US economy – slowing down – fiscal stimulus needed

Last week (March 25, 2016), the US Bureau of Economic Analysis released their ‘Third Estimate’ of – Gross Domestic Product, 4th quarter 2015 – which showed that the US economy slowed rather appreciably in the last three months of 2015. The BEA said that real GDP growth was “increased at an annual rate of 1.4 percent” after having increased by 2 per cent in the third-quarter of 2015. Two things stand out from the data: (a) Private consumption expenditure, while still relatively strong continues to slow. The main drivers of consumption expenditure are recreation and health care services and durable goods; (b) Capital formation (investment) declined for the second consecutive quarter, signalling a lack of confidence in the medium-term outlook by business firms. However, residential investment was relatively strong as was federal government spending. The BEA also reported that corporate “profits decreased by 7.8 per cent at a quarterly rate”. The data release provides no succour to those who think the Federal Reserve Bank should continue to hike interest rates. Inflation is still well below the implicit central bank target rate (2 per cent) and growth is faltering.

The BEA said in the release that:

Real gross domestic product — the value of the goods and services produced by the nation’s economy less the value of the goods and services used up in production, adjusted for price changes — increased at an annual rate of 1.4 percent in the fourth quarter of 2015 … In the third quarter, real GDP increased 2.0 percent …

The increase in real GDP in the fourth quarter reflected positive contributions from PCE, residential fixed investment, and federal government spending that were partly offset by negative contributions from nonresidential fixed investment, exports, private inventory investment, and state and local government spending. Imports, which are a subtraction in the calculation of GDP, decreased.

The deceleration in real GDP in the fourth quarter primarily reflected downturns in nonresidential fixed investment and in state and local government spending, a deceleration in PCE, and a downturn in exports that were partly offset by a smaller decrease in private inventory investment, a downturn in imports, and an acceleration in federal government spending.

The following sequence of graphs captures the story.

The first graph shows the annual real GDP growth rate (year-to-year) from the peak of the last cycle (December-quarter 2007) to the December-quarter 2015 (blue bars) and the annualised last quarter growth rate (green line). The data is available – HERE.

The year-to-year growth rate (December-quarter 2014 to December-quarter 2015) was 2 per cent, down from 2.1 per cent in the last quarter. There is considerable volatility in the data which is smoothed out by the year-to-year growth calculation.

The annualised quarterly growth rate (that is, multiplying the December-quarter 2015 performance by 4) is only 1.38 per cent down from 1.97 per cent in the last quarter. This is considerably slower than the annualised 3.86 per cent for the June-quarter.

The next graph shows the actual real GDP for the US (in $US billions) and an estimate of the potential GDP. There are many ways of estimating potential (given it is unobservable).

While I could have adopted a much more sophisticated technique to produce the red dotted series (potential GDP) in the graph, I decided to do some simple extrapolation instead to provide a base case.

The question is when to start the projection and at what rate. I chose to extrapolate from the most recent real GDP peak (December-quarter 2007). This is a fairly standard sort of exercise.

The projected rate of growth was the average quarterly growth rate between 2001Q4 and 2007Q4, which was a period (as you can see in the graph) where real GDP grew steadily (at 0.68 per cent per quarter) with no major shocks.

If the global financial crisis had not have occurred it would be reasonable to assume that the economy would have grown along the red line (or thereabouts).

The gap between actual and potential GDP in the fourth-quarter 2015 is around $US2,218.2 billion or around 11.4 per cent. The gap has been steady at around 11 per cent since the first-quarter 2014, which means that real GDP is once again growing about as fast at it did, on average in the 6 years before the crisis.

The green line is the estimate of potential output provided by the US Congressional Budget Office and made available through – St Louis Federal Reserve Bank.

Their output gap estimate (difference between actual and potential) is 2 per cent, which is clearly less than that derived from a simple extrapolation.

CBO define Potential GDP as “the level of output that corresponds to a high level of resource-labor and capital-use.”

So how do they estimate potential GDP? They explain their methodology in the document – A Summary of Alternative Methods for Estimating Potential GDP.

I discussed the methodology and limitations in these blogs – Structural deficits and automatic stabilisers and US problems are cyclical not structural.

