US Economic Growth Deconstructed

I had planned a review of the UK economy and stock market, but I was overtaken by the news that US economy ‘grew’ by 0.9 percent in the third quarter. A fairly typical explanation for the growth can be found in a Telegraph article as follows:

The primary reason US economic output has rebounded so strongly is the slug of growth contributed by state programmes, including "cash-for-clunkers" and similar stimulus schemes.

As such, I thought it might be worthwhile to return to the well worn subject of GDP growth. What we are seeing is the mirage and magic of statistics. I will explain this as clearly and simply as I am able through an analogy, and show why this is all 'magic' growth.

Imagine that I am a farmer, and that my output of food is not quite enough to feed my family. As a result, I have frequently turned to my neighbour, who has each year lent me enough food to make up for the shortfall. As each year goes by, I am borrowing more and more from my neighbour, and I am starting to owe him a great amount of food overall. Finally, one year, a river floods and damages many of my crops and drowns some of my animals. My output is reduced to an even lower level, and I am going to struggle to meet my family’s needs.

Once again, I turn to my neighbour, and ask to borrow even more food to take my family through the next year. He agrees and loans even more food than on previous occasions, and I add the borrowed food to the store of my own farm’s output in the barn. At the same time, I also do something to address the problem of the shortage. I decide to change the systems of measuring the output of my farm. For example, instead of counting my units of corn in whole kilograms, I change the units so that one unit becomes three quarters of a kilogram. With my new system, I now measure my output from the current year as all of the food in the barn, and find that I have increased my output of units of food overall for the year.

I look at the large pile of food in the barn, and behold that, despite the problems of my lack of output of food; I have actually achieved an increase in output. There are more units of food in the barn than in comparison with the previous year.

As my generous neighbour is lending me so much food, he comes around to visit my barn, and see how I am running things. As reassurance, I count out my units of output, and show him how much my output has increased. I am very pleased with myself, and I smile with pleasure as I count the units. Then I note that my neighbour is frowning and I am puzzled to find that my neighbour does not share my pleasure.

He asks whether I am going to repay him in the old units of kilograms or the new units of three quarter kilograms. Now I start to frown, and suggest that he does not understand the situation. For every unit he has lent me I will, of course, return one unit as a repayment. I am a little grumpy. Can he not see that my output has grown? Can he not see that, if I can keep up this rate of growth, I will achieve a level of output that will allow me to easily pay him his food back? I wonder at his lack of confidence in me when I have demonstrably improved my output.

I am left wondering that my neighbour simply does not understand output. My neighbour is left wondering how much longer he will continue to lend me food.

Note:

I finally got around to reading this week's copy of the Economist magazine. On reading the magazine, I was struck how many of my views which were previously considered radical (if not barking mad), are now mainstream. There was even one section where they contrasted financial wealth with 'real' wealth, which is almost a perfect mirror of my first article, 'A Funny View of Wealth' (which predicted the economic crisis in the UK). The Economist also addressed the relationship between the US and China, and much of their analysis mirrors the analysis I offered a long time ago (though with different outcomes), and the same applies to the prospects for the $US (again with different outcomes).

I should also mention that I predicted a $US collapse for April of this year and got it wrong. However, the possibility of a $US collapse is now being discussed in the mainstream. What I am really saying is that, in about 6 months time (a wild guess), expect to be reading that the growth in the US economy was not genuine growth at all.

The US - The Real Economy and the False Economy

Do you remember the stress tests for the banking system in the US? They were the subject of negotiations by the banks with regards to the outcomes, making them remarkably relaxed stress tests. There was an assumption in the stress tests for an unemployment rate of 8.9% (a curiously precise figure), and 10.3% in 2010. The unemployment rate had already reached 9.8% in September, with expectations of further rises. In other words, the worse case scenario was not indeed the worse case scenario.

Despite this, it appears that business as usual is continuing in the world of banking. When we consider that the stress tests were heavily negotiated and the worse case scenarios are being broken, this is a puzzle.

The real economy is, as you would expect, having an impact upon the banks. Bank of America, the second largest lender against credit cards is reporting massive losses on their lending, and bank failures continue at a shocking pace (106 so far this year). And then there is the exploding numbers of mortgage foreclosures, including prime loans, such that foreclosure counsellors are being deluged with requests for assistance. Commercial real estate loans in default have now reached about 6% of all loans. Small and medium size businesses are seeing continuing high levels of arrears on loans, with those that are moderately delinquent increasing (but a tiny fall in the numbers that are severely delinquent). PIMCO are warning of ongoing high levels of defaults on corporate bonds, but S&P are offering a more sunny outlook than their previous forecasts, but still at a high level.

