Basic (But Dismal) Math - Analyst Blog

Let’s start with the basic definition of GDP (Y). It is equal to the sum of spending by the consumer (C), business investment (I), government (G) and the difference between exports (X) and Imports (M). The last two items taken together are the trade deficit (X-M). Thus the change in GDP, or economic growth, will equal the sum of the changes in each of those items.

The following equation is generally taught in the first session of any macroeconomics course, and in a general economics course, it is generally the second thing that is taught after the “Big X" of the supply and demand curves. Keep it in mind for any discussion of economic policy.

When a politician or pundit says something about the economy on the Sunday morning talk shows, ask yourself how will the policies they are advocating impact C or I or G or (X-M). If they are advocating reducing one of those terms without increasing one or more of the other terms by an equal or larger amount, in effect what they are doing is advocating for a recession.

Y= C + I + G + (X – M)  

The economy had been given an artificial boost through a falling savings rate. That boost lasted not just for a few quarters, or even a few years, but for a few decades. Rising asset prices masked the effects of a falling savings rate, which actually got close to zero before the crisis hit. Now the consumer savings rate is going to have to be rising again, and unless there is robust income growth, the only way that can happen is through less spending.  Less spending = less demand from a sector that is 71% of GDP. In other words, C is headed down.

C was not always 71% of the economy -- back in the 60’s and 70’s it was more like 65% of the economy. The rise in C as a share of the economy corresponded to the fall in the savings rate. Also, spending on Healthcare is for the most part considered C, not I or G, so the rise is in large part due the rise in health care spending as a percentage of GDP, not just due to people buying more big screen TVs.

Well, if there are going to be fewer customers because C is going down and businesses already have lots of excess capacity -- after all, factory utilization is only 71.4% -- businesses don't have much incentive to add to capacity. The same holds true on the commercial real estate front, with very high vacancy rates, and CRE is also a big part of business investment. Thus, don't look for too much of an increase in I. It is the uncertainty of where the customers will come from, combined with the current high levels of unused capacity, that are the key factors in keeping business spending on the sidelines.

Beware Falsehoods

People like the U.S. Chamber of Commerce and the Wall Street Journal editorial page will try to tell you that it is uncertainty about future regulations and taxes. There is no real evidence to support that position. The actual tax burden right now, as measured by tax revenues as a share of GDP, is near its lowest point since the end of WWII. See the graph below, based on data from the Federal Reserve of St. Louis.

If, as the U.S. Chamber of Commerce and Wall Street Journal op-ed types think, that Obama is a "socialist" because over the course of his administration taxes have averaged 15.64% of GDP, then what must they think of Ronald Reagan, who had taxes average 18.69% of GDP during his administration?



As for (X-M), every country in the world right now wants to be running a trade surplus. Absent new trade routes to Mars, that simply cannot happen. Outside of the U.S., the biggest trade deficit countries had been "Club Med," and the recent crisis is forcing them to dramatically cut their trade deficits, since the financing for them to continue to import capital is just not available. Not a lot of help from the (X-M) side is going to be forthcoming.

I would note that about half of our trade deficit is due to our oil bill, so we could make some significant progress if we got serious about using less oil. That would probably require a serious tax on our usage of it, probably in the form of a carbon tax. Command and control measures like higher CAFE standards will help at the margins, but will not make a serious difference. A weaker dollar would help a great deal in helping to reduce the trade deficit and thus increase economic growth.

Government's Role - Like It or Not

Well, by process of elimination, then, if C is not going up, and is likely to go down, causing I to go down from lack of customers, and (X-M) will not improve since every country wants to have a trade surplus and this country refuses to get serious about reducing oil consumption, then the answer has to be higher G. That higher G can either come from higher tax receipts, some of which will come naturally as economic growth resumes, or from deficit spending.

There is no evidence that the markets are having a problem with the current level of the deficit. If the markets were having a problem, then they would be demanding a high interest rate on government debt. I would hardly call the current rate on the 10-year T-note of 2.93% high.

Unless we fall into deflation (which is a real risk), the nominal growth rate of the economy is likely to be much higher than 2.93% over the next 10 years. Thus the current debt is hardly a significant burden.

When Does Government Spending Become a Problem?

Government spending is a call on the real resources of the economy. With the unemployment rate at 9.5% and factory utilization at only 71.4%, it is right now calling on resources that are just sitting idle. Letting resources sit idle is just plain wasteful.

Government spending becomes a real problem, particularly deficit spending, when the private sector needs the resources that the government is using. At that point it becomes inflationary.

But right now, the unemployment rate is not going to go to zero, and factory utilization is not going to go to 100% (it didn’t even during WWII; sometimes machines have to be off line for maintenance). We do not really have to worry about the level of deficit spending becoming inflationary until the level of unemployment drops to a more normal rate, probably south of 6%, and the level of factory utilization at least returns to its long term historical average of 79.2%.

That is the point at which the government will have to go into serious austerity mode and bring the budget into balance, or ideally start to run a small surplus and pay down the debt. The time for that will come, but we are nowhere close to it now.

Not all government spending has equal effects on economic growth. To the extent that government spending is done for projects that have a positive return on investment (ROI), it will do more to help out the economy than simply projects that amount to hiring people to dig holes in the desert and then fill them up again.

There are those who argue that all government spending is, in effect, hole digging and filling. I don’t think the evidence supports that claim, although I do think that a softer form that says on average, government spending tends to have a lower ROI than private investment, is true. Provided, of course, that the private sector will actually make the investment.

However, given high enough levels of economic slack, even dig-and-fill projects would at the margin add to economic growth. The people doing the digging and filling would have incomes that they would spend elsewhere in the economy.

Government Spending & ROI

As a general rule of thumb, money the government spends by giving Lockheed Martin (LMT) a contract to build more fighter jets will have a lower ROI (one has to go to theories of imperialist exploitation, or technological spin-offs to the civilian economy, to get a positive ROI from military spending.  The tech spin-off is plausible, and in some instances large as for example the original defense spending that planted the seeds of the Internet) than contracts with Martin Marietta Materials (MLM) to build infrastructure projects.

Think what would happen to the economy if some of the major infrastructure investments of the past went away, say due to a successful terrorist plot. What would happen to the economy of New York if all of the Hudson River crossings from the Tappan Zee Bridge south (all done with Government investment) were to suddenly disappear?

Spending on basic research, regardless if done by the Pentagon (i.e. the initial funding for what became the Internet) or on the civilian side (for example, research done by the National Institutes for Health) tends to have high ROIs. Spending on education, which improves the quality of the workforce, and hence productivity also tends to have a high ROI.

In an environment where C and I are likely to shrink, the only way Y can grow is for either (X-M) to improve, or for G to grow. Sorry folks, but that is simple second-grade arithmetic, even if many pundits and politicians can’t seem to master the implications of it.
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