Shape of the U.S. Economy in Q2

Gross Output for 2014Q2 is out. Prior post here: GDP Stands For Garbage Data Point.

GDP Stands For Garbage Data Point

This isn't a discussion of China's "man made" GDP number, rather why even if the GDP were measured correctly, it doesn't tell us what we need to know about the Chinese economy, or the American economy for that matter.

How Much Will China’s GDP Continue to Grow?

Many of the reforms will focus on the financial and other services sector, and these areas of the economy are quite likely to expand. The manufacturing sector as a percentage of GDP has remained stable at about 32 percent since the nineties, through a number of economic changes, but it may be affected by a simultaneous expansion of the financial services sector and an increase in domestic consumption of manufactured goods, which will have contrasting effects. The contribution of agriculture to GDP has gradually declined over the past twenty years, and will simultaneously be impacted by urbanization and the commercialization of agriculture. Non-sector specific reforms, such as improving environmental protection laws and improving living standards have a more nebulous effect on the economy overall. The overall goal of these reforms, however, is economic expansion.

Further, we know that the leadership wants to keep growth as high as possible. Even in the face of the current downturn, growth was maintained at levels somewhat higher than expected. The fallout was contained by rolling over debt and clamping down on some abusive financial practices. Essentially, the leadership has imposed a “floor” on how much destruction can be wrought on the economy. To what extent the floor is credible (and how much it matches up with index checks mentioned above) is up for grabs, but in name at least, GDP figures have continued to be buoyant.

GDP should stand for garbage data point. GDP only measures the final sales in an economy. It does not measure debt. We use it because its a rough approximation of the economy, but that's all it is at best. The missing debt is a big problem—GDP increases when debt increases because it boosts final sales. Only when a debt is finally repaid is it clear whether the investment was profitable or not. In part due to rapid growth and in part due to low initial debt levels, China has been able to solve economic problems with more debt. Eventually, this doesn't work anymore—see the U.S., E.U. and Japan. The debts go bad, there are losses and GDP contracts (or grows much more slowly if debts are slowly worked off).

Second, GDP doesn't distinguish between spending. China can spend $10 billion on a car factory or $10 billion on a Mao statue. The impact on GDP in the short-run is the same.

Third, the economy is far larger than GDP lets on. Since GDP measures final sales, it doesn't measure intermediate transactions.

Here is Mark Skousen on gross output: Beyond GDP

In limiting itself to final output, GDP largely ignores or downplays the “make” economy, that is, the supply chain and intermediate stages of production needed to produce all those finished goods and services. This narrow focus of GDP has created much mischief in the media, government policy, and boardroom decision-making. For example, journalists are constantly overemphasizing consumer and government spending as the driving force behind the economy, rather than saving, business investment, and technological advances. Since consumer spending represents 70% or more of GDP, followed by 20% by government, the media naively concludes that any slowdown in retail sales or government stimulus is necessarily bad for the economy. (Private investment comes in a poor third at 13%.)

.......In short, by focusing only on final output, GDP underestimates the money spent and economic activity generated at earlier stages in the production process. It’s as though the manufacturers and shippers and designers aren’t fully acknowledged in their contribution to overall growth or decline.

Gross Output exposes these misconceptions. In my own research, I’ve discovered many benefits of GO statistics. First, Gross Output provides a more accurate picture of what drives the economy. Using GO as a more comprehensive measure of economic activity, spending by consumers turns out to represent around 40% of total yearly sales, not 70% as commonly reported. Spending by business (private investment plus intermediate inputs) is substantially bigger, representing over 50% of economic activity. That’s more consistent with economic growth theory, which emphasizes productive saving and investment in technology on the producer side as the drivers of economic growth. Consumer spending is largely the effect, not the cause, of prosperity.

