Anatomy of the Decline and an Early Look at the Recovery

I have found it instructive to look back for a moment and analyze the anatomy of the economic decline. From the 4Q of 2007, when the recession officially began, through the 2Q of 2009, real GDP declined 3.5%. Here are the contributors to that fall; that is, here are the actual percentage points of GDP decline caused by each sector:

Personal Consumption………………………………….-1.2%

Investment in Non-Residential Structures……-0.6

Investment in Equipment and Software………..-1.8

 Residential Construction………………………………-1.0

Inventory Liquidation……………………………………-1.2

Lower Exports of Goods and Services……… …….-1.6

                              Total Negatives…………………………..-7.4%

The positive offsets have been few:

Reduced Imports…………………………………………….3.2%

Government Expenditures……………………………..0.6

Statistical Residual………………………………………….0.1

                                    Total Positives………………………..3.9%

                            NET DECLINE………………………………3.5%

This table understates the negative contribution from residential construction because it had already suffered a hefty decline by 4Q 2007. But otherwise it shows a clear picture of what has happened.

Because one hears often about the positive contribution from exports in this recession, some may be surprised to see lower exports as an important negative force. That’s because the positive contribution has been from NET exports, which has been a negative for GDP for some years as our imports soared and surpassed our exports. (Net Exports effectively became Net Imports, but the National Income compilations left the Net Exports title unchanged). What has happened in this recession is that imports have declined much more than our exports, thus reducing the negative size of NET exports.

This is worth considerable emphasis. Reduced imports have acted like a powerful shock absorber, offsetting over 40% of the recessionary forces! This was not only the result of lower consumption of finished, imported goods. A significant part of the import growth in the decade preceding the recession was the result of domestic firms outsourcing production to foreign producers. When domestic demand contracted, therefore, the outsourced production (imports) was affected disproportionately.

Looking at what happened is of some help in judging what will happen now. It is not clear that the reduction of imports relative to exports will continue. Most recent trade figures indicate otherwise, although the dollar weakness of the past few weeks is not yet reflected therein.

The most immediate help to economic activity is coming from an end of inventory liquidation. As liquidation turns to modest accumulation, GDP could benefit by as much as 2%.

Residential construction seems to have finally stabilized, even if at a very low level. Mere stabilization can add a full percentage point to GDP growth.

Signs of stabilization have also been appearing elsewhere, notably in investment in equipment and software. No large positive yet, but stabilization will help the GDP numbers. Meanwhile the effects of government stimulus are accumulating and will be a solid positive for some quarters ahead.

John Mauldin has called it a “statistical recovery”. By that he means a recovery which looks good on paper in terms of magnitude but doesn’t really feel like a recovery. I prefer to call it a “low quality recovery”. For rather than being a broadly-based increase in aggregate demand it is quite narrow, being heavily weighted toward stabilization where there has been negative growth, plus a turn from inventory liquidation to modest inventory accumulation, and dependency upon government stimulus.

Headwinds are still very powerful: commercial construction continues to fall, state and local governments are reducing spending as tax receipts plummet, and high unemployment and underemployment make any meaningful growth of personal consumption unlikely for some time ahead.

Programs like Cash for Clunkers have come and are now gone, giving the auto industry a big shot of adrenalin but leaving consumers $10 billion deeper in debt than they would have been otherwise and the auto industry without an encore. (although, on the positive side, it’s worth noting that total consumer credit outstanding contracted at a very rapid rate in July)

The slight recovery in housing has been dependent upon large price reductions, sales of foreclosures and the aggressive FHA mortgage lending program, which has pushed that agency’s share of market from 8% to 23%. (the price? FHA’s delinquency rate has soared to 8% from 5.5% a year ago) Amazing what can happen when you ask for only 3.5% down.

Yet, as indicated above, despite the negatives, GDP growth will be nicely positive this quarter and probably next quarter. (Early this year I predicted in this blog that GDP would stabilize and /or turn up by the 3rd quarter. That prediction was made almost completely based on the huge monetary expansion we experienced during last fall and the early winter months, and on my bias toward monetarism.)

But what then? I still do not see the makings of a broad growth in aggregate demand for several years, as financial leverage at all levels continues to be reduced and as employment growth lags. And yet……..it looks as if we have survived, and have prevented a depression and extended deflationary period. The price we have paid is not yet clear. To be sure, the growth of the national debt will be a constraining force on economic policy. Any politically neutral viewer of the future almost surely sees higher taxes at all levels as a necessity. And then there are the questions about the Fed’s ability to withdraw monetary stimulus in a timely way and return to more normal levels of interest rates. So far, inflationary expectations have been well contained, but we are close to the line which, if crossed as demand levels return to more normal levels, would be devilish to control

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