Some might point to the positive increases in industrial output, and suggest that there is a genuine improvement on the horizon. However, it is not perhaps as bright news as it first appears:

September's increased output was due largely to a 3.5% increase in durable output, including a 7.4% increase in the production of automotive products. Nondurable output increased 0.5% in September. Within major industry groups, manufacturing output rose 0.9%, mining output rose 0.7%%, while utilities fell 0.7%

The first point of note is the increase in automotive production, which is likely the final residual effects of the 'cash for clunkers' stimulus working through the industry. This from the Wall Street Journal:

Retail sales fell 1.5% in September with the end of the "cash for clunkers" program, but consumer spending rose in many categories, lifting hopes that the economic recovery is gaining momentum at the start of the holiday shopping season.

Excluding sales of autos and parts, total retail and food sales increased 0.5%. It was a welcome sign of consumer activity after the deepest downturn in a generation. August sales were revised downward 0.5 percentage point to a 2.2% increase. The government's monthly retail-sales tally isn't adjusted for inflation.

The same article goes on to say the following:

Indeed, sales at motor-vehicle and parts dealers plunged 10.4% in September, following the expiration of the "cash for clunkers" trade-in program. But consumers spent more on smaller and less pricey items. Sales at clothing and accessories stores grew 0.5%. Restaurants, bars and grocery stores gained 0.2% and furniture sales rose 1.4%, in part because home sales have stabilized with help from the government's $8,000 tax credit for first-time home buyers -- a credit that is due to expire Nov. 30.

While they are heading back to stores, many consumers are doing so with trepidation. After a three-month shopping hiatus, Lauren Madrid, a 26-year-old who works in communications at a San Antonio university, returned to her regular haunts -- the mall and Target Corp. -- in August. But Ms. Madrid said she was making fewer shopping trips and going with a mind toward buying specific items. "I didn't buy a stack of T-shirts I'd never wear," she said. "Instead, I bought a cute summer dress that I knew I'd wear and appreciate properly."

The essential problem is that unemployment increases will continue to eat into consumer spending, and for those in employment, there is a shift from credit based expenditure to saving money. With the US economy having been distorted so far into credit based consumption, there can only be expansion in credit defaults across the whole US economy.

What this amounts to is the simple reality that the underlying point of the banking system, loans to individuals and commercial entities, is not a sector in a good state of health. In fact, in aggregate it is looking very ugly. A recent article in Forbes had this to say:

Do banks know something the rest of us don't?

Despite pressure from politicians to take federal bailout money and lend it to companies and consumers to kick the economy out of its doldrums, banks continue to horde cash in dizzying amounts.

Weekly data released Thursday by the Federal Reserve show excess reserves held at the Fed--the equivalent of banks stuffing bills into shoe boxes for storage--topped $1 trillion this week, a record, after climbing steadily since the markets froze up last October.

This is really no surprise. At this moment in time, would you want to be lending into the US economy? For all of the talk about recovery, the banks know that the economic crisis has a long way yet to run. They do know something that 'the rest of don't', and that there is no realistic prospect of a real recovery in the US economy. Despite this, the media, government organisations, and politicians continue to talk up the economy. For example, the Beige Book, the Federal Reserve's review of the economy, has offered a relatively upbeat review, albeit with caveats:

The Federal Reserve's Beige Book released on Oct. 21 reported "stabilization or modest improvements in many sectors," though often from depressed levels. Residential real estate and manufacturing were the more positive sectors of the economy that were helping the recovery. Reports on consumer spending and nonfinancial services were mixed, while commercial real estate was one of the weakest sectors. Transportation activity generally declined. Tourist activity was varied.

The Beige Book indicated that there were more reports of gains in activity than declines, although nearly every reference to improvement was qualified. That's consistent with what we've seen from the data and heard from Fedspeak. Regarding wages and prices, Districts generally reported little or no increases, but there were occasional references to downward pressures.