Manufacturing is the leading sector of the economy. When there is high savings and investment in capital goods, the future growth rate of the economy increases. When investment growth slows, the future growth rate of the economy will slow. In a free market, this adjustment is signaled by changes in interest rates—investments become unprofitable as rates rise. China suppressed interest rates and its currency in order to drive savings and investment higher than would be the case in a free economy. They imposed austerity on the public. At some point, I think the 2008 stimulus is a good one, investment became capital destructive. There's only so much investment that is profitable and when the marginal cost exceeds the marginal return (when businesses have a clean interest rate signal that shows the cost of debt exceeds the return on investment), investment should fall and consumption should rise. In China, this signal was incredibly distorted by government intervention and trillions of dollars worth of capital may have gone into bad investments.

Consider the U.S. growth rate in nominal GDP versus gross output. Which one is a better representation of the economy? Gross Output (GO) is more volatile than GDP, showing the major contraction that takes place all along the supply chain that is completely missed by GDP.

Now let's look at gross output by industry. Suddenly the retail sector doesn't look as important, does it?

Here is the problem if you're talking about an economic rebalancing. If the manufacturing sector in the U.S. declines by 5% and it is 20% of gross output, that results in a 1% drop in GO. In order for retail to offset that drop, it would need to increase at 20%, since it is only about 5% of GO. Skousen in the snip above measures consumption at about 40% of GO for the U.S. Now imagine the Chinese economy, where consumption is already smaller than 40% as a portion of GDP. How much smaller is it as a portion of Chinese GO?

Chinese consumption can grow rapidly because it is a smaller number to begin with, but in order to offset a slowdown or decline in the rest of the economy, it needs to grow that much faster.

Unfortunately for China, income growth has to come from somewhere and the large debt burden will slow income growth because an increase portion of national income will need to be redirected to debt servicing. As Pettis states elsewhere in the piece linked to below, the only way he sees rapid GDP growth in China would be if the state and the party paid for the bad debt by privatizing much of the economy.

Here's Michael Pettis: Bad debt cannot simply be “socialized”

4.There is a lot of confusion over how the implicit amortization of unrecognized losses takes place over time. Let us assume that an investor borrows $100 to invest in a project that creates only $80 of value. The project, in other words, creates a loss of $20. If the loss is not immediately recognized, there is a gap between the true economic value of the debt servicing cost and the increase in productivity associated with the project. This gap must be covered by implicit transfers from some other part of the economy, and these transfers reduce the economic activity that would have otherwise been created.If the gap is covered by financial repression, for example, (i.e. the authorities force down the borrowing cost to less than the increase in productivity generated by the project, so that the borrow shows a profit), the cost of amortizing the loss is passed onto the net lenders (usually, but not always, the household sector, who are net lenders to the banking system) in the form of a lower return on their savings. This lower return reduces their total income and, in so doing, reduces their consumption, which effectively reduces future GDP growth by reducing demand.

5. GDP growth is only artificially boosted during the period in which the total amount of losses rolled over exceeds the amount of the amortization. After that GDP growth is artificially constrained. When the system is still accumulating and rolling over losses, in other words, GDP growth is systematically biased upwards. When it stops, GDP growth will be systematically biased downwards.

As soon as credit growth stops, the bad debts will be revealed and total income will fall. There is no way to avoid paying this cost. It can be paid by currency devaluation, by inflation, by direct losses and bankruptcy by borrowers, by bond and equity investors, by privatizing state assets, but it cannot be avoided in aggregate.

The Chinese economy cannot grow real GDP rapidly if there is a large amount of bad debt. Bulls can argue that the bad debt levels are overstated and that the economy is healthier than it looks, but anyone who accepts the potentially large debt and malinvestment in the Chinese economy cannot expect high real GDP growth. High nominal growth with high inflation is possible (and therefore slow real growth), but not high real GDP growth, not without increasing the credit bubble further. Since credit growth is slowing naturally due to high debt levels, odds are a major increase in credit growth will require some government intervention to force credit down the throats of unwilling banks or borrowers, the end result of which will be even more malinvestment and an even bigger crisis in a couple of years if high inflation doesn't ignite a crisis sooner.