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GDP report worse than it seems

January 28, 2005

Today's report on fourth quarter GDP came in slightly lower than expected at 3.1% annualized real growth versus average estimate of 3.5%. A sharp (10.3%) increase in business investments and a continued increase in private consumption and inventories contributed to the increase while government consumption and residential investments slowed and net exports deteriorated. The increase in the personal savings rate that occured despite a rapid increase in personal consumption was entirely a result of the temporary factor of Microsoft's extra dividend of $30 billion (Roughly $25 billion went to U.S. households, the rest to state and local governments and non-Americans).

Yet the fact is that the report is weaker than it looks as it underestimates the drag from the increase in the trade deficit. The trade gap in October-November were $116.3 billion or $174.5 billion at a quarterly rate versus $153 billion in the third quarter. A increase of $21.5 billion in a quarterly $3 trillion economy would imply a annualized drag of 2.9%:points, yet the GDP report only estimates the negative effect to 1.7 %:points. This is partly due to the perverse logic in modern GDP accounting that nominal GDP increases should be deflated with the increase in export prices (as well as domestic sales prices) but not with the increase in import prices. That is with the increase in the prices of what Americans sell not with the increase in the prices of what Americans buy.

But this does not make any sense because people don't get richer if the prices of what they sell fall (quite to the contrary!) as this "logic" implies, but they do get wealthier if the prices of what they buy falls. Thus, nominal GDP increase should be deflated with the increase in the gross domestic purchases index which increased 2.7% as compared to the 2% increase in the GDP price index. This would mean a GDP increase of 2.4% rather than the 3.1% which were reported. Moreover, this report assumes a sharp fall in the December trade gap since they have calculated the total deficit in the third quarter to $171.9 billion ($687.5 billion annualized). This would imply a December trade gap of $55.6 billion, not only lower than the record $60.3 billion in November but also lower than the October $56 billion. While it may be likely that the deficit will fall from the record level in November, it seems unlikely that it will fall that much, particularly since most countries who have already reported on the December trade balance have seen their surpluses increase implying a lower likelyhood of a fall in the U.S. trade deficit.

So, unless the trade deficit falls below its October-November average and/or there is a upward revision of domestic demand, GDP will have to be downwardly revised further. Together with the adjustment for the worsening U.S. terms of trade, it implies that real GDP growth was more like 2% than 3.1%

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