What we are seeing here is a positive spin upon the most modest of indicators, and disregard for the underlying state of the US economy. Of course, many will point to the stock market as a positive sign, and this article from Bloomberg appears to contradict everything I have said:

Oct. 22 (Bloomberg) -- U.S. stocks advanced for the first time in three days as better-than-estimated earnings at companies from Travelers Cos. to McDonald’s Corp. boosted speculation that the worst recession since the 1930s is over.

Travelers jumped 7.7 percent and McDonald’s climbed 2 percent to help lead the Dow Jones Industrial Average higher, while New York Times Co. and PNC Financial Services Group Inc. also rallied on better-than-estimated results. American Express Co. climbed 3.8 percent to a one-year high after Moody’s Investors Service said credit-card defaults declined.

Perhaps the most interesting part of the article is the report that credit card defaults declined, which appears to contradict the experience of Bank of America. With unemployment increasing, it is not clear what might actually be driving a decline in credit card defaults, so I view this with some suspicion. One possible explanation is that the decline is due to consumers pulling in their horns, which would mean that the relative numbers of defaults might be increasing whilst the absolute numbers are falling.

Another interesting point is that McDonald's will inevitably do well in a recession, as cash constrained consumers are more likely to trade down in their choice of food. In a recession there will always be winners as well as losers. However, this does not explain some of the positive improvements in earnings data over the estimates, and this needs some consideration. A long while back, a friend who had worked at the highest levels of a multinational FMCG company suggested that, if he were heading a company, he would manipulate the financial data to get the bad news of the economic fall-back over in one go, which would allow for earnings in the following year to appear to be positive. It does occur to me that this is a possibility, but I am unsure. However, the same Bloomberg report says the following:

Profits have topped estimates at 79 percent of the companies in the S&P 500 that have released results, according to Bloomberg data. That would mark the highest proportion in data going back to 1993. Earnings fell for a ninth straight quarter in the July-September period, according to estimates compiled by Bloomberg, and are projected to return to growth in the final three months of the year.

The point here is that there does seem to be some basic disconnects between the real economy, earnings and the stock market. With the economy in very bad shape, excepting the natural winners like McDonald's, the news should be relentlessly negative... but this is positive news due to exceeding estimates, not increases in earnings. This appears to fit with my friends assertion, but it is difficult to see how such a contention might be supported with hard facts.

What I am trying to do is paint a picture of the real economy and the false economy. On the one hand, we have banks that are now under stress greater than that which was the worst case scenario, we have huge numbers of bank failures, money being kept on the sidelines due to the terrible state of credit markets, rising unemployment, increasing numbers of foreclosures, and on the other we have a booming stock market.

Something is wrong in this picture. It looks very much like many people will be losing a considerable amount of money on the US stock market in the near future.

Note: I will probably conduct a similar review of the UK economy for the next post, as the picture looks to be very similar. This from Financial Advice:

Despite the fact that UK GDP (Gross Domestic Product) was a disappointing -0.4% during the last quarter, against an expectation of 0.2% growth, the UK stock market ended on a high today adding 60 points to 5268. But why is the UK stock market racing ahead when the UK economy appears to be going into reverse?

An interesting point - to be continued....

I would also like to return to one of my pet subjects at some stage, which is the $US versus the RMB. The plot continues to thicken, but I would like to review the UK economy first ('events' allowing).

The Underlying Size of the US Economy

I would like to start this post with a hypothetical item of government spending, such as building an extension to a government building, and track some of the money that might be spent. The example uses the US, but the principles apply to any country. The reason for this example will become apparent later, and may be a little disturbing.

As soon as the money for the extension is approved, there will be a surge in economic activity. Project management groups will be formed, an architect firm hired, contractors will be tendering, and medical suppliers will be preparing for large orders. In this case, I will just track some of the spending as it passes to the firm of architects. Depending on the nature of the contract, money will eventually start being passed to the architect firm, and that money will arrive in the firm's bank account. Once in the account, the money will be used for a range of purposes, such as the cost of operations, cost of office space, and legal and other services. All of these economic activities will be partially supported by the government expenditure. For the next movement of the money, I will concentrate on the salary paid to the workers in the firm, and in particular one of the architects.

