Weekly Economic Commentary
Northern Trust
By Carl Tannenbaum, Asha Bangalore and James Pressler
October 26, 2012
- Fiscal policy is a matter of multiplication.
- US GDP growth accelerated in the third quarter, but remains less than ideal.
- Recent reports out of China reassured the markets, but underlying trends are not so promising.
I learned math the old-fashioned way. One of my early grade school
teachers began class every day by forcing us to fill out a
multiplication table. It started at 5 by 5 and ended the year at 15 by
15. At home, my father, an engineer by training, instructed me in the
fine points of the slide rule. When the first hand calculators came out,
they were hideously expensive and actively discouraged by educators who
viewed them as the devil’s handiwork.
Today’s statistical
routines are to the old calculators as “Mary Had a Little Lamb” is to
the “Flight of the Bumblebee.” The power in these new tools has become
essential to the analysis of complex systems. National budgets are prime
candidates for the application of these sophisticated models, but the
key to understanding fiscal dynamics can be found in simple
multiplication tables.
When a government spends money, it begins
a chain reaction of economic activity. The recipient of a Federal
contract, for example, uses the proceeds to hire workers, secure
facilities, and buy equipment. All of those activities create revenue
streams for the providers of labor and capital, which is in turn spent
on other goods and services. This cascade adds to GDP.
Offsetting
this, taxes raised to pay for the spending can hinder other forms of
economic activity, diminishing the impact of the stimulus. Economists
refer to the net of these two effects as a “multiplier” of the initial
expenditure. Measuring the ultimate impact of a given fiscal course
requires an estimation of these multiplier effects. This is easier said
than done.
The
wide ranges in the chart above reflect the uncertainty over the size of
fiscal multipliers. Estimating them with precision requires holding
everything else constant to isolate the influence of a particular
action. But nothing in economics stands still. Fiscal multipliers can
vary over time and across regions. They also depend heavily on the
posture of monetary policy.
Further,
there are stark philosophical differences in our profession surrounding
fiscal multipliers. Neoclassicists suggest that intelligent actors will
realize that a dollar spent by the government will be a dollar that
comes out of their pockets; the net benefit of fiscal stimulus would
therefore be small. “New Keynesians” observe that the action of
government spending and the reaction of consumers to expectations of
higher taxes can be incomplete or separated by lags. Under this view,
multipliers can be higher, especially in the short-term.
These
philosophical differences are often mirrored in the postures of
political parties, which lead them to reach very different conclusions
on the wisdom of proposed policies. The degree to which fiscal policies
improve GDP growth is central to estimating the ultimate impact on
government deficits. Programs that broaden the tax base can defray the
cost of stimulative fiscal policies.
In the United States,
multipliers are playing a central role in analyzing the looming “fiscal
cliff.” The spending cuts and tax increases due to take effect in
January amount to an estimated $500 billion, or 3 percent of GDP. The
impact of the cliff on growth depends on how quickly economic actors
will react to the change and adjust their expectations. We tend to think
that there would be a detrimental effect in the short-term if the cliff
is not smoothed, which could send the US economy back into a recession
in the first half of next year.
In Europe, the drive toward
austerity -- whether done voluntarily or under agreement with
international authorities -- has the potential to create a
steeper-than-necessary retreat in GDP if not designed carefully.
Across-the-board cuts may have an appealing simplicity, but using what
know about fiscal multipliers might allow for a more nuanced approach.
And
as our colleague Jim Pressler discusses later on, China will be
considering fiscal measures to sustain its rate of economic growth.
Selecting well from a broad menu of options will be a first order of
business for the new regime.
Skeptics will certainly decry the reliance that policy has on such imprecise specifications. In his Nobel Prize address of 1974,
Friedrich August von Hayek worried about basing decisions on “The
Pretence of Knowledge.” Yet we ignore the influence of multipliers at
our own peril. Or so my grade school teacher told me.
Consumer Spending, Housing, and Defense Outlays Lift Q3 GDP
The
US economy grew at an annual rate of 2.0% in the third quarter,
following a 1.3% increase in the second quarter. The acceleration in
growth is a big plus but will likely still be inadequate to bring the
unemployment rate down to a point that would meet the Fed’s goal of
“substantial” improvement in the labor market.
From a historical
perspective, real GDP for the US has advanced only 7.2% after a long
stretch of 13 quarters of economic growth. This performance pales in
comparison with its predecessors.
