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The Silver Lining Buried in the "Bad" GDP Number

The markets were hit with an unexpected twist last week. On Wednesday the Bureau of Economic Analysis shocked markets by announcing that U.S. Gross Domestic Product had declined by 0.1% in the fourth quarter.

That marked the first time economic output had fallen since the end of the Great Recession.

But the report wasn't all doom and gloom by any stretch of the imagination. 

In fact, when you look at the report more closely there was a silver lining buried in the numbers: the decline was entirely caused by weakness in government spending and inventories.

Those are areas where bad is really good.

A Drop in Government Spending

The good news for those who value free markets and limited government is that government spending peaked three years ago, in the fourth quarter of 2009. Since then government outlays have declined 6.1%.

Of course, that's not nearly as exciting news as it sounds, because the BEA nets out "transfer payments" such as social security, unemployment insurance disability payments and food stamps, on the grounds that they are just payments from one entity to another, and affect GDP only when the money is finally spent.  Needless to say, those payments have risen sharply in the last few years.

Still, a 6.1% decline in government spending on goods and services is worth celebrating as progress. About two thirds of the decline was in state and local governments with the remaining third in defense spending. Federal nondefense spending has risen slightly. 

In the fourth quarter itself, a $10 billion decline in defense spending, was converted by the magic of annualization in the figures, to a 22% annual rate of decline, and a 1.3% decline in GDP growth.

However, here the GDP accounts get funny; that decline in government spending (good) is reflected as a decline in GDP (presumably bad).

If IBM hires another researcher for $100,000, who doesn't produce anything useful, there's no effect on GDP, because nothing is produced.

But if the Federal government hires one, GDP increases, even if he's useless. As you can see, GDP accounting was designed by a Keynesian big government-lover, Simon Kuznets (1901-1985).

Inventory accounting is equally fishy. In the fourth quarter, inventories increased by $20 billion at an annual rate ($5 billion in real money). However, in the third quarter inventories had increased by an annualized $60 billion (really $15 billion.) Thus since the rate of inventory pile-up had declined, inventory pile-up contributed minus 1.3% to GDP growth in the fourth quarter.

In the real world, we don't want too much inventory; it's a pure cost, and if it piles up too much, we know we will have to reduce it in the next quarter, reducing both GDP and actual hours worked in the factories producing goods. 

Hence it makes more sense to take government and inventory out of the equation altogether. If we do that, the growth rate of private output, excluding inventory effects was 2.84% in the fourth quarter, compared to 2.25% in the previous quarter.

GDP is Picking Up Where it Counts

In other words, the recovery was far from stalling in the fourth quarter, with GDP actually accelerating.

There. Doesn't that make you feel more cheerful!

But it actually reflects better what was going on. In the summer, the recovery still felt tentative, but after Ben Bernanke's "stimulus" announced in September, it seemed to accelerate, in spite of problems with Sandy and the Fiscal Cliff.

To normal people, the fourth quarter felt better than the third quarter. That's what pushed the stock market up towards record levels and, let's face it,that may very well have been what re-elected President Obama – the Republican message of doom and gloom didn't feel credible by November.

There seems no reason why the fourth quarter's momentum in the "real" economy won't continue.

Weekly employment figures have continued to improve and the Chicago PMI climbed in January to its highest level in nine months. The markets have opened the year strong, and corporate earnings have come in above expectations as well. 

As for the "special" factors, inventory growth is likely to continue in the first quarter, so that factor won't zap the reported GDP number.

As for the government, its main danger is the "sequester" due to kick in March 1, which removes $1 trillion in government spending over the next 10 years.

If that happened, it would indeed zap reported GDP, though more in the second quarter than the first, since only a month of sequester would be in the first quarter's figures.

However, wouldn't that in reality be a good thing??

It would reduce the budget deficit and free up more resources for the private sector.  In the long run it would almost certainly be good for growth.

Now that we know how rigged the "official" GDP figures are, why do we care that it would zap reported GDP?

Sometimes, the government hides the bad stuff from the people. On this occasion, because of the way it calculates GDP, the government hid the good stuff.

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  1. Tom J | February 6, 2013

    Okay, I read this and I can kind of understand how you can make an attempt at twisting this horrific, recession-bound GDP number into a "positive" for the sake of optimism.

    However, as a realist and a fundamental investor, I have a question for you regarding your logic.

    Why would this "reduction" of GDP based on this government accounting and inventory reduction's negative effect on GDP be viewed in this favorable light, when I've never heard any mention of these shenanigans boosting GDP falsely when government defense spending was up 44% in the 3rd quarter, spiking GDP to 2%, rather than allowing it to fall to a negative GDP (had that increase in spending not occur.)

    In other words. What's good for the Goose should be good for the Gander. If you want to misguide your readers into thinking there is any "silver lining" in this horrific number, you should also point out that the 3rd Q GDP number was severely SPIKED in the last quarter and without that big increase in defense spending (just before the election, I should add), that GDP would have been -1.6 to – 2.1%.

    I understand the human tendency to try to explain away bad numbers during a bull market run, but when actual data and numbers come out showing a recessionary trend, you can't just change the metrics to support your bullish view.

    This market is within days, weeks or month of forming an all time top and will soon head to the 2009 lows over the next 3-4 years. The numbers don't lie, but people do when trying to explain them if it doesn't suit their views.

    Also, the reason companies have been meeting their earnings estimates or slightly beating them on a few occasions is that due to the horrible 3Q, companies slashed their estimates significantly. So the earnings and revenue trends are declining in both profitability, revenue and most importantly the profit margins are shrinking.

    With higher taxes, less spending and an aging population, the future trajectory of this economy and eventually the market has to be lower. The trillions in stimulus has negatively affected the velocity of money, which means net interest margin for banks is shrinking and profitability and liquidity is drying up slowly. It might take a little time for the market to top out, but my research shows that a massive decline and new long term bear market trend in imminent.

    Don't be fooled by Unicorns and Rainbows….there is no pot of gold at the end. Just Fool's Gold.

  2. Tony | February 6, 2013

    Tom J, it appears that you need a little re-education in real world economics. Do you count the weekly allowance money spent by your kids as your economic output? That money was counted once before when you sold your widget to earn it.

    The money govt spends is already counted when products made in the real economy were produced to earn the profits that got taxed to fund the govt. GDP as it is calculated is a sleight of hand used by mature economies like ours to create the illusion of growth, just like they use inflation to make you feel like you're earning more today than your parents did 50 years ago.

    We can sure play along, but you need to be able to see past the illusions.

    • Counting Ace | February 6, 2013

      Tony, it appears you need a little re-education in reading comprehension. Tom J was pointing out that we don't twist the "good" numbers down when the only reason they were good is due to inventory growth and increased gov't spending.

      How did you miss his main point?

      The fact is that markets are a function of feelings, i.e. confidence. The Fed (and apparently Mr Hutchison too) want us all to feel good and buy stocks. Feel free to do what they want…however, when that confidence wanes, LOOK OUT BELOW! Why would it not wane when government spending contracts sharply, and government spending must contract sooner or later. Guess what? That government spending represents jobs (and profits).

      We have been consuming future production for years now. The paradigm will shift. The result will be years (decades?) of no growth, maybe even negative growth. (GOD, I hate that term!) We will have nominal growth, but real growth in wages, economic output, etc will be negative.

      Why don't we call it positive contraction? Just sayin'…

  3. CESSIE | February 6, 2013


  4. Curtis Edmark | February 6, 2013

    The abundance of market optimism today is amazing when we take a realistic look at this economy. I remember similar optimism back in September/October 2007. Can anyone remember what happened after that?

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