Let us imagine that one of the the less senior architects is a man who works on the project for 6 months, and all of his pay is therefore coming from the hospital extension project. We might imagine that the architect is an average type of individual in a professional occupation, and that he is married with a young family and earns $100,000 per year. We can therefore imagine his spending, with his income covering a mortgage, payment on a car loan, and fairly large expenditure on consumer items, and consumption of services like trips to restaurants. All of these will be paid with government money. If we just consider the example of expenditure on consumer items, we might think of a toy purchase for one of the architects. He will visit a store, and we can imagine that he spends $50 on a toy for his daughter's birthday.

The $50 originates in government money for the extension, and it now lands in the till of the retailer selling the toys. The retailer then banks the money, and the money will then be utilised for a range of purposes. If we imagine that the toy has a $25 mark-up, then $25 of the money will be used to reorder the toy. The toy is made by a company based in the US, but with manufacturing overseas in China. As such, some of the money will be used to pay for the manufacturing in China, and we will just imagine that $10 covers the cost of manufacturing a replacement. That means that £15 will go to the US company, and will pay for the operations of the company and profit, with $10 'leaking out' of the US economy into the Chinese economy.

As with the architect firm, the $15 that goes arrives in the US toy company will contribute to staff salaries, pay for the costs of the office, pay for business expenses and so forth. If we imagine one of the office staff, part of the pay of the person will come from the sale of the toy, and that money has come from the architect, and that money has come from the building project, and that money has come from government expenditure. The money for the building extension is rippling through the economy creating activity....Whilst the headline amount of the money diminishes at each level, the money is utilised many times over in multiple transactions.

What I am (I hope) showing, is the way in which the money spent by government generates economic activity way beyond the headline figure of the actual expenditure. Each of the activities that the money generates, as the money use multiplies throughout the economy, is recorded in the GDP figures. It is a very complex process to track, and economists have great difficulty in trying to work out how much government spending increases activity throughout the economy. For example, one review of academic literature (see note 1) identifies that different fiscal expenditure in different situations and countries can lead to multipliers of between zero and four.

It is actually quite easy to see why the multiplier effects of government spending are so difficult to calculate. For example, the spending of government money on infrastructure such as a steel bridge might have very different effects according to the individual economy. If the economy has a strong steel industry, then the multiplier will likely be much greater, as otherwise a large portion of the expenditure will rapidly 'leak out' of the economy to pay for the purchase of the steel from overseas suppliers.

What we are therefore left with is a big question mark over how much activity each $1 of government expenditure might generate within the US economy. In light of the estimates of between zero and four, I will proceed on the basis of a multiplier of three, as the study cited suggests higher multipliers occur in larger economies. Furthermore, a large proportion of the US economy is based upon services, which again suggests a high multiplier. This means that the US might even have a multiplier of four, but I will stay with three as a more conservative estimate.

Having come this far, you may be wondering what all of this means, and why I am discussing this in so much detail. The reason is relatively straightforward. I want to give a (very, very) rough estimate of the real size of the US economy - the size if there were no borrowing from overseas. When we see that way that government spending multiplies in the economy, it is apparent that borrowing money from overseas (translated into government spending) will inflate the GDP figures more than the headline borrowing figures suggest.

Starting with the basics, the US economy for 2009 will produce about $14 trillion of GDP, the federal deficit is expected to be something like 12% of GDP for 2009 overall, and according to the Congressional Budget Office the deficit for the fiscal year (just ended)was $1.4 trillion. In order to isolate the effects of overseas borrowing, it is necessary to find out how much debt has been sold overseas. I naively thought that I might find these figures relatively easily, but this has proved to be problematic (see note 2). For example, I searched the Treasury website, and only found an 'estimate' of the overseas holdings of US government debt. Likewise, the St. Louis Federal Reserve (an excellent resource normally) only offers the following chart, for overseas federal debt holdings:



According to the chart, overseas holdings of federal debt have increased in the first six months of 2009 by $305.3 billion, making an annualised rate of overseas accumulation of US debt of around $600 billion (assuming that overseas investors continued to buy US debt at the same rate). It might be noted that the fiscal year in the US does not match the calendar year, so there is some more fudge in the numbers. However, we might make an approximation on the total amount of GDP that is actually due to the multiplier effect, by multiplying the figure by 3, which gives us $1.8 trillion.

