April 27, 2012

GDP Primer

April 27, 2012

GDP Primer

The past two weeks have shown some weak fundamentals, and there is a massive fiscal problem brewing.

If GDP does not start increasing at something at or above 4.5% for several years, the debt service on the national debt will consume a large portion of Treasury receipts.

And unfortunately, politicians are more interested in reelection that fiscal sustainability. Example: 63.5% of the national debt has been created since 2001.

GDP for 1Q2012 was 2.2%. This is the first of three readings, released today.

So let’s look at what comprises GDP.

Economists define GDP by the equation GDP = C + I + G + (X-M).

C is private consumption. It includes food, rent, medical care and consumer goods. It does not include home purchases.

I is capital investments. This is the confusing part of GDP but it is important because investments are what make for the GDP of the future.

This is new plants and other commercial real estate constructed by business. Capital expenses of business include things such as software. With the change from a goods producing to service producing economy this is significant. Buying stocks or mutual funds is not a capital investment. That is savings or transfer. If, for example, you buy Facebook’s IPO, part of your money might have become part of “I” if Facebook makes capital investment in servers. If you buy a share of Facebook there is no contribution to I. You are transferring your savings to Facebook’s accounts. Putting money into a mutual fund may be regarded by you personally as investment but it does not contribute to the Investment part of GDP. If you buy an existing share of stock you might call it an investment but someone sold that share of stock so the net change in “I” is zero.

Also included in I is business inventory buildup. If you have been reading the monthly analysis of GDP by Rick Davis you will recall that the change in business inventories has been a significant part of GDP growth.

One part of I which has been hurting is residential construction. This part of overall investment tracks the construction of housing, not the sale of homes. A new home that is built during a given period is counted in that period’s GDP. The GDP for the purchase of an existing home was counted in the GDP of the year it was constructed and is not recounted in any year in which it is resold. Counted here is the construction of multifamily as well as single family homes. Home improvements are also counted in GDP in the quarter in which the money is spent.

From my personal perspective this discussion about stock purchasing not being part of I is significant. I have always regarded daily reports of the movement of the Dow as missing the point. Yes, a higher Dow increases net worth but it is the IPO’s which create companies and it is the dollars spent by those companies which become I and the wages paid which become C. Stock markets are important because they make equity liquid and, by doing so, increase equity values above where they would be if those equity positions took longer than a few seconds to sell. I am somewhat beating this to death to make the point that the expression “investments” in GDP is not the same as “investments” used to describe a consumer’s buying stocks.

G is government spending. This is more or less everything that governments spend expect that which is a transfer from a fund . Such transfers would include social security, unemployment compensation or worker’s comp. Those transfers are not part of GDP. They do become part of GDP if the people receiving them convert them to C.

X is gross exports.

M is gross imports.

The recession hurt C and G. I seems to be waiting for something to happen. There is still a massive amount of excess reserves parked at the Fed. This is money which has the potential to become I.