For those who want even more technical detail, please consult my 2008 book with Joan Muysken – Full Employment abandoned – where we provide a mathematical and econometric discussion of the techniques that the CBO uses.

By way of summary, the CBO say that they:

They start with “a Solow growth model, with a neoclassical production function at its core, and estimates trends in the components of GDP using a variant of a tried-and-tested relationship known as Okun’s law. According to that relationship, actual output exceeds its potential level when the rate of unemployment is below the “natural” rate of unemployment) Conversely, when the unemployment rate exceeds its natural rate, output falls short of potential. In models based on Okun’s law, the difference between the natural and actual rates of unemployment is the pivotal indicator of what phase of a business cycle the economy is in.

The resulting estimate of Potential GDP is “an estimate of the level of GDP attainable when the economy is operating at a high rate of resource use” and that if “actual output rises above its potential level, then constraints on capacity begin to bind and inflationary pressures build” (and vice versa).

So despite saying that their estimate of Potential GDP is “the level of output that corresponds to a high level of resource-labor and capital-use” what you really need to understand is that it is the level of GDP where the unemployment rate equals some estimated (unobservable) Nonaccelerating Inflation Rate of Unemployment (NAIRU).

Intrinsic to the computation is an estimate of the so-called “natural rate of unemployment” or the NAIRU which is the mainstream version of ‘full employment’ but is, in fact, a conceptual unemployment rate that is consistent with a stable rate of inflation.

The literature demonstrates that the history of NAIRU estimation is far from precise. Studies have provided estimates of this so-called ‘full employment’ unemployment rate as high as 8 per cent or as low as 3 per cent all at the same time, given how imprecise the methodology is.

The former estimate would hardly be considered “high rate of resource use”. Similarly, underemployment is not factored into these estimates.

The concept of a potential GDP in the CBO parlance is thus not to be taken as a fully employed economy. Rather they use the devious shift in definition in mainstream economics where the the concept of full employment is not constructed as the number of jobs (and working hours) that which satisfy the preferences of the available labour force but rather in terms of the unobservable NAIRU.

The fact is that these estimates will typically underestimate (by some margin) the true scale of the existing output gaps because the estimated NAIRU is never above the irreducible minimum unemployment rate, the latter reflecting frictions in the labour market as people move between jobs.

You may also like to read this blog – Demand and supply interdependence – stimulus wins, austerity fails – where I discuss the US Federal Reserve Bank’s recent updated estimates of potential GDP.

Both potential GDP estimates in the graph above (the red dotted linear extrapolation and the CBO green estimates) are extremes and the truth is somewhere in between the two.

The decline in the investment ratio as a result of the crisis will have caused the potential GDP growth to slacken somewhat, which means the red dotted line is an upper limit.

The qualitative assessment is that unemployment is still elevated and underemployment is high, which means that the output gap is likely to be closer to 11 per cent than 3 per cent.

But it is true that potential output will have fallen off the red linear trend as the investment ratio (total investment as a percent of GDP) slowed in 2009. It went from 18 per cent in the September-quarter 2007 to 12.5 per cent in the December-quarter 2009.

So there was a sharp slowdown in capacity building which would have reduced the potential growth path somewhat.

It was back to 17.4 per cent in the December-quarter 2015 but is still well below the pre-GFC levels.

The following graph shows the evolution of the Private Investment to GDP ratio from the March-quarter 1950 to the December-quarter 2015.

The other relevant point about the graph is that it defies those who want to characterise the main US problem as being structural (labour market rigidities etc). The US would not have fallen off the cliff as it did in early 2008 if that was the case. Structural deterioration is gradual and cumulative not sudden and sharp.

Contributions to growth

The next graph compares the September-quarter 2015 (blue bars) contributions to real GDP growth at the level of the broad spending aggregates with the December-quarter 2015 (gray bars), where the overall real GDP growth was 1.4 per cent.

The main aggregate source of growth came from Private consumption spending (1.7 percentage points). But the strength of Private consumption has declined over the last three quarters as the household saving ratio has risen. It is hard to interpret that shift but a plausible explanation is that increasing uncertainty and high levels of household debt are promoting caution among households.

The contribution of Private investment spending was negative for the second, consecutive quarter (-0.16 percentage points) and does not augur well for the medium-term outlook.

