Wrong Diagnosis

An unsigned editorial in today’s NYT diagnosed the economy’s problem’s thusly:

The economy’s central problem is not lack of money to hire workers or make loans or rates that are too high. It is lack of hiring and lack of lending, despite cash cushions at many corporations and big banks and rates that are already very low.

Hmmm….that’s like saying the problem with the poor is that they don’t have enough money.

I’d say the economy’s central problem is a lack of innovation (with the exception of  the communication sector), combined with an increasingly oppressive regulatory structure.  Both of these combine to lower the expected rate of return from domestic investments, both for big and small businesses.

To solve these problems, we have to go beyond  monetary and fiscal policy, which have served their purpose of blunting the downturn. We have to develop regulatory policies that protect the vulnerable, while still leaving the room and incentives for innovation and growth.  We need to use the capabilities provided by our information society to better focus the regulatory apparatus, and turn it from a hammer, which it is today,  into a fine-edged scalpel.

Is the Stimulus Large or Small?

I’m going to show you a stimulus chart that surprised me. It’s chart #2, a bit down the page.

One important path for economic stimulus is the direct government contribution to personal income–that is, compensation of government workers plus government benefit payments to individuals. 

Chart #1:  The direct government share of personal income is at 29.3%,  the highest level in recent history (a thanks to Amity Shlaes, who asked me a question and got me thinking about this again). That’s based on the three months ending May 2010.  

(Personal income, as calculated by the BEA, subtracts out payroll tax payments. I add them back in again)

Chart #2:  The direct government contribution to personal income, adjusted for inflation, has increased only 16%  in the 2 1/2 years since the beginning of the recession. I was surprised!  Direct government contribution to personal income has not increased very much at all, despite the financial crisis. By comparison, the gain in the previous two mild recessions was about 14%.


Chart #3. The private sector contribution to personal income has plunged roughly 8%, in real terms, since the recession began. That’s how we reconcile charts 1 and 2.

Richard Florida responds

Richard Florida responds to my post A Bad Business Cycle for the Creative Economy here and here (“Brains Still Trump Guns and Oil”). He writes:

Or, you could ask just two simple questions. Which of these two places—Houma, Louisiana or Austin Texas—would you bet on to have higher living standards, higher wages, and higher home price values in the next decade or two? And if you had to choose between Killeen, Texas or the Research Triangle area around Raleigh, North Carolina as a place for you and your family to live, which one would it be?

I know how I’d answer. And I think Mandel would likely answer the same way.

I’m actually staying in good old New Jersey, land of pharma company mergers.

Still, I encourage people to read Richard’s thoughtful pieces. I’m going to come back again after I’ve had a chance to process them some more. For now,  I just want to make a couple of points.  First, an unusual combination of factors in the past decade may have worked against the Creative Economy–an innovation shortfall, combined with a rising cost of energy and the threat of terrorism. If these factors reverse, especially the innovation shortfall, the Creative Economy cities may once again have faster growth. I’m moderately optimistic–when I was recently up in Rochester speaking on innovation and economic development, I suggested that life sciences may still be a good route to prosperity in the future, even if it wasn’t over the past ten years.

However–and this is a big one–we can’t ignore the possibility that the innovation shortfall will continue, that energy will continue to rise in price, and that the military situation will become worse. In this future,  the Creative Economy arguments become less compelling.

Can We Grow Our Way out of Debt?

This post is mostly going to be thinking out loud–I don’t come to a definite conclusion yet. The U.S. faces both a short-term and a long-term fiscal crisis. The short-term problem is the current  gap between government spending and government revenues. Arguably that could go away if the economy recovers.The long-term  fiscal crisis is the gap between anticipated spending on Medicare and Social Security, and anticipated revenues from payroll taxes.

The question on the table: Could an acceleration of U.S. productivity growth (for whatever reason) enable us to grow our way out of the short-term and long-term fiscal problems? Or, more generally, could an acceleration of U.S. productivity growth boost the U.S. national savings rate, enabling us to save our way out of the fiscal problem?

In the past, I’ve answered this question with an resounding yes. I still think it’s yes, but the answer is more complicated than I thought.

The main reason why it should be possible to grow our way out of debt: An  increase in productivity growth–especially one that is not expected–makes the U.S. wealthier and gives Americans higher incomes. One might expect that could increase savings, especially since  higher-income, richer households are more likely to save (see, for example, the Fed’s Survey of Consumer Finances).  Or to put it a different way, income grows faster than consumption can adjust.

The reasons why it might not be possible to grow our way out of debt:

1) Empirical: During the 1990s and early 2000s, productivity growth accelerated, but consumption accelerated more, so that the savings rate dropped and the trade deficit increased.

