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Special Report: Economic Conditions May Actually be Worse Than the Headlines...

POV 03.09.2009

But…is that a recovery on the horizon?

The economy nose dived in the fourth quarter of 2008, as consumers spent less, exporting giants saw demand dwindle and companies were burdened by growing inventories. A close examination of the fourth quarter economic data presents an apparent paradox: Conditions are even grimmer than the headlines, but a recovery may be on the second half horizon.

Posting its worst performance since the first quarter of 1982 when President Reagan’s efforts to break the back of raging inflation sent the economy into a 6.4 percent tailspin of negative growth, the advance GDP estimates from the government show economic growth declined 3.8 percent in the fourth quarter of 2008. The fall in the annual growth rate for the fourth quarter follows a 0.5 percent drop in the third quarter, and it represents the first consecutive GDP declines since the fourth quarter of 1990 and the first quarter of 1991.

A careful analysis of that fourth quarter GDP report revealed an even weaker economy than the headlines stated. While such an examination rattles the confidence of the American public, economists who focus on long-term economic trends rather than the quarter-to-quarter numbers, see the steep slowdown of growth as a sign that GDP is at or near its nadir.

The Economy May Be Worse than its Numbers

Putting past patterns aside for the moment, an investigation of the advance estimate for the fourth quarter GDP exposes a very deep recession.  The decrease in real GDP in the fourth quarter primarily reflected negative contributions from exports, consumer spending, equipment and software, and residential real estate. Those negative factors were partly offset by positive contributions from federal government spending.

Federal Reserve Narrates the Pain

The Federal Open Market Committee provided an overview of the bleak state of the economy detailed in the GDP fourth quarter report when it noted, the outlook for economic activity has weakened, labor market conditions have deteriorated, and consumer spending, business investment and industrial production have declined. Financial markets remain quite strained and credit conditions tight.

Payrolls Shrink

Although not directly part of the GDP equation, the job situation is an important factor for economic growth. The National Bureau of Economic Research “believes that domestic production and employment are the primary conceptual measures of economic activity.”

The NBER “views the payroll employment measure, which is based on a large survey of employers, as the most reliable comprehensive estimate of employment.” Non-farm payrolls reached a peak in December 2007 and have declined every month since then. The biggest declines in payrolls occurred in the fourth quarter with a loss of 423,000 in October, 584,000 in November and 524,000 in December.

Consumer Spending Drops Again

Consumer spending on goods dropped 3.5 percent in the fourth quarter, compared with a decrease of 3.8 percent in the third. Spending on durable goods such as cars and furniture, which tend to carry big ticket price tags, plunged 22.4 percent, following the decrease of 14.8 percent in the third quarter. Lower priced nondurable goods repeated the 7.1 percent decline registered in the third quarter. Expenditures on services provided a positive but very small boost to the GDP with an increase of 1.7 percent, in contrast to a decrease of 0.1 percent in the third quarter.

One possible positive development came with an increase in the personal savings rate. Rather than consume, the American public more than doubled the savings rate, 2.9% versus 1.2% in the third quarter of 2008.  While a long-term rise in the savings rate makes the nation less dependent on foreign sources to buy American debt, the short-term impact is to stymie the consumer spending needed to lift the economy from recession.

Exports Collapse

Exports, which had fueled the economy’s previous growth, plummeted 19.7 percent in the fourth quarter, in contrast to an increase of 3.0 percent in the third. Real imports of goods and services decreased 15.7 percent, compared with a decrease of 3.5 percent. The drop in imports represents a positive development long-term. It also reflects the decline in consumer and business spending, which keeps the economy in recessionary mode.

Home Values Deteriorate

Residential real estate investment escalated its declines in the fourth quarter, falling 23.6 percent compared with the 16.0 percent drop in the third quarter. Fixed-residential investment for the entire year 2008 tumbled 20.8 percent, following the 17.9 percent decline in 2007 and the 7.1 percent drop in 2006. The fourth quarter 2005 was the last time fixed-real estate investment sat in the positive column.

Higher Business Inventories May Distort the GDP

In the classic GDP equation, business inventories are counted as a positive factor, but this recession is far from “classic” in size and shape. Higher inventories can be an indication that businesses are building more products in response to robust demand. In this economy, higher business inventories are an indication that goods are not moving. As such, they are a current burden for businesses, which must store them somewhere.

The rise in private inventories also distorts the reported health of the current economy, in which higher inventories represent the clogs in the economy rather than the fuel. The real change in private inventories added 1.32 percentage points to the fourth-quarter change in real GDP after adding 0.84 percentage point to the third-quarter change. Private businesses increased inventories $6.2 billion in the fourth quarter, following a decrease of $29.6 billion in the third quarter and a decrease of $50.6 billion in the second. Without the mathematical addition of inventories, the fourth quarter growth would have plummeted to a 5.0 percent decrease in the nation’s annual growth rate. Economists had forecasted about a 5.0 percent GDP decline for the final quarter of 2008.

Federal Spending Provides Growth to the Economy

Federal government spending and investment was a boon to the economy. Real federal government consumption expenditures and gross investment increased 5.8 percent in the fourth quarter, compared with an increase of 13.8 percent in the third. National defense increased 2.1 percent, compared with an increase of 18.0 percent. Non-defense spending increased 14.5 percent, compared with an increase of 5.1 percent.

What’s the Real GDP?

The increase in federal spending added 0.44 percentage point to the 3.8 percent GDP. Without that boost, the GDP would have posted a negative growth rate of 4.2 percent. If the rise in business inventories, which is a burden for businesses, also is striped out, GDP posts a decline of over 5.5 percent. That reflection of a steeper GDP decline may push the economic business cycle closer to its trough, illustrating how bad news from one perspective can provide glimmers of good news from another point of view.

How Does This Recession Measure Up?

The National Bureau of Economic Research (NBER) identified the most recent peak in economic activity as December 2007.  “The peak marks the end of the expansion that began in November 2001 and the beginning of [the] recession,” according to the NBER, which is the official record-keeper of business cycles.  The table below indicates the average duration of contractions and expansions for selected periods. The current economic contraction, as of February 2009, is in its fourteenth month.  This is longer than the Post World War II average of 10 months.  Could this be an indication that the end of the contraction is near?  One caveat in placing too much emphasis on past patterns is the presence of the worldwide credit crisis which could create additional barriers to recovery.  However, the pending passage of the stimulus package could offset the impact of the credit crisis.

The table below shows the individual business cycle dates and the duration of contractions and expansions of the 19 U.S. business cycles to hit the economy since 1910.  Notice the current recession is now longer than all but two Post Depression contractions and will most likely end up being one of the longest recessions in the modern era.