretty interesting. Instead of 3% second quarter growth, we get 0.8%. And, of course, between 2024:4 and 2025:1 actual growth was −0.5%. This is a truly avoidable cycle created by the Trump administration.
Some Calculations and Errors
The first question is what happened to those imports in 2025:1? If businesses were hoarding in anticipation of tariffs, they should have stored the goods somewhere. But inventories rose only modestly (160.5 compared to an increase in imports of 309.1). Do businesses have container ships moored offshore to avoid warehousing costs? Perhaps they’re putting them in depots in Mexico or Canada. Maybe aliens stole them and held the goods for ransom. I have no idea, but I hope to hear from the many readers who know this area better than me.
Second, let’s revisit why imports are subtracted in the GDP calculation. There are two parts to the answer:
- What does GDP measure?
- How is GDP added up?
GDP measures production, the total output of US businesses during a calendar year. GDP does not measure spending, the quantity of gold in Fort Knox, or whether Mercury is in retrograde.
That’s directly related to the procedure for adding up GDP. First add up gross domestic spending (consumption + business fixed investment + government spending). Then add three factors that convert spending to production.
First add the change in business inventories. Those are goods produced but not sold during the quarter. Since we’re trying to convert spending into production, this is a good first step. (By definition, services can’t be held as inventories.)
Second, what about products produced here but not sold here? That means they are sold in other countries (again, assuming zero sales to the aforementioned aliens). Add exports.
Third, what about products sold here but not produced here? They are part of domestic spending but should not be included in domestic production. We call those products imports and subtract total imports in the GDP calculation.
Conclusion
Hasn’t this been fun? For more hilarity, click here to download the Excel workbook.
