Thursday, October 30, 2008

U.S. GDP Report Show Significant Private Sector Contraction

Just as I expected, the third quarter GDP showed a contraction. The contraction of 0.3% was however somewhat smaller then I expected.

However, the reason for this smaller contraction is not really a sound one: government spending soared. While I had expected government spending to rise, it rose a lot more than usual. Government purchases rose from 20.1% of GDP to 20.4%-the highest since Q3 1991, and up from just 17.6% in Clinton's last quarter (During the Clinton era, government purchases decreased significantly as military spending fell). As before, military spending increased particularly much, but non-military federal spending and state & local government spending increased its share of GDP too. Excluding government purchases, the contraction would have been closer to 2%.

Although business investments fell somewhat, the main factor behind the decline in private sector activity were a continued sharp drop in residential investments and in consumer spending. The decline in residential investments is basically sound as it will reduce housing inventory. The decline in consumer spending is arguably sound too as savings is too low. It will need to fall more as it remains near a post-Depression high.

Moreover, there is also the old issue of terms of trade. Despite the sharp drop in import prices in August and September, the increases in May to June were enough to cause import prices to rise more than export prices. So despite the fact that the actual trade deficit fell (were assumed to fall, we don't have the September numbers yet) only slightly, net exports supposedly added a full 1.1 percentage points to GDP. Measured properly, it would have added just 0.5 percentage points. If you then deflate the nominal increase of GDP by the 4.7% increase in the domestic purchases index instead of the 4.1% increase in the domestic price index, the decline would have been 0.9% instead of 0.3%. Private sector activity would have declined 2.5%.

In the fourth quarter, the terms of trade factor should finally reverse, and then the volume number will actually exaggerate the decline. This combined with the deterioration in real economic activity will mean that we will see a really big fourth quarter headline decline even if government spending continues to increase.

The numbers concerning another issue discussed here, the discrepancy between the production numbers and the income numbers (national income has consistently for several quarter been a lot weaker than GDP), are not yet available. The damage created by the hurricanes has however boosted capital consumption, meaning that national income will probably continue to be even weaker than GDP.

The bottom line is that although the headline decline of 0.3% may appear mild, the numbers are far worse if you look at the details. And the fourth quarter numbers are likely to show a much greater contraction (particularly for the headline number).


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