Stepping
past the headlines, there are several noteworthy details in today’s
report. Consumer spending (+2.0% vs. +1.5% in 2012:Q2), residential
investment expenditures (+14.4% vs. +8.5% in 2012:Q2), and federal
government outlays (+9.6% after four quarterly declines) were the main
drivers of growth. Of these three components, forward momentum is nearly
certain for consumer spending and housing in the final three months of
2012, based on the nature of incoming data.
However, federal
government expenditures are projected to be a drag after the third
quarter advance, which was mainly from a jump in defense spending.
Business fixed investment failed to advance in third quarter, with
outlays on structures declining and capital spending holding steady. The
trade deficit widened in third quarter, reflecting a drop in exports,
the first decline since the early months of 2009, and a nearly neutral
reading for imports. The shaky global economic situation implies that
exports are unlikely to make a significant contribution to US GDP growth
in the quarters ahead.
Of the other components, the scaling
back of inventories was entirely from a sharp drop in farm inventories
(-$20.2 billion vs. -$7.9 billion in 2012:Q2) attributed to the drought
in the Midwest, while non-farm inventories added to GDP growth ($62.8
billion vs. $53.2 billion in 2012:Q2). The 2.8% increase of the GDP
price index after a 1.6% gain in the second quarter is largely an energy
price story. Excluding food and energy, the GDP price measure moved up
1.5%, virtually identical to the prior quarter’s reading.
Real
disposable income grew only 0.8% in the third quarter, which is well
short of the pace of consumer spending (+2.0%). This discrepancy begs
questions about the sustainability of consumption in an environment
where households are expected to save more, not less.
Looking
ahead, growth in the fourth quarter should nearly match the pace seen
in the last three months. However, the uncertainty associated with the
fiscal cliff and a strong likelihood that the 2.0 percent payroll tax
holiday will expire in 2012 suggest a tepid pace of activity in the
first quarter of 2013.
China: The Headlines Versus the Indicators
Over
the past week, markets have taken comfort in Beijing’s latest economic
releases – at least the ones that moved in the right direction.
September exports rose a surprising 9.2% over the past year, industrial
production on a real gross value added basis maintained a steady growth
of 0.8% on the month, and inflation held at a very manageable 1.9% in
September. But probably most comforting of all was third quarter (Q3)
GDP, released on October 18 (even before the US could compile its own
preliminary figures). China’s year-over-year GDP only slowed to 7.4%
growth in Q3, defying the naysayers who insist the economy is in
trouble.
In fairness, we have sided with the naysayers in past
articles, and feel that there are underlying imbalances in the Chinese
economy which are still playing out. Beijing has proclaimed that the
economy reached its low point in Q3, and would gradually reclaim
momentum going forward. And rest assured, the government’s much-touted
goal of 7.5% growth for all of 2012 will indeed be met, given the
central party track record of announcing results in line with
expectations.
What concerns us, however, is that the tea leaves
we are sifting through suggest a different future. China’s economy is
all about investment, in particular the creation of capital, which has
expanded at approximately 25% over the past decade. Between 2003 and
2011, investment in fixed assets increased from 31.4% of GDP to 63.9% of
GDP – unquestionably an amazing rate of expansion, but now a
requirement for continued growth. And that investment is presently
expanding at a ten-year low with little promise of an immediate
recovery.
As
the above chart shows, growth in investment stokes up GDP and the slide
takes away from growth. The investment trends of the last three years
are consistent with the growth patterns. Now with investment in the
doldrums and showing no sign of a quick recovery, our expectations are,
not surprisingly, somewhat bearish.
Beijing’s once-a-decade
transition in political leadership is set to take place in early
November, and we do not expect any major policy moves until after that
event. The careful choreography that typically attends this event has
been disturbed to a degree by an increasing volume of reports
surrounding wealth accumulation by senior officials. (It is unclear
whether these accounts in the Western press are visible in China, but
modern media are increasingly circumventing censorship.) The impact of
these revelations on the management of the Chinese economy is unclear.
Once
the new president has settled into office, we will be looking for signs
of a recovery agenda to be announced and quickly implemented. Formally,
growth will be reported as on the mend starting in Q4, but we don’t
think a genuine recovery will show until 2013, or perhaps later.
Eventually, soft fundamentals may hamper the ability of optimistic
economic reporting to compensate.
(c) Northern Trust