2) Empirical: The per-capita cost of health care has grown faster than per-capita GDP in the past (see, for example, the CBOs long-term budget outlook).  Assuming that relationship continues in the future, that implies an acceleration of per-capita GDP growth will actually increase the fiscal gap.

3) Legal: Social Security benefits are keyed to average real wages–so if growth accelerates, and wages rise in response,  so do Social Security benefits. That means it is very difficult to grow our way out of Social Security issues.

Let’s take these in reverse order.

3) Definitely true. As I’ve written in the past, the Social Security formula probably needs to be adjusted so that benefits don’t quite track real wages.

2) The long-term excess growth of healthcare costs is very interesting. It’s been variously blamed on institutions that make it hard to control costs;  the excess cost of new medical technologies;  and environmental and social factors (such as increased weight). I personally believe that it represents economic consequences of the innovation shortfall in life sciences that I’ve discussed before–commercially important innovations in areas such as biotech have been few and far between. I would expect that if the pace of successful innovation in the life sciences picks up, that would bring down the rate of growth of health care costs, but there’s no way to test that until it happens.

1) This is the hard one, as far as I am concerned. Take a look at this chart:

I’ve chart ten-year nonfarm business productivity growth against the net national savings rate (productivity growth on the left scale in blue, net national savings rate on the right hand scale in brown). What we see is that the two lines roughly parallel each other, as we would expect, up until the late 1990s. Net savings starts to rise as the productivity acceleration begins. Then, poof,  productivity growth and net savings go in opposite directions. Despite the unanticipated acceleration of productivity–which boosts output per worker–the savings rate collapses.

Taking this chart at face value is bad news for the “grow our way out of debt” thesis. For one, we had a big acceleration of productivity growth, and the debt problem got worse. To put it another way, we produced more output than expected, and savings went down. Second, it’s hard to imagine that we can get productivity growth up much faster than 3% a year.

But let’s think a bit more about what might explain this surprising divergence. Really, there are four possible explanations:

A) Americans might just be profligate, and quickly ramp up their spending when their income increases (this includes healthcare spending, so it takes in #2 above).

B)The derangement of the financial system and the housing market led people to think that they were richer than they really were (the syndrome of the lottery winner who goes broke).

C) Net savings is mismeasured, and we are really saving more than it seems (spending on education, for example, is counted as consumption).

D) Productivity growth is mismeasured, and the productivity acceleration was really less than it seemed.

If American profligacy is the primary problem, then we are probably out of luck…hard to change. If financial excess is the main problem, then financial reform could be a key factor for helping us grow our way out of debt. If underestimates of savings is the main problem, then we have no problem (because the U.S. is really better off than it seems). If overestimate of productivity growth  is the problem, then what happened was that we thought we were richer than we really were, and this led to overspending. (I suspect, for example, that the models for subprime defaults implicitly depended on real wage growth, which is linked to productivity growth).

I personally lean towards D,  as I’ve written before. But like I said, I’m not as sure as I once was that we can grow our way out of debt…and that’s just sad.

Are Trade Deficits Bad for Long-Term Growth?

Like most economists, I’ve been trained to believe that running a trade deficit is not an indication of economic sin, and running a trade surplus is not an indication of economic virtue. Indeed, I’ve written at various times about the virtue of running a trade deficit, if the foreign borrowing was used to fund investment.

Well, I’ve been changing my views about trade deficits, and the latest European financial crisis just brings me further along those lines. It’s not Greece that troubles me, it’s Spain and Germany.  A few years ago, Spain was the darling of investors and economists. Spain was running a trade deficit, yes, but it was vibrant and growing. From 1995 to 2005, real per capita GDP in Spain grew at an excellent 2.8% annual rate.

By contrast, real per capita GDP growth in Germany poked around at an annual 1.2% rate from 1995 to 2005. Wrote one 2006 paper from the Centre for European Policy Studies:

Germany and Italy have been the laggards in terms of growth since the start of EMU in 1999.

However,  Germany did have one advantage —it ran trade surpluses where Spain ran trade deficits. In fact, the gap between Germany’s surpluses and Spain’s deficits widened over time, even though Spain had stronger growth.

If it turns out that Spain runs into a financial crisis because of all its external debt–accumulated during the good years–then we will have to go back and ask whether that growth was sustainable and real.

And the same thing goes for the U.S. The U.S. had strong per capita GDP growth and a big trade deficit, and then was hit by a massive financial crisis. Score one for the trade deficit as a more accurate signal.

More to come on this topic.