The Government sector overall reduced its growth contribution to 0.02 points down from 0.32 points. The federal contribution strengthened to 0.15 points, while the State and Local government sector detracted from growth (-0.13 points).

Net exports drained total spending by 0.14 points (down from -0.26 points in the last quarter). Last quarter, exports added 0.09 points but this quarter they detracted from growth by 0.25 points.

The external outlook for the US is being dampened by the on-going malaise in Europe and the appreciation of the US dollar.

The next graph decomposes the government sector and shows that the contributions between the levels of government have reversed in the last three months of 2015.

Further, the strong contribution of defense spending at the federal level is apparent.

The next graph shows the contributions to real GDP growth of the various components of investment. It is here that we see why total real GDP growth slowed in the third-quarter.

Unsold inventories continued to drain growth (by -0.22 points). The two consecutive quarters of inventory run-down now suggests that the inventory cycle is turning down as firms cut production growth in response to the slowing consumption expenditure.

This would signal an on-going weakness in the economy.

There was a reduced contribution by fixed investment (0.06 points).

The data shows that the contribution of investment in structures to real GDP growth continued to decline (-0.14 points output drain).

This includes investments in factory buildings, office buildings, hospitals etc but also would include investments in mining and oil production capacity.

Residential investment remained a solid contributor in the current quarter (0.33 points up from 0.27 points).

Conclusion

Real GDP growth slowed in the September-quarter 2015 largely because of the rising US dollar value and the slowdown in investment expenditure.

The slowdown continued into the last three months of 2015, largely due to the on-going slump in private investment expenditure, negative export growth and contracting State and Local government expenditure.

Clearly household consumption expenditure is holding up and the rising pace of federal government expenditure maintained the growth impetus.

In general, I conclude that with private business investment faltering, the federal government’s deficit is now too low to support stronger growth and labour underutilisation rates (U6) remain elevated (and excessive).

FINALLY – Introductory Modern Monetary Theory (MMT) Textbook

I will write a separate blog about this presently, but today we finally published the first version of our MMT textbook – Modern Monetary Theory and Practice: an Introductory Text – today (March 10, 2016).

The long-awaited book is authored by myself, Randy Wray and Martin Watts.

It is available for purchase at:

1. Amazon.com (60 US dollars)

2. Amazon.co.uk (£42.00)

3. Amazon Europe Portal (€58.85)

4. Create Space Portal (60 US dollars)

By way of explanation, this edition contains 15 Chapters and is designed as an introductory textbook for university-level macroeconomics students.

It is based on the principles of Modern Monetary Theory (MMT) and includes the following detailed chapters:

Chapter 1: Introduction
Chapter 2: How to Think and Do Macroeconomics
Chapter 3: A Brief Overview of the Economic History and the Rise of Capitalism
Chapter 4: The System of National Income and Product Accounts
Chapter 5: Sectoral Accounting and the Flow of Funds
Chapter 6: Introduction to Sovereign Currency: The Government and its Money
Chapter 7: The Real Expenditure Model
Chapter 8: Introduction to Aggregate Supply
Chapter 9: Labour Market Concepts and Measurement
Chapter 10: Money and Banking
Chapter 11: Unemployment and Inflation
Chapter 12: Full Employment Policy
Chapter 13: Introduction to Monetary and Fiscal Policy Operations
Chapter 14: Fiscal Policy in Sovereign nations
Chapter 15: Monetary Policy in Sovereign Nations

It is intended as an introductory course in macroeconomics and the narrative is accessible to students of all backgrounds. All mathematical and advanced material appears in separate Appendices.

A Kindle version will be available the week after next.

Note: We are soon to finalise a sister edition, which will cover both the introductory and intermediate years of university-level macroeconomics (first and second years of study).

The sister edition will contain an additional 10 Chapters and include a lot more advanced material as well as the same material presented in this Introductory text.

We expect the expanded version to be available around June or July 2016.

So when considering whether you want to purchase this book you might want to consider how much knowledge you desire. The current book, released today, covers a very detailed introductory macroeconomics course based on MMT.

It will provide a very thorough grounding for anyone who desires a comprehensive introduction to the field of study.

The next expanded edition will introduce advanced topics and more detailed analysis of the topics already presented in the introductory book.

That is enough for today!

(c) Copyright 2016 Bill Mitchell. All Rights Reserved.