Now at this stage, it would be normal to then minus the $1.8 trillion from the overall size of the economy ($US 14 trillion). The first problem is that some of the borrowed money will be servicing interest payments on previous borrowing ($182 billion), such that it will not create activity. The second problem is that there is the question of how much private borrowing is sourced from overseas lenders, in particular consumer borrowing. I have tried to identify how much of this borrowing originates from overseas, but have been unable to come up with any firm figures. I will therefore just take a guess at the impacts of these two factors and raise the overall total to $2 billion, implying something like $127 billion of consumer credit provided by overseas lenders (remember the multiplier of 3), an extremely conservative guess.

With the current figure of $14 trillion, the correction to remove the activity resultant from overseas borrowing would mean that the real size of the economy is just $12 trillion. In other words, something like 17% of the US economy is funded by overseas borrowing. You may note that there is a large amount of 'fudge factor' in all of this, and comments and critiques are therefore welcomed (especially from those who are more numerate than myself - which is most people).

What does this mean?

As I have frequently pointed out, measurement of GDP is flawed in any economy that has a net accumulation of debt, for the very reason that the activity in the economy includes debt activity derived from overseas borrowing. The problem becomes particularly acute when measuring the ratio of debt to GDP, as the activity from debt is included in GDP. Even more curious is the idea of GDP growth, when a country is accumulating debt, but nevertheless economists are predicting 'growth' for 2010.

The real concern is the question of what would happen if the overseas lenders were to stop lending. In this event, the US economy would quickly revert to its real size, and that would be significantly smaller than today. The results of any halt in credit provision for the US are extremely worrying, as support for a large percentage of the economy would disappear. The result would be that unemployment would explode upwards, government could not operate at current levels, and the shock would likely precipitate a broader collapse in the economy.

The problem that is faced by the government is that for the years preceding the economic crisis, the economy was also being flattered by a combination of overseas borrowing for government expenditure, but in combination with consumer borrowing that originated in overseas credit. I am guessing that, if it were possible to strip out the effect of borrowing for the three years preceding the crisis, the same kind of results would emerge. In other words, I believe the problem is structural, meaning the current level of the economy can not be sustained. As such that there is no possibility in the near term of achieving anything near pre-crisis economic conditions unless creditors continue to fund the US at current levels.

This is improbable.

One reason is that the printing of money by the Federal Reserve and size of deficits are already alarming creditors such as China, with China giving implicit threats to stop lending. A devaluation of the $US might provide a solution to the problems by eventually return the US economy to its true size and wealth relative to other countries. However, ongoing $US devaluation will just accelerate the point at which overseas creditors refuse further lending. In other words, it will precipitate a crisis before the adjustment is completed. In the event of no further credit, the US would face the prospect of rapidly transitioning to the real size of the economy.

The only solution that I can see is for the US to first freeze the growth in borrowing, and to then implement a clear and binding plan to reduce borrowing aggressively over the short to medium term, with a clear plan for a return to surplus in five years time. This plan would give confidence to overseas creditors, and allow a more orderly transition to the real size of the economy. Such a plan would be very, very painful, as the economy would still shrink dramatically. However, it would be less painful than the sudden collapse that might take place if overseas lenders were to stop lending.

The problem is that, at present, there are no such plans. Instead, deficits stretch to the horizon, overseas creditors express their doubts, and the $US is steadily sinking. In other words, my very rough estimates may be put to the test.

Note 1: Spilimbergo, A., Symansky, S., Blanchard, O., Cottarelli, C., & Hall, W. (2009) 'Fiscal policy for the crisis', Centre for Economic Policy Research, Paper No. 7130, January 2009.

Note 2: I used the Treasury website here, and downloaded the document titled 'Ownership of Federal Securites'. Actually getting firm numbers on actual sales of new debt is very difficult, and news reports, for example, seem to focus on debt type and/or sales to particular countries. A fairly tpical example is the following report:

WASHINGTON (MarketWatch) -- Net foreign purchases of long-term securities increased to $28.6 billion in August from $15.3 billion in July, the Treasury Department said Friday. Net foreign purchases of long-term U.S. securities were $ 32.9 billion. Of this, private investors purchased $21.3 billion and foreign official institutions bought $11.6 billion. U.S. residents purchased a net $4.3 billion of long-term foreign securities. China's holdings of Treasurys slipped $3.4 billion to $797.1 billion in August. So far in 2009, China has increased its holdings of Treasurys by $57.5 billion

If you have a definitive source of sales to overseas, a link would be appreciated, or more accurate figures. I am surprised that this data is so hard to find....perhaps I am looking in the wrong places..