Economics Statistics in an Alternative Universe

Suppose I told you about a wonderful country where :

–Domestic production of goods is at an all-time high.
–Domestic production of services is an all-time high.
–10-year productivity growth is nearly at the highest level in 40 years.
–Workers are one-third more productive than a decade ago.
–Exports have expanded over the four years of the crisis, while imports have shrunk.
–Exports have grown much faster over the past decade than imports.

Seems like a pipe dream, doesn’t it? Wouldn’t you like to live in that country?

But wait! You can live in that country…..(see below)

[Read more...]

Giving Credit Where Credit is Due: Consumer Spending is *Not* 70% of the Economy

I’m sounding like a broken record, but economic journalists are doing the U.S. a grave disservice by repeatedly overstating the  importance of consumer spending to domestic economic production (which, after all, is what generates jobs).  By persisting in this fallacy,  journalists also understate the importance of investment, exports, and government spending.

Consider this:  In today’s NYT, Catherine Rampell writes:

Consumer spending makes up more than 70 percent of the economy, and it usually drives growth during economic recoveries

 Wrong.  That’s just so wrong. The number, 70 percent, comes from an apparently simple calculation of consumer spending as a share of gross domestic product (GDP). 

But it’s a wrong  calculation. Much of what consumers buy is imported–just step into your local store, friends, and take a look at where it was made. 

In fact, any economic reporter who writes the sentence “consumer spending is 70% of  the U.S. economy’ should be required to calculate how much of their household spending goes for foreign-made goods (hint–take a look at your computer,  your dishes, your phone, your clothes, your kids’ toys).   

Higher consumer spending need not be accompanied by higher domestic production, or by increased domestic jobs,  since the higher demand can be filled by imports.   In the first quarter of 2010,  imports of goods and services rose much faster than domestic production, in real terms.  

So if consumer spending is not 70% of the economy, how big is it really? I’ve estimated that ‘pocketbook spending’ really makes up 40-45% of economic activity. I’ve written about that here  and here.

There’s another point as well.  Much of consumer spending is ‘induced’  by other changes in the economy–for example,  a company gets a new order from overseas, and in response expands its factory and hires more workers. These newly-employed workers go out and spend which shows up as consumption. Should we say that this economic growth is being driven by PCE, or by exports?

Or the government steps up its spending on highways, which results in the hiring of more construction workers and more consumer spending. Should we say that consumer spending is driving the economy, or is it the increased government spending?  

In a  paper they presented at the 2009 Federal Forecasters Conference,  BLS economists Carl Chentrens and Arthur Andreassen (retired) analyzed the impact of imports and what they call ‘induced consumption’.   They point out that the way GDP is reported,  the personal consumption category is being given some of the credit for growth that should actually go to government, investment, and exports. 

The chart below shows what they found.

By their calculations, personal consumer expenditures should properly be given credit for 46% of economic activity,  rather than 70%. The government share goes up from 20% to 25%.

These are not abstract calculations. Everytime a journalist says that consumer spending is 70% of the economy, he or she perpetuates the falsehood that the U.S. cannot grow without increased consumer spending.  It’s far more accurate to say that the U.S. needs to grow as much as possible without increased consumer spending  if we are to prosper in the future.

Is Trade a Plus or Minus for U.S. Growth?

Is trade a plus or minus for U.S. growth in this recovery?  This is obviously an important question, given that domestic demand is likely to be stagnant for sometime.  We’d like to see net exports becoming less negative, which would indicate that trade is a source of growth for the U.S. economy.

However, this morning’s GDP release gave an ambiguous answer to this question.  If we look at  net exports of goods and services, measured in nominal dollars,  the trade gap has increased over the past year from $379 billion in the first quarter of 2009 to $504 billion in the first quarter of 2010 (measured at annual rates).


But if we look at the trade gap adjusting for price changes, it’s actually shrunk over the past year, from $387 billion to $367 billion.

In other words,  the real gap is shrinking while the nominal gap is increasing.

The same pattern holds over the past ten years as well. In nominal dollars, the trade gap has increased since 2000, making it a drag on the economy.  Meanwhile in real dollars the trade gap has shrunk.

The apparent shrinkage of  the real trade gap  since 2000 is either one of the key positive facts about the U.S. economy,  or an exceedingly misleading statistical illusion.

Coming Posts

These are the posts that I’m thinking about. Any preferences? Or suggest your own:

1)  Growth and government/private debt:  The arithmetic of how long-term growth affects our ability to pay off our private and public debt

2) Multinationals and exports:  Are multinationals more or less likely to export from the U.S.?

3)  Goldman Sachs and side bets:  If you are making a side bet on the economy, do you care who you are betting against?

4)  Credit ratings and growth:  Did the credit ratings issued by S&P and Moody’s implicitly depend on long-term growth expectations?

5) What can journalists learn from the financial crisis?



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