Volume 63, Number 2
First quarter real GDP came in at a disappointingly low 2.2% annual rate, and an even more disappointing 3.8% nominal rate. Despite strong boosts to car sales and residential construction from unusually warm weather, it was austerity – a hefty drop in direct government spending, higher taxes and smaller transfer payments that held back the economy. Over the past seven quarters, the US economy has been unable to achieve escape velocity and generate enough bank lending to move nominal GDP growth north of 4%. Japan languished in this situation for two decades, albeit with far less population growth, and is now using quantitative easing to avoid renewed deflation. The UK is entering a second dip recession as austerity there has overwhelmed private sector growth. Continental Europe is starting a grand experiment on how fast government deficits can contract.
Meanwhile, the US faces another massive fiscal cliff in the first quarter of 2013 with the expiration of the Bush tax cuts and payroll tax holiday at the same time that Obamacare and the sequester begin. It is hard to see how one can expect banks – all banks — to become more buoyant in their lending in the economic environment. Yes, the biggest (too big to fail) banks are gaining market share as they exit the residential market, but small banks are still suffering from a still lackluster housing market. A new economic leader is needed in the US, as the government has shifted from stimulus to austerity and seems unlikely to shift to anything but a bit less austerity.
A Sad Cast of Characters
In the first quarter, government spending on goods and services fell at a -3.0% annual rate – after falling at a -4.2% annual rate in the fourth quarter. Over the seven quarters in question, government spending has risen at a palty 0.4% annual rate – though the austerity is now shifting from the state and local to the federal level. Since the government represents 20% of GDP, this translates into a 1.0% drag on nominal GDP growth that could be almost 5% instead of the actual 3.9% average during this post-stimulus period. However, this is what the economy wants as it is excessive government deficits that are currently seen as the bane of longer term economic growth. Clearly, we cannot count on government stimulus to be the source of future growth. Indeed, we can only hope that the fiscal cliff of the first quarter of 2013 is toned down from the current -4% potential to something more like the -1.2% drag in the first quarter of 2011 or the -0.6% drag this quarter.
The consumer has also been strapped by the government’s austerity making stronger growth in that 70%- plus share of the economy unlikely. True, compensation rose a decent 4.3% over the past year and proprietors’ income rose 4.0% as well. Unfortunately, transfers from the government – which account for 17.6% of personal income – rose just 0.7% as medical transfers flattened and unemployment benefits fell. This represented most of the drag which limited personal income growth from all sources to just a 3.4% gain over the past year. Meanwhile, taxes grew by 7.5% over that period as higher fees and fewer tax loss carry forwards resulted in higher collections despite unchanged rates. Disposable income rose just 2.9% as a result. Inflation clawed away another 2.3% of consumers’ spending power — and after adjusting for population growth the real spending power of the average American household was unchanged. True, real consumer spending has risen 1.9% over the past year, well ahead of the 0.6% gain in real disposable income – but that was driven by an increase in high end consumption as the stock market recovered, not from an increase in lending. The next leg down in the savings rate likely will have to come from increased borrowing by less well-off households. It will be needed to support consumer spending if it is to grow faster than anemic austerity-sapped disposable income will in 2013. We doubt that rise in loan demand is coming. As noted above, both residential construction and motor vehicle sales – the two largest credit sensitive industries in the US – have experienced double digit growth for the past two quarters. They are more likely to see slower growth in the coming year, albeit at a higher level of activity.
Finally, the corporate sector – which has performed best of all over this economic expansion – is starting to fade. Nominal income growth of 3.8% in the past two quarters has been topped by 4.3% growth in compensation suggesting that profit margins are narrowing in an already low growth environment. Profits may have moved into negative territory in the first quarter, though preliminary data have suggested that in several recent quarters only to be revised away latter. However, at such low nominal growth, either profits move negative or hiring slows. Bottom line, corporate America will only be an economic driver if they start to release their massive surplus of cash reserves and increasing hiring or capital investment. Purchases of structures slumped in the first quarter as plunging natural gas prices curtailed drilling. Meanwhile, equipment spending was weak as accelerated depreciation tax breaks were cut in half. Capital goods orders suggest more weakness in the second quarter. Only inventory investment has been growing strongly over the past two quarters – accounting for almost one half of real GDP growth during that period. Rising initial claims suggest that firms are adjusting to the fact that growth in real final demand has grown at less than a 2% annual rate over the past two quarters.
Turning Trade to Our Advantage
As a result, the path of least resistance for stronger US growth would come from a narrowing of the trade deficit. While volatile on a month to month basis, net exports have been roughly unchanged over the past year as strong export growth was offset by still rising imports. On the nominal side, it has been higher oil prices that kept imports robust. On the real side, until this quarter, it was imports of capital goods, which got that 100% expensing benefit even though they were not made here (go figure!) In the first quarter, we had a very wide trade gap in January ($52.5 billion) and a sharp narrowing in February ($46 billion), mostly on falling imports. The Commerce Department has estimated a continued narrowing in March (as no actual data is available yet) which left trade with little impact on overall real GDP. As growth in our trade partners has been stronger than in the US, and as price increases for US exports – especially of commodities – has been rising, net exports have stabilized at 2.9% of GDP. Continued slow growth and low inflation here and stronger growth and strengthening currencies in our trade partners seems the most likely path to sustainable growth for the US. True, the 25% share of exports going to Europe is currently depressed. However, some European exporters are shifting manufacturing to the US as lack of access to bank loans is making expansion in Europe much more difficult. Meanwhile, rising labor costs in Asia, especially China, are increasing their demand for American resources — even at higher prices – and slowing the loss of US jobs overseas. So far it has been baby steps, but a narrower trade deficit is the least painful way forward for the US expansion.