While last week GDP growth came in better than expected at 3.5%, which was a very welcome development, there was very little change in the coverall shape of GDP. This is a troubling development for the long term.
GDP is the sum of spending by the Consumer, Private Investment, Government Spending and Net Exports. The Graph below shows the percentage each of them has contributed to overall GDP since 1947.
The Consumer is still by far the dominate force in the economy, and it is becoming more so. In the 3Q, PCE, meaning the consumer, rose to 70.98% of GDP, up from 70.66% in the second quarter. That is an all-time record high. At the same time, private investment was virtually unchanged near an all-time low as a share of GDP at 11.04%, up from 11.03% in the 2Q.
Government spending as a share of GDP actually declined slightly to 20.68% from 20.70%. Net Exports deteriorated to -2.71% from -2.40%.
While the Consumer has always been the biggest share of GDP, it has not always been so dominant. Back in the 1960’s it averaged only 61.83% of the economy, or more than 9 full percentage points less as a share of the economy. The other three parts of GDP were all correspondingly higher, with the biggest differences being in Investment (4.45% percentage points) and net exports (3.33 percentage points). Government’s share of the economy was just 1.37% higher than it was in the 3Q.
The decline in Investment’s share of GDP is extremely disturbing, and the drop in net exports is a little disconcerting. We have made significant progress over the last year in reducing the net export drag, and the backsliding is not welcome news. The decline in investment is even more disturbing when you consider that it was residential investment that was responsible for the slight uptick as it increased at a 23.4% annual rate (from a record low level of 2.44% to a still extremely low 2.52%). Non-Residential fixed investment dropped to 9.55% of GDP from 9.84%).
Inventory investment is also included in the Investment numbers, which is why those two add to 12.07%, not to 11.04%, as inventory investment was negative in the 3Q, just not as negative as it was in the 2Q. Thus it actually contributed to GDP growth in the quarter. But housing is not exactly something in short supply in the U.S. right now. It is not the sort of investment that creates lots of cash flows for the repayment of debt, and it does not spur innovation; it is not the sort of investment that leads to further growth.
As shown in the table below, Investment has averaged 15.53% of GDP in the post-war period. Prior to the current downturn, the lowest share of the economy it ever reached was 12.77%, in the second quarter of 1949. In fact, out of 250 quarters, only 30 have seen private investment slip below 14.0%, and six of those have been during the current downturn.
While many bemoan the debt we are leaving to our children and grandchildren, we are really shortchanging them by our lack of investment in new productive capacity. While higher consumer spending makes the economy feel better in the short term, it cannot be the basis for long-term economic health.
Our parents and grandparents deferred consuming things and put resources into the plants and equipment that made things -- and that powered future growth. Money was spent on research and development of new ideas that became new industries. We are not doing that at anywhere near the rate that we used to, or that other countries are doing today. This is a recipe for long-term economic decline.
While Government spending is higher now as a share of total GDP than its long-term average, it is below what it averaged in the 1950’s and 1960’s, and is not way out of line. I would, however, note that the measure of government spending does not include transfer payments like Social Security, Medicare, or unemployment insurance. Those are considered part of Consumption.
On the other hand, Investment is the most volatile of the components of GDP, and even if it were to return to the previous record low of 12.77% of GDP, that would be a 15.7% increase, assuming everything else showed no growth at all. A return to the long-term average would be a 44.5% increase.
With commercial rents plunging and vacancy rates soaring, the value of commercial real estate is in free-fall. It thus seems unlikely that we will get any short-term recovery on investments in non-residential structures. Thus if we are going to get a rebound in non-residential fixed investment, it will most likely have to come from the equipment and software side. That would be a very powerful tonic for the likes of companies like
Joy Global (
JOYG),
Paccar (
PCAR) and
Illinois Tool Works (
ITW).
However, will companies have a reason to invest in more equipment and software if the consumers are not buying? The key to that puzzle will most likely have to reside in the net exports area. At some point, we are going to have to get back to the point where were are running trade surpluses, where we export more than we import. Investments that reduce our oil import bill would also greatly help that effort.
The only way that Consumption will decline as a share of GDP is if consumers grow their spending at a slower rate than their incomes grow, or if we have a real boom in the other three areas of the economy. With fiscal deficits at record levels as a share of the economy, it is probably not wise to look to the government to pick up substantial share of the economy -- although in a deep downturn it has to fill in by default (after all the four areas have to sum to 100%).
Businesses have to think that people will buy their products for them to spend on building new factories and the equipment that goes into them, or they have to think that they can sell the goods abroad. Of course, if they can invest in things that cut costs, it is possible to have worthwhile investments even if they do not expand production, but those are probably in the minority.
While I welcome the increase in GDP from whatever source right now, the fact that we continue to set new records for Consumption as a share of GDP is not healthy. Prior to the 4th Quarter of 2001, consumption had never exceeded 70% of GDP. Since then, it has been above that level in all but five quarters.
Prior to the 2Q of 1990, Consumption had only exceeded 2/3 of the economy in just 3 quarters, out of 174 (1.7%). Since then, it has been above that level in 70 out of 78 quarters, or 89.7% of the time.
Conversely, during the earlier period, private Investment had exceeded 15% of GDP in 141 quarters, or 81.0% of the time, but in the later period it has only been above 54 out of 74 quarters, or 69.2% of the time, and has been below that level for 8 straight quarters. This does not bode well for future long-term growth, just as a company that has capital spending that consistently falls short of depreciation is not going to be a great long-term growth story.
Of course, shrinking Consumption’s share of the economy is going to be very painful for the huge numbers of companies that depend on that 70%+ part of the U.S. economy. That would include almost all retailers, and vast parts of the service economy, as well as the makers of big-ticket discretionary items.
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